Are corporate tax cuts a good idea

In January 2017 the UK Prime Minister Theresa May and Chancellor Philip Hammond suggested that if Brexit negotiations didn’t go well, the UK might set a ‘competitive’ corporate tax rate for its European neighbours. This brought shocked responses from EU member countries. The UK was threatening to become a tax haven and there was talk of a ‘race to the bottom’ in corporate tax rates.

The reality is that countries now use every tool they have to attract and retain industrial investment. Some view the corporate tax rate as a source of national competitive advantage, so there’s been a tax race to the bottom of sorts going on for decades.

In 1980 the average corporate tax rate (state plus local) for developed economies was just below 50%. Finland and Germany had the highest at 61.5% and 60% respectively, followed by the UK (52%) and the US (50%). Those punishing tax rates were softened by generous tax allowances, but the allowance system was so capricious that many companies paid no tax at all while the rest paid the full rate. The system needed reform.

The UK took the lead on this in the early 1980s, reducing tax rates while withdrawing allowances and widening the tax base. This set the direction for the next 30 years, with the UK corporate tax rate falling continuously in that time. Now at 20%, the figure is set to drop to 17% in 2020 as part of the UK’s aim to have the most attractive tax system in Europe. Finland, Denmark, Sweden, Switzerland and others have all followed suit.

Other countries such as Germany, Japan and the US didn’t follow, at least at first. Those nations perhaps felt confident in their industrial base, believing they were strong enough to charge companies ‘rent’ for being there. Or maybe they were using other fiscal incentives to attract businesses. Whatever the case, Germany finally capitulated in 2001 and Japan more recently still – both now have 30% rates.

Reducing the tax rate doesn’t necessarily reduce revenues – that depends on what happens to the tax base. But you hope that any lost tax revenue will be compensated by greater investment and employment in your economy. For sure, if your competitors all reciprocate then a low tax rate strategy is simply a mutually destructive race to the bottom.

Luck of the Irish

Ireland provides a beguiling example of how a low tax rate can pay off mightily, so long as competitors don’t follow suit. Clearly Ireland has many attractions – the English language, a highly educated workforce and an EU toehold. But tax has to be a major reason why Ireland attracts multinationals, which leads to high-wage employment.

Ireland’s 12.5% corporate tax rate, which has been in place since 2003, is way below any of its major competitors. Moreover, as the recent commission ruling in the Apple case revealed, Ireland was willing to make arrangements with individual companies that could get their effective tax rates down to next to nothing.

Being part of the EU is irrelevant to all this because the union hasn’t tried to harmonise corporate tax rates among its members. When Europe bailed Ireland out after the financial crisis, the obvious demand would have been for Ireland to raise its corporate tax rate to European levels. There was no attempt to do this. This remains one of the most baffling events, or non-events, in recent political economy. The same inability to harmonise corporate tax rates is evident in the OECD’s otherwise admirable BEPS initiative. Read OECD Base Erosion and Profit Sharing.

The US has stuck to its 39% tax rate for almost 30 years. It’s done this despite repeated warnings that such a rate would cost jobs at a time when many of the most successful US corporations were building enormous piles of cash offshore. President Donald Trump has said he will slash the rate to 15%. Never knowingly undersold, the UK now says it will match that.

So as we enter a more fragmented and nationalistic era, the race to the bottom for corporate tax rates will likely continue.