This article provides perspective on why the CBO's estimates of economic impact are not likely to be correct. Once again, you cannot trust what you hear from the CBO, talking heads, media, and politicians.
The Labour party has proposed increasing corporation tax to 26%, from its current rate of 19%, and in contrast to the government’s proposed reduction to 17%.
Labour claims that this will raise around £20 billion to fund various spending commitments.
On a simple mathematical basis, that looks about right. The Treasury estimates that a 1% increase in the corporation tax rate would raise about £2.3 billion. Multiply that by Labour’s proposed 9% increase and allow for inflation until 2021 when they propose to implement it, and £20 billion looks reasonable.
The problem is that the economy and business do not remain static while politicians fiddle with the tax rates. People and companies react to changes; and the bigger the change is, the more they react.
A 9% increase in tax rates therefore is highly unlikely to raise nine times as much as a 1% increase.
Higher rates, lower revenues
One thing that is increasingly well evidenced is that higher tax rates generally result in lower than expected revenues.
This is not just shown by the outcomes of previous tax changes, but is also what we would expect from people reacting to tax changes. When tax rates are increased, the return on investment is reduced, so there will be less investment and therefore less growth. If investors and entrepreneurs will see less of the rewards, there will be fewer new businesses started up, less investment in expanding existing businesses, and fewer international businesses deciding to locate in the UK.
The effect of this is difficult to quantify, but to get an idea we can look at the time when corporation tax was last at the 26% proposed by Labour. That was in 2011/12, and the tax at that level raised around £41 billion. Add on inflation and that would be around £44.5 billion today. However in fact, with the rate cut to 20%, the tax revenues have now soared to almost £50 billion a year.
Although the rate is now significantly lower than it was in 2011, the corporation tax collected is actually higher because the lower tax rates have encouraged companies to set up or expand, or to set up operations in the UK.
If that trend continues, the government’s proposed 17% might raise around £52.5 billion, £8 billion more than it raised when rates were last at Labour’s proposed 26% (all figures at today’s prices).
Assuming that trend works the same in reverse, the proposed rate increase to 26% would be expected to reduce corporation tax revenues by £8 billion, not increase them by £20 billion, as the UK becomes a less attractive place for business investment.
Who bears the pain of corporation tax?
This is not just an abstract matter of changes in an index of GDP. Nor is it merely a question of whether investors see the value of their investments fall. The effect will be real and wide-ranging, because any reduction in investment means fewer jobs, and less well-paid jobs, as companies reduce investment and try to cut costs in response to higher taxes.
The Institute for Fiscal Studies responded to Labour’s proposal by saying that “taxes are paid by people” and so corporations do not actually pay tax. They have been criticised for that by supporters of higher taxes, with one saying the IFS is “so obviously factually wrong … companies are separate legal persons … only they can pay the corporation tax a company owes”. However that criticism confuses the practicalities of “paying”, transferring money to the tax authority, with an economic concept of payment in the sense of bearing the burden of the tax.
The truth behind the IFS claim is that people, rather than companies, suffer the burden of corporation tax. Either the company has less wealth (so the shareholder bears the burden), or the company increases its prices to keep its after-tax income the same (so the consumer suffers), or wages are reduced, staff are laid off and new staff are not hired, to cut costs and maintain the same after-tax income (so the workforce bears the pain).
In practice there is a combination of the three. However, in an open, free economy, there is usually not much scope to increase prices (the business would become uncompetitive), and if shareholders see too much of a cut in their returns then they will invest elsewhere. That means that the main pain of increasing the corporation tax rate falls on the workforce, as the company seeks to cut costs to maintain its after-tax profits.
And not just the company’s employees that lose out; some of the main losers are young people trying to find their first jobs, only to discover that few companies are hiring because they have cut back on their expansion plans in the face of higher taxes.
Pretty much all economists are agreed on this; the only question is how much of the burden of a corporation tax rise falls on workers rather than shareholders or customers. However a major study by Oxford University’s Centre for Business Tax concluded that a rise of £100 in corporation tax would reduce wages by £75, through a combination of lower wages and fewer jobs. Some studies have found even higher tax burdens on the workforce, others lower, but the Oxford study is one of the largest.
If 75% of the burden of increasing the tax rate falls on the workforce, that means that Labour’s proposed £20 billion a year from extra corporation tax receipts would reduce wages by £15 billion a year.
With average private sector wages of just under £26,500, that cut in companies’ salary bills is equivalent to over 565,000 jobs.
Knock-on tax losses
If wages are reduced by £15 billion as companies react to higher corporation tax rates, that will also reduce the government’s income tax and national insurance receipts.
On that average private sector wage of £26,500, the government would expect to take around £7,720 through income tax and National Insurance. That means the lost wages of £15 billion could see a fall of £4.4 billion in the Treasury’s revenue from employment taxes.
Would the fall in wages happen as well as the fall in corporation tax receipts? Yes, it could, because they are two results of the same process.
As tax rates are increased and companies invest less, because the after-tax rewards are lower, two things happen; company profits are lower, so there is less to tax, and also there are fewer jobs and those that remain are less well paid.
The effect then is potentially disastrous for the Treasury; lower company profits to tax and less employment taxation. Plus of course the additional welfare costs; benefits for those who are unemployed because of the reduced investment, and in some cases higher tax credits for those who are still in work but on a lower income.
With a potential loss in corporation tax receipts of £8 billion and lost employment taxes of £4.4 billion, the government could be looking at a potential loss of over £12 billion of tax revenues, if this policy were implemented, not to mention the huge financial, social and personal cost of a possible 565,000 people losing (or failing to find) jobs.
The fact is that, although very important to the company, profits are a tiny part of what companies do; far more important are the goods and services that they provide and the employment opportunities they create. Over-taxing those profits, which may only be a few percent of turnover, risks losing all the other advantages.
Although taxing companies looks like a painless way for the government to raise money, it is far from that; the pain of lost taxes and lost opportunities can be large and widespread.
 That figure is based on HMRC data for tax revenues in the later part of 2011/12 and the early part of 2012/13, because corporation tax is mostly paid in the following year.
 It is now reduced further to 19%, but because of the timing of when corporation tax is due, the first tax payments under the 19% rate will not be due until the end of 2017.
 Source: HM Revenue & Customs – receipts.
 “The Direct Incidence of Corporate Income Tax on Wages”, Arulampalam, Devereux & Maffini, Oxford, 2009.
 National Statistics, “EARN02 – average weekly earnings by sector”, January 2017 (latest finalised data