Corporate health risks

Whilst the presentation of the government’s financial plans in many countries is often a dry affair focused on the impact of the fiscal measures on public finances, it is increasingly used as a showpiece political event in the UK as the government tries to put the rosiest possible spin on tax and spending measures. Not only does the UK budget generate a lot of commentary and analysis ahead of the event, but the sheer volume of the material released on Budget Day means that it often pays to avoid instant commentary as the full implications of the measures percolate through. The Office for Budget Responsibility’s Economic and Fiscal Outlook alone represented 222 pages of detailed analysis of the UK’s economic situation, covering everything you might want to know (and a lot that you don’t), and there is a lot more besides.

By general consent, Wednesday’s budget was a “spend now, tax later” affair in which the government plans to continue providing a significant amount of economic support in the near-term but intends to pursue a more aggressive fiscal tightening beyond 2023. Indeed, the fiscal expansion measures over the next two years are offset by a planned fiscal tightening over the following three years and by 2026 the ratio of tax revenue to GDP is projected to reach its highest since the late-1960s (chart 1). The fact that the majority of the fiscal tightening falls on tax increases rather than spending cuts is a recognition that it will be politically difficult to repeat the austerity measures that were implemented in the wake of the 2009-09 recession. Indeed, I have been pointing out for some years that planned cuts in corporate taxes were putting an unnecessary strain on the budget deficit.

The impact of raising corporate tax rates

The primary tax measure announced in the budget was a rise in corporate taxes from the current rate of 19% to 25% in 2023 which would leave it in the middle of the range of a group of 37 countries, rather than significantly below (chart 2). This flies in the face of the low tax orthodoxy espoused by successive Conservative governments over the past 40 years and represents the first increase since 1974, when it was raised from an already-high rate of 40% to an eye-watering 52%. This week’s announcement was driven by two factors. First, in its 2019 manifesto the Conservative party committed to not raising income tax, national insurance or VAT rates, leaving it with few alternatives. Second, there has been growing disquiet in recent years that efforts to slash corporate taxes meant that many companies were getting off lightly at a time when individuals were bearing the costs of austerity.

The OBR highlighted that although the tax rate has been slashed sharply over the years, the share of corporate tax receipts in GDP has fluctuated in a narrow range centred around 3%. This reflects the fact that the tax base has been widened over time, thus offsetting the revenue-dampening effects. In theory, applying higher tax rates to a wider base ought to significantly increase revenue. One concession applied to the latest package is that companies generating less than £50k per annum in profits will continue to pay a tax rate of 19% with a graduated scale applicable on profits above this limit, to a maximum of 25%. The government reckons that 70% of companies will continue to pay a rate of 19%. The fact that the remaining 30% will contribute an extra £20bn in taxes by 2026 compared to estimates made in November (an increase of 31%) suggests that larger companies will be hit hard. Fears expressed in EU circles that the UK would embark on a regime of tax competition to undercut companies in continental Europe appear to be unfounded.

But tax increases have consequences. In the first instance, companies that may be considering whether they need to continue operations in the UK after Brexit may use higher taxes as a reason to move elsewhere. In addition, curbs on corporate profitability may have adverse effects on job creation in the medium-term. Moreover, expectations of reduced future profitability will depress the capacity to pay out dividends, fund buybacks and pay down debt, not to mention reducing the net present value of corporate earnings. All of these factors might be expected to depress UK equity valuations relative to other markets. Raising taxes will, other things being equal, also reduce the capacity to fund capital investment.

Pros and cons of generous investment allowances

In order to offset the worst of the investment problem, the government unveiled a generous two-year temporary capital allowance covering the fiscal years 2021-22 and 2022-23, in which companies will be able to offset 130% of investment spending on eligible plant and machinery against profits. The evidence does suggest that such measures have a stimulatory impact on investment since they reduce the user cost of capital (the tax-adjusted marginal cost of capital). Moreover, tax incentives tend to have a bigger impact on long-lasting assets. At a time when the UK is keen to encourage the switch away from combustion-engine vehicles, which will require significant investment in the infrastructure to support the adoption of battery-powered vehicles, the tax breaks could give this particular project a big shot in the arm.

However, temporary tax breaks suffice only to shift the timing of investment projects rather than leading to a permanent increase. The OBR’s forecast indeed suggests that a big investment surge in 2022 will be followed by only a moderate increase thereafter. Between 2007 and 2016, business fixed investment increased at a paltry annual rate averaging just 1.6%. Between 2016 and 2019, in the wake of the Brexit referendum, it barely increased at all and despite the budget measures introduced last week the OBR’s projections point to growth of just 0.8% per annum between 2016 and 2025 (chart 3).

Moreover, there are particularly high levels of uncertainty at present which run the risk that efforts to stimulate investment may not have the desired effect. Incentive measures presuppose that there is a lot of investment waiting to be brought online. As MPC member Jonathan Haskel noted in a speech yesterday, “residual uncertainty and risk aversion over the recovery are likely to continue to weigh on investment,” particularly in the wake of Brexit. There is also a lot of spare capacity in the economy at present – my own estimates suggest that the output gap this year is likely to average -2.6%, narrowing to -0.7% in 2022. In addition, the tax incentives are only useful if companies generate a profit. In the post-pandemic recovery phase profitability may remain under pressure, although to mitigate this effect the government has extended the loss carry back rules which allow companies to offset past trading losses against profits.

Whilst efforts to boost investment are welcome, one of the drawbacks associated with the tax allowance is that it is aimed squarely at tangible assets but there is no incentive for investment in intangibles which is a problem in an increasingly digital economy. This may continue to act as a drag on multifactor productivity, which in the past decade has posted its slowest growth in a century, which will in turn hold back potential GDP growth. 

Last word

When asked last year whether I expected the Chancellor to announce fiscal consolidation measures in 2021, my response was “it is likely that some form of fiscal consolidation will be announced in 2021 though may not necessarily be immediately implemented.” This expectation has been borne out. It was inevitable that corporates would be asked to shoulder a bigger part of the fiscal repair bill and the government has tried to sweeten the pill by offering generous investment allowances. But the strategy does represent a risk to the health of UK PLC. Like many aspects of budgetary policy, however, we will only know the outcome many years from now.