The arguments for abolishing Corporation Tax

Over the last few months, I have been incensed by the comments appearing in the UK media claiming that  companies are not paying their ‘fair share’ of the taxation which is needed to fund the infrastructure from which they benefit.  

Protagonists appear to think that corporation tax is the only tax paid by corporations and that it should be pro-rata to sales.

So, how does corporation tax affect the financial health of enterprises and their relationship with the economy as a whole? The answer is that it has an adverse effect on both of the foundation stones of financial management: cash flow and the cost of capital.

Corporation tax

Financial management matches two views of cash flow. On the treasury side, it is seen as ‘distributions minus new financing’ and on the business side as ‘profit minus expansion’.  Corporation tax is an element within ‘distributions’.  You do not have to be a mathematical genius to see that, other things being equal, the higher the corporation tax paid, the lower the levels of expansion.

Like other direct forms of taxation, it is deliberately redistributive and hence penalises success. Money is extracted from businesses that have shown themselves capable of using it well and, as we have seen recently, used to subsidise, or even bail out, those that have shown themselves incapable of so doing.

Bear in mind, however, that the amount of corporation tax paid is normally only a small proportion of the total taxes paid. Take a moment to go through your accounts and tot up how much your company pays by way of fuel duty, road tax, National Insurance, business rates and VAT – all of which help to fund the infrastructure. What a pity it is not shown in the accounts.

However, the greater adverse effect of corporation tax (exacerbated by the income tax borne by shareholders) is its effect on the cost of equity capital, ie to increase it, way beyond the rate that investors seek. If people are prepared to invest for a net return of say 7% per annum, companies need to earn a before-tax return of 12% per annum. Imagine the impact on growth and  employment if all those projects that were rejected because they offered a return of 'only' between 7% and 12% per annum were revived and implemented!

It is only equity capital that is penalised in this way. Interest paid is an allowable deduction in arriving at the profit to be taxed. Hence, companies can (legitimately!) avoid corporation tax by ‘gearing up’ their net returns by borrowing, rather than employing share capital.

The downside

Clearly this discourages the use of equity capital (which is long termist and patient) and encourages the use of loans (which are short termist and fickle).

This is the very opposite of what is appropriate in conditions of uncertainty and risk. The higher a company’s gearing, the more risk averse its directors and managers will be. Equity capital, on the other hand, provides a buffer against short term fluctuations.

It is clear that corporation tax has a significant adverse effect on both the financial health of an individual enterprise as well as on the health of the economy as a whole.