It has been the stated policy of the United Kingdom's Conservative-led coalition government "to create the most competitive corporate tax regime in the G20." Chancellor of the Exchequer George Osborne reiterated this policy -- expanded to include all noncorporate business -- in his 2012 budget speech delivered on March 21.
The flagship provisions of the policy are a large reduction in the corporate tax rate, exemption of most foreign profits from tax, and the introduction of a patent box. But these high-profile tax cuts have been accompanied by offsetting tax increases on business and -- by far the most significant tax change since the new government came to power -- an increase in the VAT rate. How the Conservatives have implemented tax reform has important lessons for U.S. policymakers who are considering the same path.
Tax Cuts and Tax Increases
Conservative Party leader David Cameron became prime minister in May of 2010 by forming a coalition government with Liberal Democrats. The coalition has released three budgets -- an emergency budget in June 2010, a second budget in March 2011, and the latest budget on March 21.
The emergency budget set in motion a 4 percentage point reduction in the corporate tax rate from 28 percent to 24 percent. In each of the two succeeding budgets, the scheduled reductions were shifted downward by 1 percentage point, as shown in Figure 1. The statutory corporate rate, now at 24 percent, will decline to 22 percent by April 2014. Table 1 adds the estimated revenue losses caused by these rate cuts from three budgets for fiscal 2014-2015. The revenue loss for the rate cuts to 22 percent in 2014-2015 is £4.5 billion.
The exemption for foreign dividends and modification of controlled foreign corporation rules were first announced by the Labour government in 2009. In 2010 the Conservative government made the move much more pro-business -- and expensive -- by relaxing the previous requirement that multinationals' interest deductions be limited. Adding together the revenue effects estimated in different budgets, the cost of this policy change for fiscal 2014-2015 is about £800 million.
The patent box is simply a reduced rate of tax on income associated with patents. It was originally proposed by the Labour government. Under the latest proposal, the preferential rate of 10 percent will be phased in over five years. The government estimated that when the rate is fully phased in, it will reduce revenue by £1.1 billion. Table 1 shows the revenue cost of £550 million at the halfway point of the phase-in. (For a discussion of the patent box rules, see Tax Notes, Dec. 12, 2011, p. 1307.)
Figure 1. U.S. and U.K. Statutory Corporate Tax Rates
The three proposals combined add up to a corporate tax reduction of £5.9 billion -- about 0.3 percent of GDP in fiscal 2014-2015. To put this into context, total corporate revenues are estimated to be about £45 billion in that same year, which is about 2.7 percent of GDP.
The changes have been warmly embraced by the business community. Over the last few years, several U.K. companies moved their headquarters out of the country. The coalition's tax strategy appears to have stemmed the outflow and even reversed the tide. For example, U.K. pharmaceutical giant GlaxoSmithKline announced that it would build its first new factory in the United Kingdom in 40 years. Everywhere you read that the United Kingdom is "open for business."
But less well advertised than the high-profile cuts are tax increases on large businesses. The United Kingdom has a carbon tax (called the climate change levy) and a North Sea oil tax. Both have been substantially increased since the new government took power. The levy on bank liabilities is designed expressly to obtain the maximum revenue from the U.K. financial sector. It too is a major source of new revenue. These and other major business tax hikes are shown in Table 1. Their positive effects on government revenues more than offset the costs of the rate cuts, the move to a territorial system, and a patent box.
Table 1. Tax Changes Primarily Affecting Large Business
(millions of pounds, fiscal 2014-2015)
Corporate rate cuts -4,520
Territorial and CFC rules -805
Patent box (50 percent phased in) -550
Total cuts -5,875
Climate change levy 2,540
Bank levy 2,960
North Sea oil tax 1,105
Insurance tax 830
Total increases 9,235
Taxes on the Wealthy
In its last budget, the Labour government increased the top individual tax rate from 40 percent to 50 percent. After the 2010 election, the new cash-strapped government assented to the change but asserted that the 50 percent rate would be only temporary. Businesses complained that the high rate was scaring away mobile, talented professionals and lobbied hard for a reduction. Osborne agreed and cut the rate to 45 percent in the 2012 budget.
That is an easy-to-understand tax change and has grabbed a lot of headlines. But it would be a mistake to interpret the provision as signifying that the U.K. government is coddling the rich. Overall, it has raised taxes on the wealthy, as shown in Table 2. Since May 2010 the government has increased from 18 percent to 28 percent the capital gains rates paid by upper-income taxpayers, and it has increased the tax on wealthy foreigners living in the United Kingdom (non-domiciled residents). In the latest budget, there are increases in stamp duties (mostly on purchases of expensive homes) and a new limitation on income tax benefits for high-income households.
Table 2. Tax Changes Primarily Affecting Upper-Income Households
(millions of pounds, fiscal 2014-2015)
Reduce rate from 50 to 45 percent -100
Increase in stamp duty 290
Limit of tax benefits 490
Increase in tax on non-domiciliaries 70
Capital gains tax 835
VAT Rate Increases
Besides the aforementioned tax changes, there are many other moving parts in the tax reshuffle over the last two years. In addition to the tax cuts for big businesses, there were tax changes that primarily benefited small and midsize companies like the 2010 reduction in the employer contributions for social insurance and the 2010 reduction in the small business tax rate. The government has also provided significant relief from individual income taxes. That came primarily in the form of increases in personal allowances (the U.K. equivalent of the U.S. personal exemption). The net revenue impact of the changes is shown in Table 3.
But all this is overshadowed by the largest policy change of all. In its 2010 emergency budget, the new government increased the VAT rate from 17.5 percent to 20 percent. As shown in Table 3, that move, by far the largest tax increase by the new coalition, raised an additional £13.7 billion in fiscal 2014-2015 -- about 0.8 percent of GDP. In the United States, the equivalent amount would be about $150 billion.
Putting all of this together, the bottom line is that since taking power, the Conservative-led government has made tax competitiveness one of its top priorities but has not cut taxes. For fiscal 2014-2015 the net increase was about £7.8 billion, as shown in Table 3. Clearly, the most important contribution to this deficit reduction came from the VAT, and it was the VAT increase that gave the government the fiscal room to cut other taxes.
Table 3. VAT Pays for Tax Cuts and Deficit Reduction
(millions of pounds, fiscal 2014-2015)
A. Other Major Items
VAT increases 13,740
Antiavoidance measures 1,260
Employer contributions to national insurance -3,720
Small business profits -1,400
Personal taxes -7,310
B. Overall Tax Change
2010 budget 8,230
2011 budget 115
2012 budget -520
Total over three budgets 7,825
Is the U.K. Now More Competitive?
There is no one definition of competitiveness. For economists with an academic bent, it usually refers to a policy program that will most increase national income. Because the corporate tax is a major impediment to growth, cuts in corporate taxes generally promote competitiveness. Also, if there must be tax increases -- and certainly this is the case in the debt-ridden United Kingdom -- the least economically damaging method to do it is to expand broad-based taxes on consumption like the VAT. So, looking at the broad brush strokes of U.K. policy, the coalition government is moving in the direction of a more competitive tax system.
For politicians and the press, competitiveness usually has a narrower meaning. Simply put, they equate tax competitiveness with lower taxes on businesses, particularly multinationals. If you just look at the headline changes, the United Kingdom appears to have furthered this goal as well. It has put in place a three-pronged pro-business tax program that U.S. businesses can only dream about: a 22 percent corporate rate, a territorial system with relaxed CFC rules, and a 10 percent rate on income from patents.
But there is a lot more to the coalition's tax program than those three changes, and it is not all rosy. Banks, oil companies, and public utilities are being hit hard with other measures. There are winners and losers, and many of the losers may have wished they had been more careful about seeking a more competitive tax system.
The main lesson for U.S. businesses and their supporters in Congress is that if they want a tax system with more competitive features, they must raise somebody else's taxes -- or perhaps face offsetting tax increases on themselves. Otherwise, all their efforts may not amount to much more than talk. Without some break in the logjam of offsetting revenue increases, they may have to resign themselves to the status quo. And no doubt for some of them -- once they get a glimpse at the reality of a detailed proposal -- that will be just fine.
Notes on the Data
Most estimates shown in tables 1, 2, and 3 are line items or combinations of line items from three sources: HM Treasury, Budget 2012, March 2012, Chapter 2, "Budget Policy Decisions," Table 2.1; HM Treasury, Budget 2011, March 2011, Chapter 2, "Budget Policy Decisions," Table 2.1; HM Treasury, Budget 2010, June 2010, Chapter 2, "Budget Policy Decisions," Table 2.1. Steady-state estimates for the patent box that were originally estimated to be £1.3 billion were subsequently revised to £1.1 billion. The Table 1 figure for territorial taxation includes an estimated £275 million revenue loss for fiscal 2011-2012 (the latest year available) published in the November 2008 pre-budget report. Assuming normal growth, using this figure for an earlier year understates the cost of moving to a territorial system, but not significantly.