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Andrew Smithers founded Smithers & Co in 1989. He is a regular financial commentator, columnist, and author
The way to boost growth, and it’s probably the only way that will work in practice, is to reduce the net revenue derived from Corporation Tax (CT) either by cutting the rate or, for a quicker impact, by subsidising tangible business investment.
CT is not a tax on shareholders; it is a tax on investment. We know this because we have 224 years of data on the return shareholders have received from holding US equity and it has no relation whatever to the level of CT, as Figure 1 shows.
As paying CT doesn’t reduce the return to shareholders, it can’t reduce profits unless the value of corporate equity falls when the tax is increased. Shareholders become poorer if the assets their companies own decline in value and respond by sacking managements, so managements respond to higher levels of CT by cutting investment, which slows the speed at which the economy and the incomes it generates grows. Old equipment is less efficient than new because the technology involved has improved. The faster new equipment is introduced the quicker wages advance and, as the efficiency of the old equipment is unchanged, profits fall as wages rise and the speed at which old equipment becomes obsolete accelerates.
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Companies will not invest if such action reduces the value of their assets but will respond positively if they expect good returns. Investment will thus be depressed by increases in CT and boosted when it is cut. But the return on equity does not change as CT alters, so the rate at which the equity capital stock rises varies with changes in CT, without altering the return on equity. More capital results in faster growth, so the rate at which the economy and its stock of equity capital changes varies with the level of CT. The increased growth allows profits to rise, but only in proportion to the increase in the equity, because the amount by which profits grow is limited by the speed at which wages rise. The rates of obsolescence and depreciation therefore change with the level of CT.
A simplified account of how a cut in CT accelerates growth is as follows:
Step 1 is a cut in CT which increases investment as companies will expect to pay less tax and thus receive a higher return.
Step 2 is that the stock of capital rises as more capital is added through the extra investment.
Step 3 is that some old capital is scrapped as labour is shifted to operate the new capital, which is more efficient than earlier vintages, which become obsolete. The existing stock of capital thus becomes more efficient, and depreciation increases with the additional scrapping.
Step 4 is that wages rise as the new jobs must pay more to attract employees away from their previous jobs. Companies don’t expect, quite reasonably, that wages will rise if they, individually, increase investment. Wages only rise if many companies increase investment. Companies may expect this, but they will still invest when CT falls because their profits will fall if wages rise unless they install more modern and efficient plant.
After all four stages, a higher proportion of national income has been invested and wages, profits and depreciation have risen. The supply of labour is unchanged, so wages per employee rise, but the amount of equity capital increases proportionately so the return on it is unchanged.
This account makes the assumption that all improvements in productivity require more tangible investment, which is known as hard-baked clay technology. It is possible for advances in technology to result in higher productivity without more physical investment, which is known as putty-putty technology. Assuming that some growth does not need tangible investment is thus a simplification, but it does not alter the conclusion that a reduction in CT will cause more tangible investment and accelerate growth. This is because growth caused by putty-putty technology will happen anyway and growth will still accelerate if there is more tangible investment. Cutting CT is therefore the way to boost growth and, as numerous failures to do so by other means have shown, probably the only way to do so in practice.
I can’t produce a chart comparable for Figure 1 for the UK, because the necessary data are not available before 1997, and what are published seem incomplete.1 But we do know that business investment fell by 25 per cent of GDP in the seven years after Gordon Brown doubled the effective rate in 1997. Between 1973 and 1997 a withholding tax on income called Advanced Corporation Tax (ACT), which was levied at the same rate as CT, was deducted from dividends. It cost companies nothing; they paid the dividend and not the ACT, so the cost was independent of the tax rate. The level of ACT had no effect on corporate cash flow.
ACT seldom cost the shareholders much either. It was reclaimed if they were pension funds or charities and offset against any liability they might have to income tax. It was, however, treated in companies’ tax returns as if it was a form of CT, and allowed as a deduction against their liability to pay it. Press comment at the time shows that it was generally assumed that companies, from whom the tax was collected, had borne the cost. As they didn’t, the result was that the effective tax rate of CT varied with the dividend pay-out ratio. In 1997 the CT rate was 32 per cent, so companies which paid out 50 per cent of their profits as dividends paid CT on only half their profits and their overall rate was 16 per cent.
It was the name ‘ACT’ that caused the confusion. Most economists and financial journalists assumed that it was a form of CT – they assumed that the name on the tin described its contents. But ACT wasn’t a form of CT: it was a withholding tax on income like PAYE. For the 24 years it lasted, ACT roughly halved the effective rate of CT. The result was that 1973 to 1998 was the only post-war period when Britain outperformed France and Germany. The UK underperformed both before and afterwards, as Table 1 shows.2
France and Germany have very different ways of taxing corporate profits than the UK. Only when ACT existed was corporate taxation in the UK less damaging to its economy.3 It is not possible to compare the data because those for the UK are only available since 1997, but it appears that France and Germany have habitually had lower effective rates of CT, have grown faster than the UK and invested more in business plant and equipment, with the exception of the years in which ACT applied in the UK.
ACT boosted growth because it reduced CT and encouraged tangible business investment. The result was that by 1997 the UK compared favourably with the US as well as with France and Germany. As Figure 2 illustrates, tangible business investment, as a percentage of corporate net output, was one percentage point greater than in the US but, after ACT was abolished, it had fallen to four percentage points less by 2010.
The impact of the abolition of ACT was so misunderstood at the time that it was generally vilified, not because of its effect on investment and growth, but as a “raid on pension funds”, which it wasn’t; their short-term returns continued to vary with share prices and their long-term returns were unaffected.4 The low level of discussion which accompanied the introduction and abolition of ACT demonstrated that many economists, actuaries and financial journalists had a profound misunderstanding of macroeconomics and there is, sadly enough, little evidence that there has since been much improvement.
The level of public debate on macroeconomics today resembles that on medicine in the 18th Century, when doctors were probably more deadly than the diseases they sought to treat. I am not therefore praising either Anthony Barber for introducing ACT or blaming Gordon Brown for abolishing it. Neither they, nor their Treasury advisors, knew what they were doing. They were not being stupid any more than were 18th Century doctors; in both cases the problem was ignorance and it was the type of ignorance which is the kind most difficult to change. As Keynes wrote “The difficulty lies, not in the new ideas, but in escaping from old ones, which ramify, for those brought up as most of us have been, in every corner of our minds”.5
Both tangible and intangible investment can be increased by subsidies. Both in the UK and the US the intangible type has been far more heavily subsidised. The US introduced a credit subsidising corporate expenditure on research and development (R&D). The amount companies claimed to spend on R&D then rose from 16 per cent of the amount they spent on tangible investment to 70 per cent now, while the trend growth rate of the US has slowed sharply.
Persisting with a policy and expecting the outcome to change has been called a form of insanity. Subsiding intangible investment has failed to raise the rate of growth, which we desperately need. We should change policy and subsidise tangible investment.
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The ONS seeks to help, but the published data series (CPRN) does not provide the revenue raised. “Unfortunately, we do not publish any breakdowns of this top level measure.”
GDP is measured at purchasing power parity, but the conclusion is the same if measured at current rates and either per head or in total.
In France the effective rate of CT is reduced by the precompte mobilier and in Germany most companies are Gesellschaft mit beschränkter Haftung (gmbh) rather than Aktiengesellschaft (AG) and not subject to CT.
Those who misunderstood the impact included the actuaries, who advised Chancellor Gordon Brown that pension funds would suffer a £67 billion loss of the actuarial value of their assets as a net result of a combination of policies including the ACT change.
Preface to The General Theory of Employment, Interest and Money (1936) by John Maynard Keynes Macmillan.

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