The IoD's View

Profit is the reward for taking business risks and offering consumers the goods and services they really want. It should not be penalised. Taxes on profits should therefore be held down in percentage terms. Rate reductions can actually lead to more money for public services, as economic growth is encouraged.

Key Points

• Profits are subject to income tax and national insurance (for individuals and partnerships) or corporation tax (for companies). Salaries are subject to income tax and both employees’ and employers’ national insurance.
  
  
• The highest direct total burden on each extra pound of profit made by a self-employed individual is 41% (higher-rate income tax plus national insurance). This rate could easily be enough to deter people from taking extra business risks in order to expand their businesses, take on more employees and generate extra wealth. and of course there are vat and other indirect tax burdens to take into account as well. Furthermore, changes announced in November 2008 mean that the marginal rate will be even higher for high-income people in future.
  
  
• Once rate changes over the next few years have been implemented, companies will face tax rates of 22% on profits of up to £300,000, 29.5% on profits between £300,000 and £1.5m, and 28% thereafter. These rates are internationally reasonable, but not particularly competitive. The EU average rate is now 24%, following widespread rate reductions in recent years.
  
  
• a current hot topic is the taxation of foreign profits of multinationals with UK holding companies. In 2007, the Government published proposals to exempt from tax foreign dividends received by UK companies, replacing the current system of taxation with credit for foreign tax suffered. This would be a great improvement, removing large administrative burdens while having little or no effect on tax revenues. But the accompanying proposal to amend the controlled foreign companies regime so that far more foreign profits could be taxed in the UK would have imposed an onerous new burden. Concerns about this new burden have led several groups to consider relocating their holding companies outside the UK. In July 2008, the Government announced a re-think and a continuation of the consultation process. Some parts of the new package should be implemented in 2009, and others later.
  
  
• Tax-motivated incorporations have been a major concern for the Government over the past few years. The “IR 35” legislation on personal service companies, the 2007 legislation on managed service companies and the planned increases in the small companies rate are all intended to address this concern. But the structure of income tax and national insurance, together with the anomalous rules on the taxation of dividends, mean that all of these can only be seen as sticking-plaster remedies. Unfortunately, a thorough-going reform would have huge re-distributional effects unless it was preceded by significant reductions in the rates of some of the taxes involved (which we would favour, subject to fiscal constraints).
  
  
• Governments are constantly tempted to introduce special reliefs. We favour the alternative approach of reducing tax rates for everyone, rather than creating new complexities and distorting the tax system in favour of specific sectors. Governments should not try to micro-manage the economy through the tax system (or in any other way), but should use the tax system only for its primary purposes of raising money and correcting clear externalities.
  
  
• Taxes on salaries are high. The maximum rate is 53.8%, made up of 40% higher-rate income tax, 1% employees’ contributions above the upper earnings limit and 12.8% employers’ contributions – and even higher rates are proposed for future years. In addition, high rates of national insurance mean that a merger of income tax and national insurance would have politically uncomfortable re-distributional effects.

Q & a

Q. Is the reduction in the main corporation tax rate to 28% enough to keep the UK internationally competitive?

a. It helps, but it will not keep the UK ahead of the game. Other countries continue to reduce their corporation tax rates. The EU average rate is now 24%, and a KPMG study of 92 countries found an average rate of 27%. We also have to remember that the headline rate is not the whole story. allowances, particularly for capital expenditure, can make a big difference. The reduction to 28% is being paid for by a reduction in the main rate of capital allowances from 25% to 20%, meaning that relief for expenditure on plant and machinery will be slower than before. We would like to see further reductions in the corporation tax rate.

Q. Do we want the UK to become a leading location for group holding companies, or should we be concentrating on getting the operating companies in multinational groups into the UK?

a. Both are important. Operating companies bring jobs. Holding companies bring some jobs to financial and legal service providers, but they also bring a bias in favour of the countries where they are located. If times are hard and operations have to be closed, operations in other countries are likely to be closed first. Low corporation tax rates particularly help to attract operating companies. Sensible regimes for the taxation of foreign dividends received and for the taxation of controlled foreign company profits help to attract holding companies. The UK needs to be competitive on both fronts.

Q. Why does the Government appear to be pursuing small businesses for extra tax all the time?

a. The Government is waging a constant battle against those who save tax by choosing incorporation, or by choosing the right structure of ownership. In general, small businesses are only making use of the basic structure of the tax system rather than indulging in crafty avoidance. The latest Government concern is income-shifting, where for example ownership of a company is divided between husband and wife in order to make use of both spouses’ personal allowances and basic rate income tax bands against dividend income. Legislation had been expected in 2009, but fortunately the Government has decided not to press forward with this at the present time.

Q. are employees over-taxed?

a. The overall tax burden is certainly very high. The IoD surveyed a sample of 500 members in spring 2007. 78% of respondents agreed that “income tax on employees and national insurance (both employees’ and employers’ contributions) are creating an excessive gap between the cost to business of employing people and the take-home rewards to employees” (The tax system – at a tipping point? IoD, 2007). There is a danger of making it uneconomic to employ the talented and skilled people who are needed for the future health of the UK economy.

Q. Wouldn't the taxation of employees be a lot simpler if income tax and national insurance were merged?

a. Yes it would, but the re-distributional effects would be huge. National insurance raises £100bn a year, compared to £150bn from income tax. If we were to abolish national insurance and re-allocate the amount it raises, with employers’ contributions being replaced by a payroll tax that would be a flat percentage of total payroll, and employee’s contributions being replaced by an increase in income tax, employers who mainly had lower-paid employees would pay more and income tax rates would have to rise by about a quarter, to something like a 25% basic rate and a 50% higher rate. The latter in particular would have a significant disincentive effect. We can only regard a merger as a serious prospect if national insurance rates are first reduced substantially, a process that we favour but that would take several years.

Q. Does the IoD support flat taxes?

a. a flat tax regime would bring huge opportunities for simplification, both in the structure of the legislation and in the day-to-day administration of the tax system. It could also have a considerable positive effect on incentives, so long as the tax rate were low enough. It would however require many years of firm control over the growth in public spending before the UK could implement a flat tax regime with a reasonable tax rate. The first step is to start a programme of tax rate reductions, leading to an ever-flatter structure of tax rates.