There was a lot of talk in the Budget about the productivity challenge we have in the UK. This is not surprising since, according to a recent McKinsey report, if UK productivity continues to lag behind at the same rate, by 2025 the UK will be nearly one third less productive per hour worked than Germany.
There is widespread agreement about some of the necessary conditions for productivity improvement: long term focus, often linked to continuity of ownership; investment in the workforce; innovation; patient external capital; encouraging productive investment; encouragement of exports. Something that is slightly more controversial, but still part of the consensus, is the idea of wider employee share ownership. Finally, if we are making a comparison to the German Mittelstand, this could be linked to long-term ownership by entrepreneurial families.
So far, so good. However, something that is far less discussed is the question of what the tax system might look like if its incentives were even modestly aligned to these objectives.
Dividend tax rates lower than the CGT rate for the mid-market business?
At the moment, we have Entrepreneurs’ Relief, and this broadly gives a 10% tax rate where business value is realised by sale. If value is realised by dividend extraction the rate is 38%.
So, this is a huge incentive for businesses to be built up in a way that maximises short-term profit, followed by an early sale. Instead, if dividends were the most tax effective way of realising value, the incentive would be to build long-term sustainable profit to support a long-term dividend stream to owners. That could incentivise ownership continuity, investment in the workforce, innovation, and investment in developing overseas markets – all of which tend to underpin long-term sustainable profit, and therefore dividend payments.
The Budget suggested that Entrepreneurs’ Relief was self-evidently a good thing. “Short-term gains relief for passive investors” might be an equally accurate description of how it can operate. This sounds less self-evidently sensible.
Not privileging inbound investment over UK investment?
The proposed ‘digital services tax’ was a step in this direction, but its main target is a relatively small group of giant tech companies.
More generally, inbounds have greater opportunity to manage down their effective tax rates compared to UK business. If inbounds can pay next to no tax, and UK business does not have the same opportunity, that therefore puts UK business at a competitive disadvantage.
Policy should therefore support a systematic levelling of the tax burdens of both UK and inbound investment.
Higher CT rates but super-deductions for investment to increase productivity?
It is an article of faith to some that the way to attract inbound investment and help business is by minimising UK tax rates (and UK regulation).
This does not in any way channel investment towards building productivity. So, instead, it might be better to have higher CT rates but super-deductions for genuine investment in workforce skills, capital investment, and innovation. This would be likely to enhance productivity.
The UK already does this for technical innovation through R&D credits. Businesses that would invest in the long-term productivity improvement would therefore have a lower effective tax rate than businesses which did not.
Ensure productive investment is privileged over rent-seeking?
As a generalisation, tax reliefs for investment in genuine productive business should be enhanced, and reliefs attached to rent-seeking removed.
The recent removal of tax incentives for buy-to-let – which were not available to those buying their own home – is an example of a move in the right direction.
However, why, for example, are venture capital reliefs so fiendishly complex? Why do we give 100% Inheritance Tax Relief to passive landlords of agricultural land?
Better models for employee ownership?
We have a fairly good model for selective employee ownership in the Enterprise Management Incentive (EMI) scheme, although even this tends to encourage early sale.
Our models for collective employee participation in the mid-market sector (notwithstanding the lip service given to the ‘John Lewis model’) are, however, pretty terrible. Essentially, these turn any employee return on investment into earnings taxed at the highest marginal rates of income tax and NIC. There is therefore a significant tax penalty attached to these arrangements. Collective employee participation needs to have access to the same tax treatment as direct owners of shares.
Much of this may seem counterintuitive: higher CGT than dividend rates for the mid-market business; higher headline CT rates rather than lower; better employee share ownership models.
However, it can equally be argued that the current tax system is founded on a set of orthodoxies which turn out, on a closer look, to create economic incentives that work against productivity growth. Valuing the ‘entrepreneur’ or venture capitalist over those whose skills create productive output (engineers, designers, programmers, teachers, etc.); valuing inbound investment over UK investment; a failure to differentiate between productive investment and rent seeking; and a failure to recognise that a successful business is a place of collaboration rather than of conflict.
Time for a change in approach?