Green Budget: Conjuring a solution to the corporation tax conundrum

Those of us who have been campaigning for years for a Green Budget - where "Green" means consultative, as in Green Paper, not environmental as in Green Taxes - we awaited Gordon Brown's statement with huge curiosity.

Would it be like a real budget - a list of proposed measures - but with a built in implementation lag to give people time to argue against measures they hated? Or would it be a list of reform options, like the Institute for Fiscal Studies' Green Budget, with an invitation to interested parties to argue in favour of options that took their fancy? Or would it just be a macro-economic framework with an indication of the amount available for spending plus an indication of the areas of the tax system that the Chancellor was looking at?

In the event we got a bit of all three. The Chancellor promised to consult on North Sea taxes, on environmental taxes, on alcohol and on charities. He indicated, without making concrete proposals, that he was hugely interested in getting the tax and benefit system to motivate people to move from welfare to work. And then he coolly produced a fully worked out and costed corporation tax package which included the abolition of Advance Corporation Tax and a further cut in the headline corporation tax rate. Moreover, he has found a way of making these popular pro-business changes create an increase in government revenue. More on this conjuring trick later.

Corporation tax had to feature prominently in this not-quite-a-Budget because the Chancellor had got himself into a bit of a mess in July, and this was his first opportunity to clear it up. The UK has an imputation system of corporation tax. This is supposed to prevent the double taxation of dividends that occurs if profits are taxed first under the corporation tax system and then again under the income tax system when they are distributed as dividends.

The way it works is that the company makes a tax payment, called Advance Corporation Tax (ACT), which is linked to the distribution of dividends. The Advance Corporation Tax then counts both as a payment on account toward the total Corporation Tax bill, and as a part payment of the income tax bill on the dividend. These arrangements have long been disliked by companies that pay out high dividends, whose advance payments of corporation tax are greater than their total liability - a condition known as Surplus ACT. This can easily happen to international companies headquartered in the UK, who distribute dividends based on worldwide profits, but only have mainstream corporation tax liability on UK profits. It can also happen to companies who choose to signal their long term confidence in the future by maintaining dividends when profits dip in a recession.

The Surplus ACT problem has also afflicted the water companies who were given large capital allowances as a dowry on privatisation and hence have small taxable profits. In his July budget the Chancellor dealt a couple of body blows to the Advance Corporation Tax system. He decided that tax credit paid to pension funds would not be repayable. And he held down the income tax bills of higher rate taxpayers by reducing the rate of income tax applied to dividends. So the link between paying corporation tax in advance and relieving payment of income tax was seriously ruptured then. He has now broken the connection altogether. There will still be imputation - recipients of dividends will get a tax credit, associated with the payment of corporation tax. But it will not be linked to the advance corporation paid when dividend is distributed.

By abolishing Advance Corporation Tax the Chancellor gets rid of the problem of surplus ACT. This will make him popular with the large multinationals and with the water companies. It will continue Labour's love affair with business and will certainly go down better with Mr Blair than with the troops on the back benches.

It also deals with the problem created in the July budget which made it very attractive to use the system of Foreign Income Dividends (FIDs) to reduce surplus ACT. To the extent that this revenue would have disappeared anyway, as companies changed their behaviour to take advantage of FIDs, the abolition of ACT costs less than Inland Revenue calculations, based on constant behaviour, suggest. So it is a sensible reform, which tidies up much of the mess left by the over-hasty July budget. But how has the Chancellor managed to pull off the trick of cutting a tax rate and raising revenue all at the same time?

The answer lies in the arithmetic of early payment. If corporation tax is expected to rise reasonably rapidly over the next couple of years, reflecting buoyant profits in the boom, then bringing payments of corporation tax forward produce an increase in revenues for three years. From a tax- design point of view it is brilliant. Incentives to invest are increased by the lower tax rate, but companies face what is effectively an additional lump sum tax for a few years. Such taxes are always unpopular and sometimes unfair, but they scarcely affect incentives.

So this package of measures, if implemented as announced, will be bad for corporate cash flow. The corporate sector will squeal loudly. But Mr Brown can say with his hand on his heart that this is another budget for investment.

The main reason for this is that he has proffered an olive branch to the international business community. He is right to do so because the multinationals are a footloose breed. They can invest anywhere in the world. If you tax them more heavily in the UK they will do their new investment somewhere else, taking the jobs, the profits and the tax revenues with them.

By abolishing ACT, the Chancellor has made the UK a more attractive environment in which to locate an international company, and a more attractive place to invest.

Bill Robinson is a director

of London Economics