The curious incidence of taxing companies

Economic View: George Osborne’s apparent desire to push down the UK’s rate of corporation tax until it disappears altogether doesn’t look so smart

Corporation tax implies less profit for shareholders, less investment, and higher prices (AFP/Getty)

“Guns don’t kill people, people kill people,” argue opponents of gun control in America. Tax economists have their own, analogous, rallying slogan: “Companies don’t pay tax, people do.”

The key word here is “incidence”. What these economists mean is that we should think carefully about who, ultimately, is going to end up bearing the cost of a proposed tax.

Many on the left, such as supporters of the Labour leadership contender Jeremy Corbyn, are in favour of raising corporation tax so companies pay their “fair share” to the Treasury’s coffers. But companies are not individuals with a taxable income in their own right. All their net income, or profits, must in the end flow to the firms’ shareholders. So, in theory, it is shareholders who ultimately bear the costs of corporation tax. And that, by the way, includes all of us who have a pension invested in company shares.

But like a medicine ball dropping on a water bed, the cost of corporate taxation bulges out in other areas too. The Institute for Fiscal Studies points out that corporate taxes, as well as often leading to smaller dividends to shareholders, can be passed on in the form of higher prices for consumers and lower employment by that firm than would otherwise have been the case.

It’s the latter effect that prompts many to label employers’ national insurance contributions (the contributions that firms must make to HMRC on behalf of each employee on the payroll) a “jobs tax”.

The proposed European Union tax on financial transactions is also criticised on incidence grounds. Critics claim it will not ultimately be paid by the hated banks who perform the transactions, but will merely be passed on to the innocent users of the banks’ services.

The theory of tax incidence is the proper guiding principle for politicians, civil servants and anyone in the debate about tax. It is naïve to regard private companies as some kind of a magic piñata which can be endlessly (and costlessly) beaten with a tax stick in order to fund public services and welfare payments.

Nevertheless, it is also naïve to veer to the other extreme and interpret the insight of tax incidence as a clinching argument against any corporate taxation. For a start, we should be wary of assuming we know what the incidence of a given tax will be.

The Independent’s campaign on the airport VAT scam inadvertently highlighted this danger. Our reporters have drawn public attention to the fact that the benefit of the VAT tax exemption for goods sold at airports to people travelling outside the European Union is often effectively pocketed by the vendors, rather than being passed on to customers.

In a truly competitive airport retail market, that benefit ought to flow directly to customers in the form of lower prices. But retail markets in airports, it would appear, are not truly competitive. Believe it or not (and many on the right have trouble accepting this fact) this is sometimes the case outside airport terminals too.

There are times when taxes on companies are justified on other grounds. One instance is when they are used to target “externalities”, or activities that impose economic costs on society in general. The primary purpose of a financial transactions tax, as originally proposed by the Nobel Laureate James Tobin in 1972, was not to raise revenue but to “throw sand in the wheels” of currency speculation, which he held to be responsible for harmful volatility in nations’ exchange rates.

It is true that under the EU Commission’s version of the tax, financial trading in bonds, shares and financial derivatives will be made less profitable for banks. And, yes, they may well attempt to pass on the cost to customers (asset managers and hedge funds) to preserve their profit margins.

But it should also reduce the gargantuan volume of socially useless inter-bank trading of financial securities that takes place by rendering it less lucrative. And as far as the banks’ customers are concerned, it would be a very good thing if it results in less demand for their trading services. All the available evidence suggests that the ultimate owners of shares would benefit from less churn of their portfolios by their designated asset managers.

The UK’s bank levy is another example of a corporate tax that is justified on economic externality grounds. This levy taxes banks based on the size of their balance sheets. The Chancellor, regrettably, watered this down in his most recent Budget to please the powerful banking lobby. But nevertheless, the existence of this tax helps to compensate the state for the fact that these institutions are widely seen as “too big to fail” and receive a de facto lower funding cost in the markets as a result of the assumption that the state would have to rescue them if they got into trouble again. The levy helps to defray the incentive for the managements of these financial institutions to grow their balance sheets still further to capitalise on the de facto state subsidy.

Finally, there are practical reasons for taxing companies directly, rather than recouping the money from individuals when they receive the corporate income as dividends. As the IFS itself argues, corporation tax makes sense because it’s a way of taxing the dividends due to foreign owners of shares in UK-listed companies. It would otherwise be very hard – probably impossible – for the Treasury to tax this income. Given that more than half of the shares in UK-listed companies are now held abroad, up from 10 per cent in the 1960s, that’s clearly a significant advantage. And in that context, George Osborne’s apparent desire to push down the UK’s rate of corporation tax until it disappears altogether doesn’t look so smart.

“Companies don’t pay tax, people do,” is certainly the right starting point for any debate about corporate tax. But it shouldn’t be the last word.