First a disclaimer. Although I’m a chartered accountant I know next to nothing about tax and this article in written from a UK perspective although I expect its lessons for strategy purposes will apply in many parts of the world.
Austerity Cuts & The Tax Debate
The impact of tax on business is an important issue at the moment because of the Austerity Cuts to reduce Annual Deficits.
One alternative to difficult spending cuts is to increase taxation since the annual deficit is the difference between tax revenues received and the public expenditure made.
The Main Taxes That Impact On Business
- Income taxes
- National insurance / employment taxes
- Corporation tax
- Capital gains tax
- Capital transfer tax / inheritance tax
- Value added tax / sales tax
- Excise duties on petrol, alcohol, cigarettes
- Import duties
- Property taxes and business rates
- Specialist taxes e.g. tax on North Sea oil exploration and the Bankers’ levy
The Controversy Of High Tax Rates
There are only three options for assessing tax:
- The poor should pay most of the tax because they benefit most from the government spending
- Everyone should pay a flat rate of tax e.g. 25% of income so the high earners pay more in cash terms but the same proportion
- Tax should be levied on the ability to pay so the high earners and wealthy should pay more tax proportionately than the poor.
That last option is usually the one adopted because of the apparent fairness that tax should be linked to the ability to pay.
But there are two problems which leads to a third problem.
First, the wealthy benefit little from state spending so they’re paying for something that they wouldn’t do in a rational, free world. You don’t eat dinner in a restaurant, get the bill for £85 and say to the waiter, because I earn ten times the average income I’d like you to charge me £850 (or more if you follow the increased proportion logic).
Second, high tax rates have been proven to provide a disincentive to earn more and create wealth. That’s not good for the individual but terrible for the country which desperately needs growth and for businesses to create more employment.
These factors together therefore encourage high earners to look for ways to legally avoid paying tax.
They can do that through:
- Moving their homes and businesses overseas – or if they are not in the UK, avoid coming in the first place, therefore creating a potential shortfall of top talent.
- Paying accountants and tax lawyers to look for every loophole and using artificial tax avoidance schemes which reduce their effective tax rate (tax paid as a proportion of income).
This creates an effect where increasing the tax rates can reduce the tax collected by the government and reducing the tax rate can increase the tax collected by government.
Into the logic of the numbers you then need to consider the political issues (cutting taxes is good, increasing public expenditure is good, increasing tax on the high earners is seen as good because of the apparent fairness) with the emotional reactions of the general tax payers and the people who have to pay the extra tax.
I’ve read that about 90% of the 30 million taxpayers are net takers rather than net contributors. That is they get more back from state expenditure than they pay in tax. That makes the 3 million net contributors very important to the economy and you can see how there’s a risk of “killing the golden goose.” Push too hard and they can decide that it’s not worth playing and that means trouble for the rest of us.
The Tax Controversy In The UK
The UK currently has a 50% tax rate on incomes introduced as one of the final acts by the last Labour Government. The Institute of Fiscal Studies suggests that the highest tax rate that won’t reduce tax revenue is below 50% and HM Revenue & Customs are reporting on the impact of the 50% tax rate in 2012.
For comparison purposes the top rates of income tax are:
- Canada 29%
- India 30%
- United States 35%
- European Union average 37.5%
- France 41%
- Germany 45%
- Japan 50%
- Netherlands 52%
- Sweden 56.6%
Tax freedom day in 2011 (when you’ve worked long enough to pay the tax) was May 30, after that everything is yours to keep.
The top 1% of earners pay 24% of all income tax.
In a new survey of global competitiveness the UK is ranked 94th out of 142 countries for the extent and effect of taxation. In 1997 it was fifth.
Tax & Red Tape
The tax rules are incredibly complicated as politicians have tinkered with them. The problem is that the more complicated it gets, the more it opens up opportunities for loopholes.
The big advantage of the flat rate tax is its simplicity and how it stops exceptions.
The Impact of Tax On Business
The Impact Of Income Tax Changes On Business
We need to look at income tax from the perspective of customers and the entrepreneurs, managers and employees.
We can include in this any national insurance or social security, pension or healthcare tax that is paid by the employees as a proportion of income
A reduction in income tax will put money into the pockets of employees and since most people spend what they earn, will increase consumer expenditure and create a surge in demand.
Consumers will buy more if they wanted more or will trade up in price/quality. They will switch from low priced substitutes to higher priced substitutes (e.g. move from home cooking to takeaways to meals out at restaurants).
Tax breaks for the less well-off are more likely to create demand throughout the rest of the economy than for the better offer who may decide to save more.
An increase in taxes has the opposite effect as it reduces discretionary expenditure. Basic products and services – food, energy, accommodation – will be less affected than the treats we buy.
Higher tax rates for the entrepreneurs are likely to change their behaviours in terms of the risks they are prepared to take and could force some to review where they decide to live.
Higher tax rates for well paid employees – e.g. top footballers – act as a demotivating factor to come to this country which can only be offset by increasing pay rates to compensate. The same can happen with professional managers although boards need confidence that the extra value created will cover the increased costs.
The Impact Of National Insurance On Business
Employers have to pay a proportion of the employee’s gross salary to the government as national insurance. While it sounds like political rhetoric, this is literally a tax on jobs.
Along with the red tape of employment law, the minimum wage and the difficulty of finding employees who can make a positive contribution, it helps to explain why so many one-man-band businesses don’t have any intention of employing anyone else.
The Impact Of Corporation Tax On Business
Businesses pay corporation tax on taxable business profits.
Owner-managers of businesses are able to look across the income tax, national insurance, corporation tax and other tax schemes to find the best profit extraction policies that maximise the cash they bank personally compared to the cost to the business.
Shareholders receive their dividends from profits after tax so higher tax rates reduce the likely returns on equity investment and may make it tougher for small, entrepreneurial businesses to raise finance.
The Impact Of Capital Gains Tax on Business
Businesses can pay capital gains if they sell a capital asset (rather than a trading asset like stock) for a profit but the main capital gains issues arise when the business itself is sold.
Various reliefs are given to entrepreneurs who have sacrificed their short term rewards by leaving profits in the business to finance future growth. Often an entrepreneur will see their business as their pension, an asset to be sold to finance their retirement.
Increasing capital gain tax rates and cutting back on the entrepreneurs’ reliefs may provide a disincentive to grow the business. Personally I think income tax and corporation tax rates have more impact on incentives because of their “cash now” impact.
Impact Of Capital Transfer Taxes On Business
Apart from a few stamp duties on the transfer of particular assets, the big issue here is inheritance tax on family businesses. I have no idea how this works at the moment. If you’re in this situation, go and talk to a tax expert.
Impact Of VAT / Sales Taxes On Business
In the UK, very small businesses have a choice of whether to register for VAT or not (HMR&C guidelines).
A VAT unregistered business doesn’t charge VAT on their sales. This can give them a profit or pricing advantage for sales to consumers compared with bigger competitors but they can’t reclaim the VAT they pay on their purchases. Increases in VAT rates therefore increase their costs but increase their pricing advantage as well.
For businesses that do register for VAT, an increase in the rate becomes an administrative burden. If VAT rates change, then prices should change which creates short term difficulties with labelling. VAT is added to the price of what they sell but reclaimed on their purchases.
VAT changes affect the ability of the consumer to buy at the margin. Recent years have seen VAT in the UK reduce from 17.5% to 15%, return to 17.5% and then increase to 20% on most items excluding food and children’s clothes.
Those people on a fixed budget will be able to buy less of something which may be the item the business sells if it is considered a non-essential. For other customers a small increase (2.5% either way) will make little impact on deciding whether to buy an item or not although it may bring forward purchases to beat the increase.
Impact Of Excise Duties On Business
Tax is raised on purchases of items like petrol and diesel, cigarettes and alcohol through various duties. This may be because the government is trying to discourage consumption e.g. environmental issue for petrol, health issues for cigarettes.
Increases in excise duty make the items more expensive for consumers and will dampen demand although there is a “you’ll have to grin and bear it” factor too. I can’t say that my purchasing behaviour seems to be influenced much by the duty except where it forces prices to go past a psychological barrier.