Issues in the design of taxes on corporate profit
The Institute for Fiscal Studies recently organised a high profile study of the fundamental design of the tax system, chaired by Nobel Laureate, James Mirrlees. This study presented a proposal for the reform of corporation tax that is essentially an updated version of the proposals of the IFS Meade Committee, thirty years earlier. The Meade Committee proposed a flow of funds tax, which would permit expensing for all expenditure, including capital expenditure. The Meade Committee proposed an allowance for corporate equity (ACE) which would give a notional deduction for the cost of equity finance, similar to that for debt finance. These are equivalent over the lifetime of an investment, with the tax applying only to economic rent, that is, profit over and above the minimum required rate of return.
A CBT research project addressed the merits of this proposal, which originated with an earlier IFS proposal. It is true that the proposed structure has distinct advantages over existing corporation tax. It solves the problem of discrimination in favour of debt finance, and by taxing only economic rent it avoids distorting marginal investment decisions. These would be significant gains if they were introduced in practice.
However, Mirrlees did not make any proposals designed to address one of the most difficult and intractable problems in international taxation, and one that has become increasingly important since the Meade Committee reported: where profit should be taxed. The problems encountered internationally are similar to some of those encountered domestically: how tax affects the choice between mutually exclusive options, and how income can be manipulated into forms that are taxed less heavily. But both of these issues become particularly important in an international context, with taxes affecting the location of real economic activity and the location of profits.
Modifying the structure of the tax within a country does not address these fundamental problems. They instead need a complete reexamination of how profit is allocated between countries for tax purposes. One option would be to tax profit on the basis of the destination of sales, as with a VAT. Admittedly there are strong institutional barriers to fundamental change. But it is disappointing that Mirrlees chose not to examine these questions.