Full Expensing And The Corporation Tax Base

7th October 2023

A report from the Institute for Fiscal Studies discusses the temporary full-expensing policy and whether it should be made a permanent part of the corporate tax base.

Economic growth is not well served by subsidising unproductive investments that would be unviable in the absence of tax.

1. Corporation tax is the fourth-biggest source of UK government revenue: the £82 billion it is expected to raise this year amounts to 8% of total government revenue. In the coming years, corporation tax revenue is forecast to reach its highest-ever share of national income.

2. For decades, UK corporation tax policy followed a broad pattern of rate cutting and base broadening. This pattern has now sharply reversed. In April 2023, the main corporation tax rate was increased from 19% to 25%. At the same time, the base was narrowed through a temporary ‘full expensing' policy which allows companies to immediately deduct 100% of the cost of qualifying plant and machinery investments when calculating profits.

3. For now, the full-expensing policy has been put in place for three years. The government has stated a desire to make the policy permanent.

4. The design of the corporation tax base creates a range of undesirable distortions, including to the level and type of investment and to how investments are financed.

5. If the full-expensing policy ends up being temporary, it will have little or no long-run effect on the UK's capital stock. It will bring forward some investment that would otherwise have happened later, but there is no obvious reason to want to distort the timing of investment in that way at the moment.

6. The key reason the full-expensing policy is temporary appears to be cost: the Treasury estimates an up-front cost of around £10 billion a year for each of the three years it is in place. That estimate may be correct in terms of the short-run effect on measured government revenue, but it gives a vastly inflated impression of the long-run cost of the policy. Most of the up-front cost will be recouped in future years (because full expensing is instead of a stream of capital allowances). Accounting for this, the true ultimate cost is around £1-3 billion for each year the policy is in place. There is a risk of letting short-run scorecard impacts govern long-term policy choices.

7. If full expensing is made permanent, it would bring benefits, simplifying the tax system and removing the corporation tax penalty for equity-financed investment. But, in isolation, it comes with trade-offs. Notably, it creates a bias towards investing in the kinds of assets that qualify (i.e. towards investing in plant and machinery rather than other assets), and it increases the large and problematic existing subsidy for debt-financed investment - it makes even more unprofitable projects viable. This is not good for productivity. Our view is that, on balance, making the current policy permanent would be preferable to letting it expire - though neither is ideal.

8. Ideally, the full-expensing policy would be made permanent as part of a broader reform package that extended full expensing to all investment and changed the treatment of debt interest payments. There are several ways to move towards a well-designed corporation tax base.

9. Uncertainty is bad for investment. The government - and the opposition - should set out a clear long-term plan for corporation tax.

10.1 Introduction
The 2023 Budget announced that, from April 2023 to April 2026, companies will be able to deduct 100% of qualifying plant and machinery investment immediately (known as ‘full expensing') when calculating taxable profits. In April this year there was also a big increase in the main rate of corporation tax, from 19% to 25%; this was the first rate increase since 1973, half a century earlier.

This year therefore marks a major change in direction in corporation tax policy. Chancellors over several decades (and in most developed countries) have tended to reduce the headline rate while also broadening the base. Across the 2010s, the UK's main corporation tax rate was cut substantially (from 28% to 19%) while the tax base was broadened, including by making most capital allowances less generous.

In February 2022 Rishi Sunak, the then Chancellor, argued that it was ‘unclear' that recent cuts to the corporation tax rate had led to ‘a step change in business investment’1 and that increasing capital allowances would be better at promoting investment. The 2022 Spring Statement suggested various specific options for increasing capital allowances for plant and machinery investment, and a policy paper in the May sought views on them (HM Treasury, 2022). While briefly Chancellor, Kwasi Kwarteng chose to announce an increase in the generosity of the capital allowance regime in one of the specific ways suggested in the Spring Statement, setting the annual investment allowance (AIA) at £1 million on a permanent basis from April 2023 rather than allowing it to fall back to £200,000 as it had been due to.2 Temporary full expensing, which is equivalent to an unlimited AIA (for the investments it applies to), thus continues to move in the same direction.

The question facing the government (and future governments) is whether to make this full-expensing policy permanent and, if so, whether to do it alongside a broader set of reforms.

The temporary nature of the full-expensing policy is a problem. The UK needs an investment-friendly tax system for the long term, not just for the next three years. The increased generosity of capital allowances will boost business investment in the short run, but essentially by changing the timing of investment rather than its overall level. There is no good reason to distort the timing of investment at this point in time. And even the short-run impact will be limited because some large investments cannot be arranged quickly enough to be carried out within three years. The Office for Budget Responsibility (OBR) predicts that the long-run impact of the policy on the UK’s capital stock will be zero. Said differently, the policy will only have a meaningful positive impact if it is made permanent.

Making the current full-expensing policy permanent, rather than letting it expire in April 2026, would come with trade-offs. On the one hand, it would provide a simple, neutral and robust treatment of equity-financed investment in ordinary plant and machinery on a permanent basis and this would be valuable. On the other hand, the current policy is limited to (certain types of) plant and machinery, and to companies but not unincorporated businesses, meaning there would be a greater distortion to some asset choices (e.g. plant and machinery versus buildings) and across legal forms. In addition, the more generous capital allowances also interact with the treatment of financing costs to increase the subsidy for many debt-financed investments. That is not a good thing. What matters is not only how much firms invest overall, but what they invest in. Economic growth is not well served by subsidising unproductive investments that would be unviable in the absence of tax. It is difficult to weigh up the economic trade-offs involved in making the current full-expensing policy permanent. In addition, there are political economy considerations: would permanent full expensing of main-rate plant and machinery for companies make further reform more likely (e.g. by marking a clear direction of travel towards a different system) or less likely (e.g. because takeaways related to the treatment of debt finance may be harder in isolation than if accompanied by the giveaway of full expensing)? Our view is that, on balance, making the current full-expensing policy permanent would be preferable to letting the temporary measure expire, but this is a finely balanced judgement and others could reasonably take a different view. We would have much more confidence that making the full-expensing policy permanent was part of a move towards a well-designed tax base if the government had set out a plan for corporation tax.

Ideally, the full-expensing policy would be made permanent as part of broader reforms that include extending full expensing to all investment and changing the tax treatment of debt finance.

A better-designed corporation tax base would improve investment incentives. UK rates of business investment are among the lowest in the developed world; in 2019, UK business investment was the lowest in the G7 and the third-lowest in the OECD (Adam, Delestre and Nair, 2022). Higher investment in economically profitable projects would boost productivity, which would improve living standards and make meeting future challenges easier (see Chapter 3 of this Green Budget).

The government should set out a clear sense of direction and a plan for the corporation tax base. Ideally, that would involve a fully reformed base that improves investment incentives and lays down the conditions for higher and more productive business investment in the long run. But, whatever the plan, it is important that businesses know what to expect. There is clear evidence that policy uncertainty holds back investment, so should be avoided where possible. Important features of corporation tax have changed almost every year since 2010. The temporary full-expensing policy is just the latest in a long line of (often temporary) changes to capital allowances that have been put in place since 2010. This is a bad way to make policy. For any level of allowances, investment would be higher if the system were stable.

Section 10.2 describes how corporation tax affects investment incentives and how this compares with what a well-designed tax base would achieve. Section 10.3 sets out policy options. Section 10.4 concludes.

10.2 Corporation tax and investment incentives
Corporation tax is the fourth-biggest source of revenue for the UK Treasury. In March 2023, it was forecast to raise around £82 billion in 2023–24, 7.8% of total government revenue. Corporation tax revenue is forecast to reach its highest-ever share of national income. In part, this is the result of the increase in the main rate from 19% to 25%. Looking back, revenues from corporation tax have been volatile, but have not declined overall despite large cuts in headline rates in the 1980s and 2010s (see Figure 10.1). This is partly because the tax base was broadened while the rate was cut (Adam, 2019).

Read the full report HERE
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