The UK's Low Corporate Tax Rate; Will it Attract Investment?

What are the merits of George Osborne’s slashing of the UK’s corporation tax rate? In the previous coalition government he reduced both the main corporation tax rate (from 28% in 2010) and the small profits rate (from 21% in 2010) to 20% in 2015–16. After the Brexit vote the chancellor has argued for a drastic reduction of the rate to below 15 per cent in order to demonstrate that Britain is “open for business” to international investment? In an Opinion piece published on the Wall Street Journal , on July 10, Mr. Osborne wrote:

Now we intend to offer even more competitive taxes, and to become a home to more, not less, international business. To signal our intent, we will cut our corporate tax rate still further. It was already set to reach 17% from the 28% rate I inherited six years ago; now I want it to fall to 15% and preferably lower. What stronger message could we send that Britain is open to business?

Will the lowering corporate tax policy improves British industry's competitiveness and enhance its productivity? Or would it likely exacerbate a zero-sum international race to the bottom between governments on tax rates as some have argued it would?

There has been a tendency throughout the advanced countries to reduce corporation tax rates since the stagflation of 1970s as the policy makers have tried to improve competitiveness and expand export markets. This tendency has been the most striking in the UK, where since 2010, it has cut tax rates deeper and at a greater speed than her competitors, to the extent that as the following chart shows the rate is now among the lowest in the G20, and as we saw earlier may become the lowest if other countries do not respond.

Corporate Tax Rates Across G20

Source: IFS

As we have argued last August, the British economy is plaggued with underinvestment which is hampering its productivity growth and its competitiveness. Corporate tax rate reductions that are not being tied to the companies' investment in innovation and agility will just deteriorate the fiscal stance of the country and will add to uncertainty which would discourage capital expenditures.

Sources of Growth in the UK economy

(year-over-year growth rate)

Source: Hover

The above chart indicates that UK investment has been decelerating at an alarming pace since the first quarter of 2015. As we have argued before, because of businesses’ utilization of contingent capacity the UK productivity has been misleadingly signaling some artificial improvements. We argued:

This is because in planning for capacity during uncertain times businesses usually postpone their irreversible component of investment and utilize intensive margin production processes. As a result of this focus on short-term capacity corresponding to existing cost structure the longer-term capacity signals will be hidden. (...)

We argued that consistent with Ben Bernanke’s option price of waiting it would be quite rational for businesses to postpone their strategic investment plans at uncertain times and focus instead on their contingent capacity limits, which would result in transmission of inconsistent and misleading signals on capacity utilization rate and productivity improvement. A misinterpretation of these signals by policymakers would deepen and prolong uncertainty.

A corporate tax reductions cannot eliminate or mitigate such uncertainties and in contrast it may just add to them if other countries would retaliate by lowering their tax rates. In the meantime productivity growth — defined as the rate of change of output minus rate of change of hour worked — may continue to send false rising signals misinterpreted by policymakers as the indication that markets have agreed that the economy is open for the business and that the businesses are investing in innovation and competitiveness to expand the production possibility frontier. Whereas in reality because of postponement of real investment and utilizing contingent capacity the economy is falling behind.