Peter Geoghegan: Corporation tax cut is no cure-all

Alex Salmond has stated plans for a cut in corporation tax. Picture: Neil Hanna

Last month, Alex Salmond unveiled a central plank in the SNP’s economic strategy for an independent Scotland: a 3 per cent cut in corporation tax. The move, the First Minister, said, would create 27,000 new jobs and lead to a 1.4 per cent increase in output and a 1.9 per cent rise in investment over 20 years.

Salmond’s claims sparked lots of frothy invective from both sides of the independence debate. But before getting dragged into that particular sandpit, it’s worth taking a step back to look at the broad assumption behind the strategy: namely that a reduction in corporation tax would lead to an increase in government revenue in the medium to long term.

The idea that there is a trade-off between tax rates and tax revenue is not exactly novel. It wasn’t even new in 1974, when Donald Rumsfeld, chief of staff to then US president Gerald Ford, and his deputy Dick Cheney, sat down to dinner with Chicago university economist Arthur Laffer. As discussion turned to Ford’s plans to control inflation by increasing taxes, Laffer, a former classmate of Cheney, is said to have grabbed his napkin and sketched a graph that showed a reduction in tax revenue as tax rates grew beyond a certain point.

It was an Archimedes-getting-into-his-bathtub-moment for the New Right. This bell-shaped graph– which became known as the Laffer Curve – was quickly adopted as economic orthodoxy. Under Ford’s successor, Ronald Reagan, the marginal higher rate income tax in the US was cut from 70 to 28 per cent – and has stayed comparatively low ever since.

In the UK, corporation tax has followed a similar trajectory. Tax on business profits was set at 40 per cent when it was introduced in 1965 and increased to 52 in 1973, but quickly began to tumble thereafter. The current rate is 23 per cent and this is due to fall to 20 per cent under the coalition government.

Governments and politicians like the Laffer Curve because it suggests something similar that sounds impossible: that tax cuts can actually increase government revenue. But four decades on from Laffer’s post-prandial napkin scribbling, the academic evidence is, at best, mixed. “As a testable hypothesis, however, the original Laffer Curve has not fared well,” wrote Austan Goolsbee, a Chicago economist and current chairman of president Barack Obama’s influential Council of Economic Advisers.

There does seem to be an inflection point above which tax increases will reduce the amount of revenue recouped. But identifying that point is notoriously difficult, and there is precious little evidence to suggest that a just a fifth of profits UK firms are being taxed to a counter-productive extent under the coalition in Westminster.

Indeed, it hard to see how an independent Scotland shaving 3 per cent of the corporation tax rate available in the rest of the UK would act as a significant spur to economic growth and inward investment. Chancellor George Osborne has cut corporation tax with little effect on British growth; why would the situation in an independent Scotland be so different?

At the heart of the SNP’s analysis of the links between a cut in corporation tax and an increase in growth and jobs is the assumption that businesses will reinvest tax savings into wages and research and development.

At a time when companies around the world are sitting on ever greater piles of cash – witness the stock market surge and Apple’s mountain of cash, which now sits at $145 billion (£93bn) – there is scant evidence for such rosy suppositions.

The Scottish Government’s August 2011 discussion paper on corporation tax, which formed the basis of last month’s economic announcement, hailed competitive corporation tax rates as the cornerstone of a successful independent economy.

Lowering corporation tax would, the paper said, “make the country more attractive as a location for multinational investment. It could also act as an important signal to global companies and investors as to Scotland’s ambition to be a location for competitive business.”

It could also lead to a race to the bottom, as the Scottish Council for Development and Industry noted recently. The pro-business think-tank said that its members had “no great desire to participate in a race to the lowest tax environment”.

It is a race that Scotland can never hope to win – when it comes to bargain-basement corporate tax rates, Ireland has the market sewn up. At just 12.5 per cent, Ireland’s headline corporation tax rate is the lowest in the European Union, and was widely credited for the country’s economic boom.

But the Celtic Tiger was as much a product of years of economic under-performance and emigration, which left huge spare capacity in the Irish economy, as it was of low corporation tax rates. Ireland’s low-ball offering also came with specific extras to entice multinationals: an incredibly relaxed attitude to tax and transfer pricing, and membership of the EU and, more importantly, the eurozone.

The SNP has ruled out the euro for an independent Scotland, and while it would most probably join the EU, few could want Scotland to follow Ireland’s lead on lax tax policy: earlier this month, an embarrassed Irish premier, Enda Kenny, was forced to publicly reject the claim that Apple paid just 2 per cent tax in Ireland, as its chief executive Tim Cook had, under oath, told the US Senate homeland security and governmental affairs committee’s investigations subcommittee.

Ireland flags up the difference between effective and headline rates of corporation tax. Behind the “headline” figure of 12.5 per cent, most companies in Ireland pay just a few percentage points. If Scotland were to challenge on those terms, it would need to go much lower than 17 per cent.

There are dangers in this, too. More than 90 per cent of Ireland’s export activity comes from US companies funnelling profit through the country to avoid taxes. Ireland’s status as an effective tax haven has damaged its reputation internationally.

Salmond might argue that this is a price worth paying for good jobs, but, as Ireland is discovering, the jobs are rarely high-end: a recent investigation by the Irish Times found that of 1,900 employees at Google in Dublin, 70 per cent were in low-paid administration jobs. Just 8 per cent were engineers.

There are substantive questions about Salmond’s proposals, too. How would Holyrood plug the funding gap that a corporation tax cut would, at least in the short term, produce?

The answer, of course, would be spending cuts, which the SNP has set itself up as the only guardian against.

If Scotland is to become independent – and even if it isn’t – the country needs an economic vision beyond loping a few digits off corporation tax and hoping for the “trickle-down” growth. There are real problems in the Scottish economy – regional imbalances; unemployment; low rates of business start-ups – but cutting corporation tax will do little to address these.

That the debate remains fixated on corporation tax speaks volumes for the poverty of the economic discussion on independence.

The Scottish Government’s version of the Laffer Curve promises low-tax and high public spending. It’s a glorious idea, but one with little basis in economic reality. If it is to convince floating voters of the benefits of independence – remember Clinton’s campaign team maxim, it is the economy, stupid – then the SNP will need to provide a much more coherent economic vision. And soon.