Overall tax rates on self-employment profits, dividends and capital gains on business assets (including both personal and corporate taxes) are lower than those on employment income. Often, these lower tax rates on the incomes of businesses and their owners are defended as a means to promote investment, risk-taking and entrepreneurship. But while there are reasons to encourage some activities related to entrepreneurship, lower headline tax rates are poorly targeted. Much of the tax break goes to highly profitable projects that would have happened absent any tax break, or to businesses that are not entrepreneurial. At the same time, making investments, and taking risks with the possibility of making a loss, are often discouraged by the tax system because of the design of the tax base – the definition of what is taxed. As a start, tax base reform should be used to minimise these disincentives. And if the government wants to go further and actively encourage certain activities, measures targeted at those specific activities are likely to be more effective than across-the-board reduced tax rates for business income.
Market failures and entrepreneurship
A good rule of thumb is that similar activities should be taxed similarly. Usually this is fairer, is simpler, helps to prevent tax from driving people’s decisions, and reduces tax avoidanceThe use of lawful means to pay less tax, particularly where contrary to the clear intention of parliament.Read more (which almost always arises when similar activities are taxed differently).
However, there are reasons to deviate from this to try to influence behaviour. To justify preferential tax treatment of certain types of activity such as entrepreneurship, it is not sufficient to cite the benefits the activity brings. If there are benefits to those involved, why won’t the activities be undertaken without government intervention? What is required is a case for government action based on a clear reason why the market will fail to generate enough of a certain activity. This can occur when an activity creates positive spillover benefits (externalities) to others. For example, some businesses may be less keen to try out risky new ideas than would be best for society as a whole, because part of the benefit flows to other firms which can learn from the new products or processes rather than to the one taking the risk. Imperfect markets may also inefficiently constrain worthwhile activity. For example, if there are barriers to entry or obstacles to growth (such as businesses with good ideas facing difficulty raising finance), the market can generate too little activity in the small business sector.
In principle, the many ways in which markets fail to produce the best possible outcomes lead to multiple possible arguments for government intervention. However, in practice, correcting market failures using the tax system (or other policies) is fraught with the dangers of complexity, special pleading and unintended consequences, so there should be a high hurdle to justify these types of policy. Tax should be used to try to influence outcomes if, and only if, all of the following are true:
- There is a very clear rationale based on a specific reason why we want more (or less) of something relative to market outcomes.
- Tax is the most appropriate policy tool. Broadly, taxes are a good tool when the market failure is best targeted by changing prices or rates of return on investments.
- It is possible to design an actual tax policy whose benefits outweigh its costs.
Low headline tax rates are poorly targeted
Some businesses are innovative and generate positive externalities, and others are facing credit constraints that we would like to alleviate. But many businesses are in neither category. As a result, reduced tax rates that apply to all businesses or business owners are not well targeted at the kinds of activities that government policies may sensibly want to promote. Although lower tax rates may boost some of the activities that the market would otherwise undersupply, the benefits will be spread much more widely. And the benefit of lower headline tax rates accrues disproportionately to those who make high private returns on their activities – activities that are likely to be viable even without support.
At the same time, preferential tax rates create a series of unintended side effects. Aside from the unfairness and revenue loss created, giving tax breaks where they are not justified can actually create too many businesses and reduce productivity. Tax policy should not, for example, encourage people to become self-employed (or encourage employers to use self-employed contractors) if they would otherwise be happier and more productive with an employment contract. The rapid growth in the number of small businesses in the UK is often hailed as a success. But this is not necessarily true and this narrative sits uneasily alongside evidence that many small businesses have low productivity and create low incomes for their owners.
Tax base reform better targeted at investment and risk-taking
As highlighted above, as a starting point, government policy should aim to be neutral towards commercial decisions. For example, it should aim not to affect which types of assets people buy, how much risk they take or which legal form they choose to operate in. Due to the current design of the tax base, the tax treatment of returns to investment is a mess: incentives vary depending on the asset type, source of finance and legal structure involved and they range from large subsidies to large penalties. For example, there is a disincentive to invest money in your own or another’s company but a subsidy for many debt-financed investments. There is also a discouragement to risk-taking. The tax base should be reformed to remove, as far as possible, disincentives to invest and take risks and differences across different types of investment. For example, rather than try to use lower tax rates on future profits to minimise disincentives for risk-taking, it would be better to make the treatment of losses more generous. More broadly, removing problems with the tax base would be better targeted at improving investment incentives than preferential tax rates for business owners.
Moreover, some ways of removing disincentives to invest could also help to alleviate market failures that impede growth. In particular, providing up-front deductions for investment (rather than allowing investment costs to be deducted later) can help to alleviate credit constraints.
If the government wants to go further and actively incentivise certain types of activity, it should avoid focusing support on activities that are most likely to happen even without the support, as reduced headline tax rates do. Instead, the government should be looking to target support to activities that cannot go ahead or are only borderline-viable without support. Moreover, it should target the specific activities or features that are associated with market failures.
It is difficult to target market failures precisely. The three conditions enumerated above should be a guide.
First, there must be a clear and specific market failure. For example, it is often argued that the government should actively promote risk-taking. We highlighted above that taxes currently discourage risk-taking and that, as far as possible, this should be stopped. But it is not at all clear why the government would want to go further to encourage more risks to be taken: if the market does not provide enough of a reward for people to be willing to take a risk, why push them to do so? The question in that case is therefore whether there are particular types of risky activity that do need to be encouraged and, if so, why. Many activities that cannot happen without government support simply should not go ahead: it is not always a market failure. A classic example where there is widely accepted to be a market failure is in R&D, which will tend to be undersupplied because part of the benefit from new ideas or products that are developed goes to people other than those developing them. Governments therefore use measures such as R&D tax credits specifically designed to encourage it. The challenge is to identify other such cases.
Second, it should be remembered that tax is not the only policy tool available. For example, intellectual property rights, loan guarantees, regulation, information provision, competition policy or direct funding for particular activities may allow government intervention to be targeted more efficiently at market failures than tax measures. Tax will sometimes be the most appropriate tool to address a specific market failure, but not always.
Third, it must be possible to design a real-world tax policy that targets the market failure effectively without too many unwanted side effects. For example, enhanced investment allowances could be given for particular forms of investment identified as having positive spillovers. But not all socially beneficial innovation can be pinned down to specific activities such as R&D that can be identified in tax law. Tax breaks that distinguish between two types of activity risk encouraging people to ‘dress up’ activities in the tax-favoured form as well as encouraging more ‘genuine’ activity of the desired type. And excessively complicated provisions can be ineffective or counterproductive.
Promoting entrepreneurship is worthwhile, but is difficult and must be approached with care. A good starting point, however, would be to remove (as far as possible) the barriers to investment and risk-taking in the current system – and that is more readily achievable.
The issues highlighted in this article are discussed further in the following IFS report: ‘Taxing work and investment across legal forms: pathways to well-designed taxes’.
This article, and the underlying research report on which it draws, have been funded by the Nuffield Foundation, but the views expressed are those of the authors and not necessarily the Foundation. Visit www.nuffieldfoundation.org.