Corporation-Tax

OWNERS OF SMALL FIRMS PAY SALARIES TO AVOID CORPORATION TAX

Owners of small firms pay themselves salaries to avoid paying corporation tax on the profits of their company – at a significant cost to the government and also the overall economy. That is one of the findings of research by Michael Devereux, Li Liu and Simon Loretz, presented at the Royal Economic Society’s 2013 annual conference.

The research looks at corporate tax returns in the UK between 2001 and 2008 to see how they are affected by changes in the tax rate. It focuses on the effect of changes in the starting rate of corporation tax between that would have had the largest effect on small firms.

The study suggests that the introduction of a marginal tax rate of 23.75% on any profits above £10,000 provides an incentive for many small firms to adapt their businesses in such a way as to make just less than £10,000 profit, thereby avoiding the tax.

The study describes the extent to which such firms change their reported income as the ‘elasticity of taxable income’ (measured as the percentage change in taxable income over the percentage change in the tax). It argues that because tax revenues will fall, this elasticity can be seen as a loss to society – known as a ‘deadweight loss’.

The study shows that this is a particular problem at the lowest rate of corporation tax. It points out that for many small business the owner is often the manager as well. This person then has a choice over whether to declare income as corporate profit (and pay corporation tax and tax on dividends) or as a salary (and pay income tax and national insurance). By comparing company tax records with data on the salaries of directors, the study finds that owners often pay themselves salaries to avoid paying higher corporation tax.

Adjusting the study for firms where the owners operate in this way, the authors still find that there is substantial deadweight loss from corporation taxes because of the way firms adjust their behaviour to avoid the tax. Looking at the behaviour of firms with around £10,000 profit and around £300,000 profit – the point at which another tax rate is introduced, the study finds that:

  • The elasticity of taxable income is between 0.14 and 0.18 for companies with profits around the £300,000, implying a deadweight cost of 8% of revenue.
  • For companies with around £10,000 profit, the elasticity of taxable income is much higher at between 0.54 and 0.57, implying a deadweight cost of around 25% of revenue.

More…

This study uses the population of UK corporation tax returns between 2001 and 2008 to estimate the elasticity of corporate taxable income with respect to the statutory corporation tax rate. Under certain circumstances, this elasticity can be a ‘sufficient statistic’ for evaluating the costs to society generated by the corporation tax.

The idea is based on the assumption that if a company changes its behaviour to reduce its tax liability, it will do so up to the point at which the marginal cost of changing the behaviour is just equal to the marginal benefit of the tax saving. This would be true of any form of behavioural change – for example, lower investment, higher debt or less effort. If there are noexternalities associated with the change in behaviour, then the elasticity of taxable income can be used to infer the welfare costs of the tax. While this approach has been used to explore the costs associated with personal income taxes, it had not previously been used to explore the costs of corporation tax.

The researchers exploit two types of variation in corporation tax rates to identify the effects of the tax across different companies. The first arises from a number of reforms to the corporation tax regime for small companies, especially in the introduction, reform and abolition of a starting rate of corporation tax between 1999 and 2006.

The second arises from discrete changes to the marginal tax rate at various kink points in the tax schedule. For example, when the starting rate of tax was zero, the marginal tax rate for taxable profit just above £10,000 was 23.75%.

To identify the elasticity, the study uses a technique based on the extent to which companies ‘bunch’ at the kink points in the marginal tax rate schedule. For companies with taxable profit above £10,000, for example, the relatively high marginal tax rate they face is likely to induce companies to change their behaviour in ways that reduce their taxable profit. This means that the distribution of taxable profit is shifted downwards.

But the incentive to reduce taxable profit was not present below £10,000. That means that some companies that would have earned profit just above £10,000 in the absence of tax may reduce their profit to £10,000. By analysing how many companies do so, it is possible to infer how far companies tend to reduce their profit in response to the tax.

The researchers apply this technique to two kinks in the tax schedule, at £10,000 and also at £300,000. They find a rather low elasticity at the higher kink, but a higher elasticity at £10,000.

But one aspect of the taxation of small business, especially at the £10,000 kink, is that there is often no distinction between the owner and the manager. That means that this person has a choice as to whether to declare income as corporate profit (and pay corporation tax and tax on dividends) or as a salary (and pay income tax and national insurance).

The higher elasticity at the £10,000 kink point might therefore reflect the fact that a higher corporation tax rate induces owners to take their income in the form of salary; that is, there may be only a small effect on total income, but a larger effect on the form in which the income is taken.

To analyse this, the researchers match the corporation tax return data to individual company accounting records to identify the total remuneration of directors. Taking this to be the personal income of the owner, they identify companies where the level of this income was at the personal allowance kink in the personal tax rate schedule. They repeat their analysis of bunching at the kink in the corporation tax schedule, but only for companies whose owners whose estimated personal income was also at the personal allowance kink.

On the grounds that they were unlikely to change their personal income in response to a change in the corporation tax rate, the study takes the elasticity of corporate taxable income for these companies to be an estimate of the elasticity of total income to the corporation tax rate. This makes it possible to decompose the effects of corporation tax into an effect on total income and an effect on the share declared as corporate profit.

Using the techniques described above, the researchers estimate that the elasticity is between 0.14 and 0.18 for companies with profits around the £300k kink in the marginal tax rate schedule, implying a marginal deadweight cost of 8% of revenue. They find a much higher elasticity of between 0.54 and 0.57 for companies around the £10k kink.

Decomposing this into two parts, they estimate an elasticity of total income with respect to the net of tax rate of between 0.2 and 0.3, and an elasticity of the share of income taken as profit with respect to the difference between the personal and corporate tax rates of between 0.04 and 0.07. Together these imply a marginal deadweight cost of the tax around £10k of around 25% of revenue.

ENDS


Contact:

Michael Devereux, Li Liu and Simon Loretz

RES media consultant Romesh Vaitilingam:
+44 (0) 7768 661095
romesh@vaitilingam.com
@econromesh

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