Chancellor Kwasi Kwarteng’s mini-Budget last week set out a plan for growth driven by tax. The cancellation of the increase in corporation tax, the removal of the 45% additional rate of income tax and a 1.25 percentage point reduction in National Insurance, among many other measures, are designed to accelerate economic growth and encourage businesses to invest.

The markets’ response was swift: the pound’s value fell dramatically and UK businesses saw value fall from their stocks. Businesses themselves were less pessimistic overall, but it is a strong demonstration of the balanced approach necessary to ensure that a tax system encourages business investment.

The UK competes for capital with other jurisdictions so a low headline rate of tax on investment can attract capital. The Republic of Ireland’s economy, for example, is in part delivered by its low taxes and attractive reliefs for business investment.

However, predictability in tax policy is equally important, says Jonathan McMahon, former Director of Credit Institutions at the Central Bank of Ireland and now Chairman of Parallel Wealth Management. “Volatile tax rates complicate financial modelling. They also unsettle investors because of the impact on return assumptions, which itself pushes up the cost of capital.”

Changes to tax rates, or the introduction of a new tax, can alter investment return assumptions used when planning how to repay capital, McMahon explains. “For example, if I buy a business with an intention to grow and then sell it, I am exposed to taxes on capital gains. I need to know as an investor what I am likely to pay on exit so I can build this into my cost of capital.”

The current debate about a windfall tax on energy producers is a good example of this issue, says MchMahon. “Opponents claim it will deter investment needed to increase future supply. Proponents argue that the current levels of exceptional profits would be excluded from investment assumptions, limiting any impact from a one-off tax. The true impact is likely to depend on whether any windfall tax would tax profits beyond what investors might reasonably consider a fair return.”

Making incentives work

Incentives are another route to encourage business investment – and there is a desire to make these more effective. HM Treasury released a policy paper earlier this year inviting views on how to provide greater incentives to invest in plant and machinery. Paul Vohmann, Associate Director, Capital Allowances, Grant Thornton UK LLP and Richard Jones, Business Tax Manager for ICAEW, looked into the effectiveness of capital allowances in response to this policy paper. ICAEW members indicated that capital allowances are seen as a reward for making capital investment rather than as an incentive to invest.

Vohmann and Jones suggest that a credit-based system might be more successful. Capital allowances are deduction-based, provided by way of a deduction on taxable profits. If the business is loss-making, they have no profits to offset the deduction against. Expenditure also tends to be pooled and allowances are given on a reducing balance basis. As a result, it takes a while for relief to be given on expenditure, reducing the cash flow incentive that capital allowances would otherwise provide.

“By contrast, a tax credit-based system would provide businesses with a tax cash benefit that could be obtained relatively quickly after the relevant claim was made,” Vohmann and Jones say. “Businesses would see an identifiable amount of credit coming back that is directly related to the expenditure incurred. Businesses may even increase the amount of the expenditure they make by reference to the amount of the credit, knowing the funds are coming back.”

The government has extended previously implemented measures to encourage investment, keeping the Annual Investment Allowance at £1m for the foreseeable future. This is welcome news for many businesses, offering consistency and certainty after years of changes. But with the pressures of inflation, rising energy bills and continuing supply chain challenges, it might not be enough to encourage them to spend.