A New Approach to Modelling Corporation Tax

Abstract

It is likely that in the next few years a substantial amount of attention and comment will be devoted to the state of the public finances. In his budget, the Chancellor of the Exchequer, Mr. Norman Lamont, forecast that the Public Sector Borrowing Requirement (PSBR) for 1992-3 would be £28 billion or 4V2 per cent of GDP. This figure should be contrasted with the government's own policy of balancing the budget over the medium term and the objective set out in the Maastricht Treaty on Euro pean Union of avoiding 'excessive budget deficits'. In this context, a topic of some interest is the likely pace and scale of any improvement in corporation tax receipts as the economy recovers from recession. The purpose of this note is to describe a new method of modelling corporation tax that has been introduced into the National Institute model of the UK economy. Cor poration tax receipts make an important contribution to central government revenue (of the order of 10 per cent of total receipts). This contribution increased substantially in the 1980s especially after the reform of the system in 1984 before falling back in the current recession. How ever it is not obvious whether the increased importance of corporation tax receipts is a permanent change or a temporary response to the shift in 1984 away from the provision of generous first year capital allowances towards less accelerated depreciation. The model described here takes account of such shifts in the system in making forecasts. It is hoped that the changes in the model will lead to a reduction in forecasting errors and an improvement in its simulation properties. The new approach has also allowed a closer integration of the modelling of the corporate tax system and company investment decisions. The strategy that has been adopted in this work is to model the tax liability of the corporate sector as the product of a tax rate and a tax base, where the tax base is determined by the provisions of the corporate tax code. Whereas for an individual firm this procedure should in principle determine the tax liability exactly, there are a number of reasons why this is not the case in aggregate. Among the most important of these is the lack of a clear correspondence between the national accounts definition of profits and the aggregate of that used by the Inland Revenue for the profits of individual firms. Other factors are the effects of tax exhaustion and the variable lag between the accrual of a tax liability and its payment. The structure of this note is as follows. The first section describes the system of company taxation in the UK. The second section describes the model of payments devel oped here. The third section puts forward some results including as an example an assessment of the cost of a policy to encourage investment by raising capital allowances. The final section concludes.