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How Britain's Tax Reform Boosted Economic Growth

Article by Ike Brannon September 15, 2014 //   4 minute read

The food fight over corporate inversions -- whereby a U.S. company moves its domicile overseas to avoid paying U.S. taxes on future income earned abroad -- shows no sign of diminishing in the near future, and for good reason: the dispute underscores stark philosophical differences between the two parties.

Democrats opine that the response to the uptick in corporate inversions ought to be to merely outlaw them -- or at least make them much more difficult to do. Republicans argue that the way to stop corporate inversions is to reduce the corporate tax rate and move to a territorial tax system, which would obviate the tax benefits of a company moving its domicile overseas. More broadly, they hope that the recent skirmish might kick start serious discussions on tax reform.

If the fight over inversions were to start the ball rolling on reform, it might make sense to look at another developed country -- namely, the United Kingdom -- that until recently had a high corporate tax rate, a raft of corporate inversions, and a moribund economy. A simple, three-pronged reform helped kick the economy into a higher gear.

It began in 2009 when the UK repealed its worldwide tax regime. A worldwide tax regime meant that UK firms effectively faced a higher tax rate than most of its competitors when competing in a foreign market, since most other developed countries do not tax the foreign profits of domestic companies. The move to a territorial tax regime ended corporate inversions in the UK, and actually led some countries to move their headquarters back.

The second thing the UK did was lower its tax rate, which at the time was 28 percent, by one or two percentage points a year, so that by 2015 the rate will be 20 percent. But the UK wanted to also attract new business and investment -- especially in high-tech industries -- and so it also implemented a patent box tax regime that taxes profits accruing to any patents developed by a UK at just 10 percent.

Besides increasing the investment of UK industries that do a lot of research and experimentation -- and encouraging entrepreneurs to either start such businesses or move them to the UK -- the hope was that such companies already in the UK would shift more of their research back to the UK. And along with more research and development, these companies might be inclined to locate future production near their research and development, since there are natural advantages having the two near one another for many industries.

These reforms were not without detractors: The Financial Times warned that the UK could not afford such tax cuts, and the OECD forecasted that the country would go into recession for eschewing demand-side stimulus. However, the corporate tax changes have been a success. The country has outperformed the rest of the G-7 nations and has been enjoying above-trend economic growth over the last year. The OECD actually took the rare step of apologizing for its harsh criticism of the UK’s tax reforms, acknowledging that their predictions were far off the mark.

There are long odds that Congress will have the temerity to try to broker a bipartisan tax reform, of course, especially this close to an election. But it’s worth noting that another country with the same problem as the U.S. engineered a simple but elegant reform that has kick-started its economy.