Saturday, February 24, 2007

Cut Taxes and Business Rates Unilaterally Without Involving Civil Servants to Administer 'Approved' Schemes

Eamonn Butler, Director of the Adam Smith Institute, makes a poignant remark about a concern expressed by a BBC business presenter that struck an immediate resonance with my recent experience, and perhaps explains this is the way we are now:

“The lunch, by the way, featured BBC business presenter Declan Curry, who was complaining about how hard it is to get businesspeople to go on TV and defend their own business and business in general. I was not surprised. Too many businesspeople actually want to defend subsidies and regulation, rather than free markets. Frankly, I would prefer to keep them off the airwaves. Such is life.” (Eamonn Butler, ASI at:

I attended a meeting of the David Hume Institute in Edinburgh recently (I declare an interest: I am a Trustee of the DHI) where the participants were discussing how to get Scottish businesses to increase their relationships with its 14 universities and invest more in R&D (however defined).

Data were presented showing relatively poor performance by said universities and local businesses, especially SMEs, and while specific proposals were not outlined, except as goals, it struck me that some suggestions fitted the centre of gravity of current thinking among business people. They didn’t want to spend time searching among the university to find somebody who could help them (the procedures they had to go through were off-putting; it took too long and they risked ending up with somebody who didn’t understand business).

In my view, the problem for SMEs, and other enterprises, including universities which are not very enterprising, and investing in innovation is one of incentives. If you wanted to understand why SMEs do not do more than they do ion this area (most innovation is small-scale, unsung and not exceptional), you should look into their profitability, which operates under regimes of corporation tax and local business rates, imposed by legislatures, national and local, under the impression that they can extract from private sector profits without consequences to the behaviours of people in the organisations they tax.

If you add the uncertainties associated with anticipations about the future (not a problem in neoclassical economics), you would conclude that if you want this situation to change you must offer the right incentives.

Now, of course, the advisors to the legislatures, and business people too, may recognise the truth of the need for incentives, but such is the mindset of the modern adviser, that their version of ‘offer the right incentives’ is a bureaucratic one with all this implies in managed ‘tax breaks’, ‘grants’ and ‘aid’ packages.’ One such successful business leader proposed to the meeting that any package must be practical and structured within the terms of what is acceptable to the ‘politics’ of the current system, if it was to have any chance of being passed into law.

Economists, as per Adam Smith, are mindful of the practicalities involved in persuasion, when set against the standard of natural liberty. The two go together, as Smith shows repeatedly in Wealth of Nations, sometimes without drawing the point out, which causes fast modern readers to miss it. First, show how natural liberty produces an outcome; then show small practical changes that are steps towards that outcome, but do not contradict it. In other words, state how the system of natural liberty applied to the economy works and then make proposals that move the situation from where it is now to where it might move over time in the future.

His proposal was to ‘allow SMEs to retain more of their profits’. Great. It sounded quite radical: his method was to offer them tax credits, as a percentage of their tax deductions, on condition that they spent the money on employing local universities to help with R&D. This would lead to a bureaucratic mess of form filling, compliance reporting and inspecting, plus the usual proportion of ‘fraud’ as some firms tried to get round the rules, with civil servants deciding whether their expenditures (remember, out of their profits!) qualified under the tax-break rules, as if civil servants were competent to do so, or likely to do a better job than the business people who had earned the profits in the first place.

I thought about how Adam Smith might have proposed a remedy for the alleged problem that Scottish SMEs were not innovating to the same degree as in other countries (England included). First, he would have set out his ‘model’ of how an economy in a commercial society produced the ‘necessities, conveniences, and amusements of life’ each year and how it grew by net investment one year with another. He would have located the source of growth in the annual produce of the country as being generated by the productive labour in employment, defining productive as labour that added value to produce for sale in markets, the revenue from which was added to the equivalent in money terms of the annual production of the ‘necessaries, conveniences, and amusements’ of life (GDP).

Productive labour created the produce that its revenue in exchange (its money equivalent) repaid the costs of land (rents), labour (wages), and capital stock (profits). Unproductive labour does not produce this exchange because its services did not produce revenue for those who purchased them. Smith’s definitions of productive and unproductive labour were crucial to his ‘model’, though is use of them was sometimes inconsistent; it is the fact that most instances of unproductive labour did not exchange in markets that is the crucial difference with productive labour, not whether they were services per se, because some services, though their ‘products’ perished instantly, were sold in markets (such as public restaurants, coffee shops, ale houses and houses of ‘entertainment’).

Activities that exchanged products in markets did so when the factors involved in their products earned their reward, as rents, wages or profits. Entrepreneurs who made profits from their business would remain in that line of activity when they received net profits over and above the costs of the factors, including their own capital stock and their own subsistence. All charges on their net profits that reduced their incentives to continue re-investing in economic activities would undermine their willingness to sacrifice consumption and to take risks.

Taxes on profits reduce net profits; increases in business rates reduce net profits; profligate spending, including investments that fail to reproduce their costs, reduce incentives, and thereby reduce the amount available for investment and re-investment, which reduces the rate of growth of the capability for future wealth creation. Frugality, successful investments and re-investment in profitable ventures increases their incentives, and thereby increases the proportion of revenue available for investment and re-investment, which increases the rate of growth of the capability for future wealth creation.

To increase the rate of growth of future wealth creation, proposals that reduce the tax burden on the factors causing wealth creation (land, labour, and capital-stock), would be beneficial. The direct approach of legislatures, national and local, unilaterally cutting such burdens is more likely to achieve the goals of policies to increase the investment of SMEs in such activities as R&D and innovation (should such activities be related to increased future capabilities in competitive markets), than use of indirect approaches to the problem of first taxing the enterprises and then returning a proportion of taxed money in schemes that require unproductive administrative costs to decide on the suitability of individual schemes to have the taxed money returned. Entrepreneurs do not need the central direction of civil servants to take advantage of profit incentives, nor do they need administrative regimes of formal applications for eligibility, the inevitable inspection rules of compliance inspections.

To the extent that added unproductive administrative costs of compliance, which do not reproduce their costs as revenue earned in markets, reduces net profits (they have to be paid for as a charge on the employment of productive factors), they reduce the gains from returning taxed money to entrepreneurs, and undermine the demonstration effect of experimenting with the policy. I would prefer, on impeccable Smithian grounds, that more direct measures are undertaken to solve the problem.


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