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Corporation tax should be reformed or replaced by a higher VAT rate to reduce disincentives to invest in the UK, according to the Mirrlees Review of the British tax system.
Two new studies from the body argue that globalisation and the growth of the financial sector require a new approach to the taxation of profits in a small open economy.
The papers' authors recommend moving to a 'source-based' corporation tax that exempts dividends paid to UK companies by their foreign subsidiaries.
They also advise exempting from taxable profits the normal rate of return, to encourage investment and thus increase national income and real wages.
The Mirrlees studies go on to warn that Treasury proposals to move from a 'credit' to an 'exemption' system for foreign dividends are handicapped by the proposed treatment of intangible assets held by UK multinationals offshore, and they will add a further burdensome layer of anti-avoidance rules.
To discourage investors from hiding their wealth in foreign tax havens, the documents recommend exempting interest income from personal tax and allowing shareholders to deduct an imputed normal return on the basis of their shares, before imposing tax on dividends and capital gains.
Abolishing the personal dividend tax credit and aligning the combined tax rates on corporate and shareholder income with that on labour income could then avoid some of the incentives to choose the legal form of a business for tax reasons, say the studies
They then argue that taxable profits would be lower under an allowance for corporate equity (ACE) than under the existing corporation tax, meaning that a higher statutory tax rate would be required to bring in the same revenue, increasing the potential gains to multinational companies from shifting their profits to jurisdictions with lower statutory tax rates.
The authors suggest moving to a form of 'destination-based' corporate tax, levied where the sale of a good or service is made to the final consumer, and they argue that this would remove distortions to the location of investment, and substantially reduce the opportunity for companies to shift profits between countries.
The papers suggest that moving to a destination basis could be achieved by introducing border adjustments, similar to VAT, in which exports of goods and services become tax-exempt, and imports of goods and services are taxed.
Robert Chote, director of the Institute for Fiscal Studies, said: 'Notwithstanding announcements by a couple more multinational companies that they are thinking of leaving the UK for tax reasons, the Treasury will be reluctant to abandon the domestic corporation tax while it continues to raise £50 billion or so a year.
'But these studies lay out some interesting directions for reform, both to make the existing system of company taxation more efficient and to provide a long-term alternative if corporation tax revenue goes into long term decline.'
