Taxation and Small Firms: Creating Incentives for the Reinvestment of Profits

Abstract

In this paper we examine, using the NatWest/Manchester Business School (MBS) tax models, the impact of taxation on the small business sector over the last few years. Because it is known that a small number of growth businesses provide most of the new wealth and additional employment created by the small firms sector, consideration is given to the combined effect of the different elements of the tax regime on small firms, with particular reference to the tax implications of business growth. The NatWest/MBS tax models, for incorporated and unincorporated small businesses, contain accounting data for a stratified random sample of almost 4000 small UK firms. These data are employed to estimate the total tax burden borne by small firms in the United Kingdom, including the total value of taxes collected from this sector by the Exchequer and the aggregate value of compliance costs borne by small businesses. Unincorporated firms employing fewer than 20 staff contribute just 5% of government revenues, and small limited companies with fewer than 100 employees provide 15% of total taxes collected. These figures of total tax revenues together with estimates of the compliance costs borne by small firms are assembled into tax indices for incorporated and unincorporated firms, set at 100 in 1994/95. Changes to the total tax burden are traced from 1994/95 (the base year in the models) up to 1996/97 in the light of the changes introduced in successive budgets. Although the index for small companies falls by 2.5 points across this period the position of unincorporated firms remains virtually unchanged. The reasons for these differential effects are considered and explained. We identify three important areas in which the growth and development of small business is restrained by the tax regulations currently in force: sales growth, employment generation, and investment for the future, We conclude that the fiscal barriers in these areas could be reduced by raising the VAT registration limit (initially to £100 000), by compensating small businesses for the cost of collecting tax on behalf of government and by reducing the level of taxation on profits reinvested in small businesses.