Taxation and small firms: creating incentives for the reinvestment of profits

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 businesse s provide most of the new wealth and additional employment created by the s mall firms sector, consideration is given to the combined effect of the dif ferent elements of the tax regime on small firms, with particular reference to the tax implications of business growth. The NatWest/MBS tax models, fo r incorporated and unincorporated small businesses, contain accounting data for a stratified random sample of almost 4000 small UK firms. These data a re employed to estimate the total tax burden borne by small firms in the Un ited Kingdom, including the total value of taxes collected from this sector by the Exchequer and the aggregate value of compliance costs borne by smal l businesses. Unincorporated firms employing fewer than 20 staff contribute just 5% of government revenues, and small limited companies with fewer tha n 100 employees provide 15% of total taxes collected. These figures of tota l tax revenues together with estimates of the compliance costs borne by sma ll 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 f rom 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 com panies falls by 2.5 points across this period the position of unincorporate d firms remains virtually unchanged. The reasons for these differential eff ects are considered and explained. We identify three important areas in whi ch the growth and development of small business is restrained by the tax re gulations currently in force: sales growth, employment generation, and inve stment for the future. We conclude that the fiscal barriers in these areas could be reduced by raising the VAT registration limit (initially to pound 100000), by compensating small businesses for the cost of collecting tax on behalf of government and by reducing the level of taxation on profits rein vested in small businesses.