Questions and answers about
the economy.

Can investment tax reform boost economic growth?

Taxing capital affects investment and economic growth, with both tax bases and tax rates playing an important role. In the UK, growth-enhancing tax policies should target innovation and investment rather than savings. There may also be room for fiscal reforms that do not reduce revenue.

Taxation can reduce investment, distort the allocation of resources and reduce individuals’ efforts to make money. All this harms economic growth. Investment and innovation are particularly important for driving long-term growth (Acemoglu et al, 2018), and while many forms of taxes can act as a drag, capital income taxes such as corporate and capital gains taxes may have the most direct effect.

With high government debt and stagnating productivity in the UK (Financial Times, 2024), the relationship between tax policies and growth is critical. Since the fiscal space for large tax reductions is limited (lowering taxes without a reasonable surplus means cutting public services, which is politically unpopular), the most useful tax reforms may be those that can increase growth without reducing government revenue significantly. If policy-makers can promote growth and increase the tax base, part of the hit to public finances may be recouped.

How do investment taxes work?

Corporate profits are the main source of capital income for individuals. They are taxed at two levels in the UK. First, corporations pay a 25% corporate income tax on taxable profits. Next, shareholders pay tax when corporate profits are transferred to the individual as dividends or capital gains. The top tax rate on dividends is currently 39.35%, while capital gains from shares in corporations are taxed at a maximum rate of 20%.

But not all profits are treated the same. Traditionally, corporate income taxes provide full tax relief for debt-financed investment, but not for equity-financed investment. And in last year’s Spring Budget, the Chancellor of the Exchequer, Jeremy Hunt, announced an increase in the corporate income tax rate from 19% to 25%, combined with full expensing of investment in plant and machinery (HM Treasury, 2023).

Full expensing means that any expenses on eligible investments are immediately deductible against a firm’s tax bill. This provides stronger incentives for firms to invest in the types of investment covered (Maffini et al, 2019; Zwick and Mahon, 2017).

The government also provides direct tax incentives for innovation. Ideally, such schemes produce more growth for an equal loss of revenue compared with lower overall tax rates on corporate profits. There is evidence that such incentives have significant positive effects on investment (Guceri and Liu, 2019). And research shows that due to variations in the returns to research and development (R&D) in firms, higher subsidies for firms that conduct less R&D may improve technology spillovers across firms (Akcigit et al, 2022).

On the other hand, if highly successful individuals are the main innovators, taxation may not be very important, as financial gains are large in any case (Bell et al, 2019). There is a balance to strike between providing incentives for innovation in the wider economy and simply alleviating the tax burden for innovators who are already successful.

What is the role of international investment?

Corporate income taxes apply to all firms’ investments in the UK. But dividend and capital gains taxes mainly apply to UK resident investors on their national and international investments. Since the UK is an open economy, many corporations raise finance internationally as well as domestically. This means that savings by residents in the UK need not equal the capital available for investment. There are pools of capital beyond UK household savings from which UK firms can benefit.

The conditions for investment by national and international investors may therefore be more important than policies that increase savings by residents. One such condition is economic stability. Research shows that the effects of investment incentives vary with stability (Guceri and Albinowski, 2021). Large and frequent tax changes can reduce stability. Creating a stable environment should not be overlooked: change is not always a good thing.

But which system is better from a growth perspective? As corporate income tax applies to investment by all investors, it is likely to affect internationally mobile activity and investment (and growth) to a larger extent than taxes on dividends and capital gains (Alstadsæter et al, 2017; Devereux et al, 2014; Yagan, 2015). The implication is that even with full expensing, multinational corporations may prefer to conduct certain forms of activity where corporate income tax rates are lower (Devereux and Griffith, 1998).

Due to tax competition and profit-shifting to low-tax jurisdictions (including to ‘tax havens’), corporate income tax rates have fallen across a wide range of countries over the last few decades (de Mooij et al, 2021). Currently, the average statutory corporate income tax in Europe is 21.3% (Tax Foundation, 2024). But again, statutory tax rates do not provide the full picture, without accounting for differences in the tax base.

How can profit tax reform increase growth?

One reform that would increase investment and reduce the debt-bias in corporate income tax could be to extend full expensing to all forms of investments. This could be combined with abolishing the tax deduction for interest on debt.

The current design of corporate income tax provides stronger incentives for investment in plant and machinery compared with other forms of investment (such as intangible capital). This limitation is unlikely to be growth-friendly. Presumably corporations are better suited than governments to decide which forms of investment provide the best growth potential. Providing immediate expensing to all forms of investment could be a smart move, but opportunities for tax avoidance must also be considered.

A more radical tax reform would be a reduction in the corporate income tax rate combined with increases in dividend and capital gains tax rates (Berg, 2024). This would provide greater incentives to invest in the UK for both foreign and resident investors, as the after-tax return on investments in the UK relative to elsewhere would go up.

Lower corporate income tax rates could attract mobile activities undertaken by multinational corporations. Even though dividend and capital gains taxes would go up for resident investors, these taxes apply on investments in any country (except for those with non-domicile status), such that they face increased incentives to invest in the UK relative to other countries.

Some revenue loss from a corporate income tax reduction would also be recouped by dividend and capital gains taxes. Since dividends and capital gains depend on after-tax profits, any increase in after-tax profits in firms owned by resident investors will also increase dividends and capital gains in the long run, such that the dividend and capital gains tax bases and tax revenues from those bases increase.

One downside of such a reform package is that increased dividend and capital gains taxes may reduce savings and lead to outward migration among wealthy individuals. But this may not matter much for investment in an open economy like the UK if investors who migrate keep their portfolio fixed and any shortfall in resident investment is replaced by foreign investment.

Reductions in savings and outward migration may reduce tax revenue, but revenue effects of tax-induced migration need not be large (Advani et al, 2023). The risk of scaring away wealthy investors from residing in the UK should not be overstated.

Many European countries appear to have moved in the direction of higher dividend and capital gains tax rates relative to corporate income tax rates (see Figure 1). This has taken place mainly by reducing corporate income tax rates, but some countries have also increased tax rates on dividends and capital gains.

Figure 1: Relative tax rate on dividends compared to corporate income in Europe

Source: Author’s calculations based on OECD data (Berg, 2024)

Overall, the corporate income tax base is large. This means that joint reform of the different tax bases may not have a neutral effect on tax revenue without significant increases in dividend and capital gains taxes.

Other measures to strengthen the dividend and capital gains tax base could be implemented, such as stricter rules for taxation at exit through outmigration or introducing interest payments on investors’ gains from delaying the tax payment through keeping their funds in the firm (Auerbach, 1991).

Still, policy-makers face a trade-off between higher revenues with more reliance on corporate income taxes and higher investment with more reliance on dividend and capital gains taxes. Getting the balance right is a significant challenge.


Taxes on capital are important for raising public finances and can be used to distribute funding to promote investment and innovation. Still, total tax rates do not provide the full picture, and understanding the tax base and who is liable to pay a tax (corporations or resident investors) is crucial for assessing the wider effect on investment. More evidence on the differential investment effects of corporate, dividend and capital gains taxes is required to make solid conclusions about the most desirable policy direction.

Given this caveat, one potential way to increase growth could be a tax reform that involves greater taxation of savings and lower taxation of investment. What could be required for growth-enhancing taxation is not generally lower taxation of capital per se, but more investment and innovation-friendly tax policies.

Promoting economic growth is high up the policy agenda in the UK, and finding the right fiscal tools to achieve this is likely to remain a vital goal over the coming years. Investment is critical for driving growth, and the design of tax policy has significant implications for the economic conditions that determine the level of investment.

Where can I find out more?

Who are experts on this question?

  • Stuart Adam (Institute for Fiscal Studies)
  • Arun Advani (University of Warwick)
  • Michael Devereux (University of Oxford)
  • Irem Guceri (University of Oxford)
  • Helen Miller (Institute for Fiscal Studies)
Author: Kristoffer Berg
Image: DenisMArt on iStock
Recent Questions
View all articles
Do you have a question surrounding any of these topics? Or are you an economist and have an answer?
Ask a Question
Submit Evidence