What's the deal with investment allowances?

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In yesterday's Budget the Chancellor announced an increase AND an extension to the Annual Investment Allowance.

From April 1 to the end of 2015 a company investing in qualifying plant and machinery can immediately write off the first £500,000 of investment against corporate tax

The move was billed as a measure that would help all businesses invest. And at a cost of £2 billion this was intended to send a strong message that the government is serious about investing. And so it should be. Business investment ticked up in 2013, but still stands some 20% below its pre-recession peak. Across manufacturing, delayed investment spending will also be impacting on productivity and the ability for the supply chain to respond to a sustained improvement in demand.

What difference does tax system make to investment?

We've blogged on the link between tax and investment in the past - see here and here. But here's a quick summary of why the tax system matters for investment:

  • As a piece of machinery has a useful economic life spanning multiple years, the tax system has to reflect this ongoing use. This means that (in normal circumstances) it doesn't make sense to simply write off the entire cost of a machine in the year of purchase, but neither should companies investments be funded out of post-tax profits - this is not how other inputs are accounted for.
  • The design of the tax regime to account for these assets matters - particuarly for SMEs.
  • Higher capital allowances boost cashflow therefore boosting companies' ability to invest.
  • The link between cashflow and investment is strongest when there are constraints in capital markets and firms are struggling to access finance.

Wasn't £250k enough?

For a lot of businesses it was. Manufacturing is, however, more capital intensive and a higher proportion of investment is accounted for by mid-size businesses - a group that is generally investing in excess of £250,000 per year.

So, as investment intentions are on the rise a bigger incentive from the allowance is needed to have an impact on firms accounting for a higher share of overall manufacturing investment. To illustrate we've pulled some old ONS data from 2010 on levels of investment by different sizes of firms and we estimate that the higher £500k investment allowance should cover three-quarters of investment by SMEs, compared with around 60% of investment covered under the £250k allowance.

So we're all good now?

Yes, this is a good move. The OBR forecast that the change will result in around £1billion of investment being pulled forward from 2016 and 2017 to 2014-15.

But what about after that? Manufacturing is not just about the next investment, but sucessive rounds of investment in product development, technology and productivity. If the increased investment allowance expires at the end of 2015, the UK will return to having a relatively uncompetitive regime for investment in plant and machinery - in contrast to the rate of corporation tax, or areas such as the R&D tax credit.

I say if, because the main rate of capital allowances and the level of investment allowances have been subject to so much change in recent years - as shown in the table below.

A temporary boost to investment allowances is welcome, but an economy in want of a lot more investment needs a more competitive and predictable tax regime over the long term. With a generous increase in place, a review on what a future system needs to look like should follow.


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