THE NEW INVESTMENT INCENTIVES

By Ro THOMAS

It was recently reported' that at least thirty major companies have informedthe Department of Trade and Industry that they must postpone, or even abandon,important development schemes following the withdrawal of investment grantsin favour of the new system of capital allowances introduced in last year's WhitePaper.2 Of these schemes, at least ten are reported to be in Scotland, and anothertwelve in the Northern Region. The aim of this paper will be to compare thevalue to firms of the new incentives with those previously available; to evaluatetLe effects of the changes on the margin of preference enjoyed by favoured areas;and finally to assess the arguments for and against a system of investmentincentives based on tax allowances as opposed to cash grants.

The main changes in investment incentives in manufacturing from 1963onwards are summarised in Table 1. Section 1 (a) indicates the position in1963--65; 1 (b), the position in 1969-70 following the changes introduced in theIndustrial Development Act, 1966, and the subsequent creation of specialdevelopment areas (1967) and intermediate areas (1969); and 1 (c) the proposalscontained in the October 1970 White Paper.

Apart from changes in the form of incentives, the geographical coverageof the different types of area classified in the table has been subject to periodicrevision. The principal change occurred in 1966, when the former developmentdistricts were replaced by very much broader development areas, which encom-passed the whole of the Northern region of England, almost the whole of Scotlandand Wales, most of Cornwall and north Devon, and Merseyside. The actualincrease in terms of manufacturing employees, compared with the formerdevelopment districts, however, amounted to no more than 13 per cent. Therehave been no further changes in the development area boundaries as such since1966. However, certain parts of the development areas, mostly mining districtsthreatened with pit closures, were granted special development area status inNovember 1967. Firms expanding in these areas receive the same benefits asthose in standard development areas in respect of expenditure on plant andequipment, but are accorded preferential treatment for investment in industrialbuildings. A new class of area the intermediate areawas created in April1969. The principal areas granted intermediate area status included the southYorkshire and Notts/Derby coalfields, north Humberside and parts of north eastLancashire, south east Wales and south Devon. Firms in these areas receivespecial assistance with industrial building (but not plant and machinery). Thisassistance was provided initially at development area rates, but under the WhitePaper proposals has been set at rates somewhat below those in the developmentareas. There have been a number of minor additions to the list of intermediate

1 The Times Business News, 28th January, 1971.2 Investment Incentives, HMSO, October, 1970, Cmnd. 4516.

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THE NEW INVESTMENT INCENTIVES 95

areas in recent months, notably the city of Edinburgh. Of greater significancehas been the recent extension of special development area status to cover thewhole of west central Scotland, Tyneside and Wearside in the North East, andlarge parts of South Wales. In assessing the recent changes in investmentincentives, it should be borne in mind that the special development area incentivesare now available over a much wider area than previously.

For expenditure on plant and equipment, the 1966 Industrial DevelopmentAct introduced a system of direct cash grants. These investment grants weretreated for tax purposes as capital receipts, and as such were not liable tocorporation tax. However, if the purchase of a capital asset qualified for a grant,the amount of grant received was deducted from the cost of the asset in com-puting the capital allowances arising from its purchase. In other words, thecapital allowances available to a firm to set against tax were based on the netexpenditure incurred by the firm after deducting any investment grants received.Thus, by virtue of the receipt of a grant, a firm's capital allowances were reduced,and its tax liability thereby increased.

When first introduced in 1966, investment grants were payable eighteenmonths in arrears. It was the intention that this delay be reduced to six months.By the end of the first year of the scheme's operation the delay had been cut totwelve months. Following the 1967 devaluation it was announced that therewould be no further acceleration in payments until economic circumstancesimproved, and since 1967 the grants have continued to be payable some nine totwelve months in arrears.

The recent White Paper proposes that investment grants be replaced bytaxation allowances. This implies in effect a return to the pre-1966 situation.There are however a number of differences between the incentives proposed inthe White Paper and those available under the 1963 Local Employment Act.Both investment and initial allowances were provided before 1966; only thelatter are included in the new provisions. Moreover, under the pre-1966 provisionsannual writing-down allowances began in the year in which expenditure wasincurred. In other words, the first writing down allowance was added to theinvestment and initial allowances iii computing the capital allowances availableto be set against tax in the accounting period in which an asset was acquired.For example, in the case of an asset which qualified for a 25 per cent writing-down allowance, the sum of the current year capital allowances available to afirm in a non development district amounted to 65 per cent (compounded of a30 per cent investment allowance, 10 per cent initial allowance, and 25 per centfirst writing-down allowance). The recent White Paper has introduced a newtype of capital allowance, the 'first-year allowance'. This first-year allowancerepresents a combination of the old initial allowance and first writing-downallowance. In other words, if a firm is given a first-year allowance, its annualwriting-down allowances will not begin until the following year. Thus the new60 per cent first-year allowance in non development areas is in effect the equiva-lent of a 35 per cent initial allowance, and for purposes of comparability has beenrecorded as such in Table 1. In development areas, the pre-1966 provision forfree depreciation has been re-introduced. In effect, a 100 per cent initial allow-

96 BULLETIN

ance, free depreciation gives firms the option of claiming the whole of theircapital expenditure on plant and equipment as a current expense for taxpurposes. It should, however, be stressed that initial allowances do not effect anet reduction in a firm's liability to tax over the life of an asset. The amount ofthe initial allowance claimed in any one year is deducted from the total of theallowances available to be set against tax in subsequent years. Thus an initialallowance is tantamount to an interest-free loan.1 and in this respect is funda-mentally different from the investment allowances available before 1966. Thelatter constituted an additional allowance over and above the statutory annualwriting-down allowances. Thus the pre-1966 30 per cent investment allowanceraised the total of the allowances arising from an expenditure on plant andequipment to 130 per cent of the net cost incurred by the firm, thereby effectinga net reduction in its tax liability.

In order to derive maximum benefit from tax allowances, a firm must bemaking sufficient overall profit to be able to claim the tax allowances in full asthey arise. The delay before actual benefit is reaped in the form of a tax remissionvaries in accordance with the relationship of a company's financial end-year tothe date upon which tax payments fall due. If one assumes that expenditure isincurred mid-way through a company's financial year, the delay ranges fromfifteen to twenty-seven months. In the calculations that follow, an average delayof twenty-one months will be assumed.

In the case of expenditure on industrial building, the form of the incentiveshas remained basically unchanged. The 1970 White Paper raised the standardrates of building grant in development and special development areas, whileleaving the intermediate area rate unchanged. For purposes of taxation, buildinggrants are treated in the same way as investment grants. Unlike investmentgrants, however, building grants have throughout been subject to an employmentproviso. Receipt of the full 25 per cent grant in development areas under theprevious arrangements was dependent on the expectation of a reasonable densityof employment in relation to floor space.2 On tile other hand, if it was consideredthat a firm faced exceptional problems which justified additional asistance, therate of grant could be increased to 35 per cent. Out of a total of 1,728 grantsoffered in the development and intermediate areas for the year ending March31st, 1970, 114 were at the higher rate of 35 per cent, and 113 were for less thanthe full amount.3 Under the new arrangements provision has once again beenmade to raise the rates of grant by ten percentage points where special circum-stances apply, and the government has indicated that henceforth the amount ofassistance offered is to be more closely related to the additional employmentexpected. The delay before grants are received can vary quite considerably

It is of course true that if investment is viewed as a continuing process, the higher first-year allowances on new assets may well more than offset the reduced annual writing-downallowances on old assets, in which case the 'loan' need never be re-paid. (See M. T. Sumner, 'ANote on Initial Allowances', Scottish Journal of Political Economy, November 1966). However,for our present purposes, we are concerned simply to evaluate the effect of the allowances on asingle investment.

2 For details, see Roy Thomas, 'Financial Benefits of Expanding in the Development Areas'BULLETIN, Vol. 31, No. 2, 1969, p. 78.

Local Employment Acts, 10th Annual Report by the Minister of Technology, HMSO,1970, Appendix 111B.

B

THE NEW INVESTMENT INCENTIVES 97

since each application is subject to separate negotiation, and in those caseswhere building costs exceed L1O,000 has to be referred to an independentadvisory committee. A survey conducted by the North East DevelopmentCouncil in 1967-4968 revealed an average delay of thirteen months in dealingwith applications, but steps have been taken since then to speed up the admin-istrative procedures.

The 15 per cent initial allowance granted on expenditure on industrialbuilding under the Industrial Development Act was increased in the 1970Finance Act to 30 per cent in ordinary areas and to 40 per cent in developmentand intermediate areas. These higher rates were to apply for a two-year periodup to April 1972. It was announced in tile October White Paper that the 40 percent rate in the favoured areas is to be continued indefinitely, but that the 30per cent rate in ordinary areas will revert to 15 per cent after April 1972. Therates indicated in Table 1 under (b) were those applicable before April 1970,while the rate in ordinary areas under (c) is the rate due to come into force inApril 1972.

One further change in respect of taxation allowances needs to be noted. The1970 White Paper introduced a single standard rate of annual writing-downallowance (reducing balance) of 25 per cent for expenditure on plant and equip-ment. This replaced the previous scale of allowances laid down in the 1963Finance Act, whereby rates of 15, 20 and 25 per cent were granted depending onthe anticipated normal working life of an asset.

Finally, it must be mentioned that the coverage of qualifying assets wassomewhat more limited under the Industrial Development Act than was thecase under the pre-1966 arrangements, or is to be the case under the new pro-posals. Eligibility for investment grants was restricted very largely to new assetsused in manufacturing processes. Office, canteen, and welfare equipment, andindividual items costing less than 25 were specifically excluded from eligibility.1Under the new proposals, all expenditure on new plant and machinery to he usedfor industrial purposes in the development areas, other than mobile equipment,is to qualify for free depreciation. Second-hand plant and machinery installedin development area factories is to attract the 60 per cent first year allowance.Outside the development areas, the 60 per cent first year allowance, is to beavailable for expenditure on all plant and equipment, new or second-hand. Noaccount has been taken of changes in qualifying assets in the assessment thatfollows.

The value to a firm of tax allowances depends on the rate at which companyprofits are taxed. The position immediately before the introduction of corpor-ation tax in 1965 was that profits were subject to standard rate income tax at41.25 per cent and profits tax at 15 per cent. Profits were effectively taxed at thesame rate whether they were distributed or retained in the company, andshareholders whose marginal rate of income tax was the standard rate were notsubject to any additional taxation on dividends received. The tax allowancesavailable to a company could be set against both income and profits tax. In

'Assets which did not qualify for investment grants were eligible for a 30 per cent initialallowancç.

98 BULLETIN

assessing the value of the allowances provided under the 1963 Local EmploymentAct the effective rate of tax on company profits was therefore taken to he 56.25per cent. The rationale behind corporation tax was to keep company andpersonal taxation separate, and to discriminate against distributed as opposed toretained profits. Company profits became subject to corporation tax, hut inaddition, companies were required to withhold, and to forward to the taxauthorities, income tax at standard rate on the profits distributed to their share-holders. Tax allowances could be set against corporation tax alone, and it istherefore the rate of corporation tax which has effectively determined the valueto a company of the fiscal incentives available on investment since 1966. Tnwhat follows a 45 per cent rate of corporation tax was taken to he the operativerate in assessing the value of the incentives provided under the IndustrialDevelopment Act. This was the rate of tax in force before the publication of the1970 White Paper. It was announced in the White Paper that corporation taxwas to be reduced to 42.5 per cent, and this was reduced further to 40 per centin the 1971 Budget. In what follows the new 40 per cent rate will be applied tothe fiscal incentives introduced in the 1970 White Paper.

To simplify it will be assumed that all expenditures are incurred at a singlepoint in time (end-year 0), which can be taken to lie mid-way through a com-pany's financial year. In order to reduce the incentives available under thedifferent systems to a comparable basis, the sum of the tax savings and grants(where applicable) arising from expenditures on plant and building respectivelywill in each case be discounted back to their value at end-year 0. A 10 per centrate of discount will be used for tIns purpose in the case of the post-1966 incen-tives. This corresponds to the current i'reasury Test Discount Rate, which isbased on the average after-tax DCF rate of return which companies expect onnormal risk investments. The average rate of return which company shareholderscan expect under current tax provisions will be somewhat lower than this sincedividends are subj ect to an additional withholding tax, and moreover share-holders are subject to capital gains tax on any appreciation in the value of theirholdings. Since, however, this did not apply before 1965, a downward adjustmentis called for in the rate of discount used to calculate the present value of theincentives provided under the 1963 Act. The pre-corporation tax equivalent ofthe Treasury's currently recommended 10 per cent discount rate is usuallyconsidered to be in the region of 7 per cent,' and this is the rate which has beenapplied to the pre-1965 incentives in the calculations that follow.

It will be assumed that in all cases expenditure is on new capital assets, andthe rates of grant and allowances are therefore those indicated in Table 1. Thepre-1970 rate of annual writing-down allowance on plant and equipment is takento be 25 per cent.2 Firms are assumed to earn sufficient profits to take fulladvantage of tax allowances as they arise. In the case of plant and machinery,however, it is assumed that firms choose to forgo any balancing allowances thatbecome available at the end of an asset's life, and elect instead to tax-depreciate

1 See, for example, A. M. Alfred, 'The Correct Yardstick for State Investment', DistrictBank Review, June 1968.

This was the rate applicable to assets with an anticipated normal working life of less thanfourteen years.

THE NEW INVESTMENT INCENTIVES 99

their assets to perpetuity.1 For expenditure on industrial building, the rate ofannual writing-down allowance (straight-line) has remained throughout at 4per cent, and it is assumed that the company claims this allowance each yearuntil such time as its total capital allowances are exhausted, i.e. the written-down value of the building for tax purposes falls to zero.2 Finally, it is assumedthat the various categories of cash grants are all payable twelve months in arrears.

For purposes of evaluating an investment project, cash grants, where applic-able, together with all tax savings, irrespective of whether they arise from initial,investment, or normal annual writing-down allowances, must be included in theappraisal. However, it is clear that the tax savings that arise from normalwriting-down allowances ought not properly to be regarded as constituting an'incentive' to investment. They are merely a reflection of the fact that capitaloutlays, like any other outlays, are a deductible expense for tax purposes. Inorder to isolate the present value of the actual incentives, the present value of thetax savings that would arise in the absence of any form of incentive must bededucted. The results are given in Table 2.

TABLE 2Present value of investment incentives on a unit capital outlay

What emerges from Table 2 is that there has been a progressive dilution inthe value of the incentives available for expenditure on plant and machinery.In the case of industrial building, the value of the incentives in favoured areashas been increased as a result of the changes introduced in the 1970 White Paper.The effect of the recent changes in the case of a mixed project in these areas willdepend therefore on the ratio of expenditure on plant to buildings. 1f we comparethe White Paper proposals with the previous system, the 'break-even' ratio, inthe case of development and special development areas is 2:3, and in intermediateareas, 3:4. (In those districts that llave recently been granted special develop-ment area status, the break-even ratio works out at just under 3:2). For allprojects where the actual plant: building expenditure ratio exceeds these break-(Sven ratios, the effect of the changes introduced in the White Paper will he toreduce the value of the incentives available.

1 This eases the task of calculation, while introducing only a very small degree of error intothe results. For example, assuming a zero scrap value after ten years, the present value of thegrant and tax savings arising from a unit capital outlay which qualified for a 25 per cent grantunder the Industrial Development Act, would be understated by .00t3, i.e. by i3p per 100expenditure.

2 The number of years for which the allowance would be available is given by the formula1 - (R ± .04) where R is the rate of the initial allowance.

LocalEmployment

IndustrialDevelopment

White PaperOctober, 1970

.Vew Plant and Machinery Act, 1963 Act, 1966

Non Development Areas ... .161 .122 .034Development Areas ... ... .261 .244 .073

New Industrial building

Ordinary Areas ... ... ... .096 .050 .044Intermediate Areas ... ... .227 .279Development Areas ... ... .243 .227 .345Special Development Areas ... --- .297 .411

loo BULLETIN

Of greater significance in determining the proportion of new industrialdevelopment obtained by favoured areas, however, is the effect of the changes onthe margin of preference accorded to these areas. If this is measured by thedifference between the value of the incentives in favoured areas and thoseavailable in ordinary areas, then it is clear that for both plant and buildings, thechanges introduced in the 1966 Industrial Development Act increased thedifferential in favour of development areas, albeit marginally. The 1970 WhitePaper, compared with the previous system, has considerably reduced thedifferential in the case of plant and machinery, but has increased the margin ofpreference in the case of industrial building. The position with regard to a mixedproject, therefore, will again depend on the composition of capital costs. In thecase of the development and special development areas, where the plant: buildingexpenditure ratio exceeds 6:4, the margin of preference is reduced. (The break-even ratio in the case of those districts to which special development area statushas recently been extended is just over 2:1). Irrespective of the composition ofcapital costs, the position of intermediate areas relative to ordinary areas hasbeen somewhat improved.

There is very little published information on the actual ratios of plantexpenditure to building costs for new projects in the development areas. Inmanufacturing industry in Scotland, in both 1958 and 1963, the ratio was of theorder of 3:1. In Wales in both years it was somewhat higher at 5:1.1 A com-parison of expenditure in development areas on investment grants2 with that onbuilding grants3 also suggests a ratio of plant expenditure to building costs of theorder of 4:1. It is, of course, possible that plant expenditure includes a somewhathigher proportion of investment devoted to the replacement of existing assetsthan is the case with expenditure on industrial buildings, so that the ratio in thecase of new projects may be somewhat lower than the above figures mightsuggest. Even so, it seems probable that for the majority of mixed projects infavoured areas, the value of the incentives available has been reduced as a resultof the changes introduced in the White Paper. It also seems likely that for mostprojects the margin of preference in favour of development areas has beenreduced, although the position is less certain in those districts that have recentlyacquired special development area status.

The value to firms of the tax savings arising from capital allowances variesdirectly with the rate of tax. Thus the reduction in corporation tax from 45 to40 per cent has effectively reduced the value to firms of the tax savings attribut-able to capital expenditures. As against this, however, the tax on the profitsaccruing from an investment is also reduced. To take account of both effectssimultaneously, the present values of profits before-tax needed to attain equiva-lent after-tax DCF rates of return (10 per cent under the corporation tax system,7 per cent, pre-1965) were calculated, and the results given in Table 34

1 Board of Trade, Report on Census of Production, 1963. Summary Tables, 47A, and 48A,HMSO, 1969.

Investment Grants, Annual Report by the Board of Trade under the Industrial Develop-ment Act, 1966, HMSO, 1969.

Local Employment Acts, Annual Reports.The values are derived from the formula

1PV of grants and tax savingsEffective net of tax factor

THE NEW INVESTMENT INCENTIVES 101

TABLE 3l're5ent value of profits before-tax required to attain equivalent after-tax rates of return on a unit

capital outlayPlant and Macllinery

The table reveals a substantial and progressive increase in the gross profitswhich companies must earn on their investments if they are to maintain the samelevel of after-tax profitability. If the current position is compared with thatpertaining in 1969-1970, it is clear that in the case of new investment projects,the benefit from the recent reductions in corporation tax on the profits accruingfrom an investment is more than offset by the depreciation in the value of theincentives to capital expenditure. The figures in parentheses indicate thepercentage increases in gross profits required if firms are to attain the sameafter-tax rate of return under the current provisions as was obtained under theprevious system. The percentage increases confirm the relative deterioration intite position of development areas, and the relative improvement in the positionof intermediate areas.'

In our assessment of the changes in financial incentives we have beenconcerned exclusively hitherto with the effects on the value of the benefitsavailable to companies embarking on new capital projects. However, there is awidely held view that the form in which incentives are provided is no lessimportant than their value in monetary terms. In what follows we shall examinebriefly, the principal arguments for and against a system of incentives based ontax allowances as opposed to cash grants.

One of the arguments used in the White Paper is that 'investment grantsbenefit firms whether or not they are making profits and they can thereforeresult in uneconomic investment leading to waste of resources.' The notion that,unlike grants, tax allowances constitute a profit-related incentive, rests on a

1 The required increases in gross profits in those districts that have recently been added tothe list of special development areas work out at 14.7 per cent under (b) and 8.2 per centunder (e).

Non-D evelop nsentArea

DevelopmentArea

Pre-1965 ... ... ... .842 .643Industrial Development Act ... .935 .7381970 'White Paper ...

(b) ]Viixed project

1.059 (13.3%) 1.000 (35.5%)

Exp enditare ratio plant: buildings = 3. 1Ordinary Inter- Develop- Special

_4rea mediate ment Develop-Area Area ment Area

Pre-1965 ... ... ... .959 - .736 -Industrial Development Act .. ... 1.023 .952 .804 .7761970 White Paper ... ... 1.104 1.016 .947 .922

(o) Mired project

(7.9%) (6.7%) (17.8%) (18.8%)

Expenditure ratio plant: buildings=2.l

Pre-1965 ... ... ... ... ... 1.008 - .779 -Industrial Development Act ... .. 1.058 .964 .834 .7961970 Whïte Paper ... ... 1.123 1.006 .935 .902

(6.1%) (4.4%) (12.0%) (13.2%)

102 BULLETIN

confusion between the current profitability of a company and the future profit-ability of an investment. Ability to benefit fully from accelerated depreciationdepends not so much on the future profitability of new investment, but on whethera company is making sufficient profits from its existing operations to take fulladvantage of the tax allowances which become available when capital expenditureis incurred. The same basic misconception underlies the argument that newprojects in development areas are unlikely, initially, to engender sufficientprofits to enable firms to benefit from free depreciation. In so far as the majorityof such projects are either transfers, or the offshoots of established companies,the argument will not generally be valid. In normal circumstances, it is likely toapply only in the case of single-plant undertakings embarking on a rapid pro-gramme of expansion, or overseas companies setting up their first Britishsubsidiary. However, given the current depressed state of company profits, it isprobable that there are a good many domestically based multi-plant concerns,which for the present at least, will be unable to benefit fully from accelerateddepreciation. Given this situation, it is difficult to escape the conclusion thatwhatever intrinsic merits the new scheme might be thought to possess, thetiming of its introduction was singularly inopportune.

Table 4 shows quite conclusively that the new system of tax allowances doesnot, in fact, discriminate in favour of more profitable projects. The table com-pares the DCF rates of return before tax, and after account has been taken oftaxation and incentives, on two notional projects. The precise results depend onthe assumed lives of the projects (in our example, 10 years), and the time-patternof gross profits, which, to facilitate calculations, were assumed to remain constant.

TABLE 4Internal Rates of Return (before and after-tax) on a 1 0,000 investment in new plant and equipment

Annual Returns Before-Tax(Before-Tax) Yield

10 Years

After- Tax Yield

Ordinary A vea Development Area

The results show that, under the new provisions, in ordinary areas, the com-bined effect of taxation and incentives penalises both projects more or lessproportionately, while in development areas the effect is completely neutralirrespective of profitability. It does appear to be true, however, that under theprevious system, less profitable projects received a proportionately greater boost.On this basis one could conceivably argue that the new system at least has themerit of redressing the previous discrimination in favour of projects which arerelatively unprofitable.

One of the alleged defects of the previous system of development areaincentives was that they encouraged the establishment of capital-intensive

PROJECT A1295 5% 7.0% 4.7% 11.4 5.0%

PROJECT B2385 20% 20.6% 18.0% 26.4% 20.0%

Previous New Previous Newf System System System System

THE NEW INVESTMENT INCENTIVES 103

projects in areas of labour surplus.1 It was partly to redress tins capital-intensivebias that REP was introduced.2 Whether or not the location of capital-intensiveindustries in development areas is necessarily undesirable is open to question.3But in so far as the criticism does have any validity, there are grounds forsupposing that it is partly met by the White Paper proposals, albeit quiteinadvertently.4 One of the main differences between the new package of develop-ment area incentives and the previous provisions is the switch in emphasis fromsubsidising plant and equipment to subsidising industrial buildings (Table 2).Under the new arrangements, the smaller the ratio of expenditure on plant:buildings, the greater is the value of the benefit received. There are a number ofreasons for, supposing that the plant: buildings expenditure ratio for differentindustries might well be associated with capital intensity. To test this hypothesis,the average ratio of expenditure on plant: buildings in 1958 and 1963 for eachindustry was calculated, and the figures related to a measure of capital intensity(the ratio of fixed assets to net output) for the corresponding industries. Toobtain estimates of capital intensity for as large a number of industries as possibleit was necessary to use Barna's 1955 figures.5 The correlation that emergesbetween the expenditure ratio ou plant: buildings and capital intensity (in theabove sense) is very high (R=.89 for 29 industries). What this suggests is thatby concentrating assistance on buildings as opposed to plant and machinery, therelative attractiveness of the development areas for capital-intensive industrymight well be considerably reduced, quite apart from the further considerationthat building grants, unlike the incentives available for investment in plant andmachinery, are subject to an employment proviso.

We turn finally to examine the relative effectiveness of different forms ofincentives. There is considerable evidence that a good many firms failed to takeaccount of the tax savings available under the pre-1966 system.6 This was, infact, one of the principal reasons for the introduction of the investment grantsscheme, the argument being that the benefits from cash grants could be calculatedmore readily than those arising from a system of capital allowances. Thisargument can easily be exaggerated. If account is taken of the increase in afirm's liability to tax by virtue of the receipt of a grant, the calculation is no morestraightforward than the calculation of the benefits arising from investment orinitial allowances. This is confirmed by reference to Table 2, which shows thatthe effective value of the 40 per cent investment grant previously available indevelopment areas was, in fact, in the region of 25 per cent of the capital cost.By contrast, whether by accident or design, nothing could be simpler than to takeaccount of the benefits arising from free depreciation under the new provisions.

i See, for example, Hunt Report, op. cit., Appendix J.2 Green Paper, o. cit., para. 28.

See, for example, Wilson, l'olicies for Regional Development, Oliver and Boyd, 1964,Chap. 3, Section 5.

The argument is nowhere mentioned, in fact, in the White Paper itself.Barna, 'The Replacement Cost of Fixed Assets in British Manufacturing Industry in

1.955,' Journal of the J?oyal Statistical Society, Series A, Vol. 120, Pt. 1, 1957.See, for example, G. 11. Lawson, 'Criteria to be observed in judging a Capital Project',

4 ccountant's Journal, June 1964; R. R. Nield, 'Replacement Policy', National Institute EconomicReview, November 1964; D. C. Corner and A. Williams, 'The Sensitivity of Businesses to Initialand Investment Allowances', Economica, February 1965.

104 BULLETIN

Irrespective of the rate of corporation tax or the delay before tax payments, theafter-tax internal rate of return on a capital outlay on plant and equipment willin all cases be identical with the before-tax rate of return (Table 4). In otherwords, a firm undertaking expenditure on plant and machinery in a developmentarea, will be able to take incentives and taxation fully into account by simplyignoring them! It is, of course, true that firms that habitually carry out theircalculations before tax, and who would therefore presumably tend to overlookthe effect of cash grants on their tax liability, are more likely to be attracted by agrants scheme than by a system of incentives based on tax allowances. Thismay well have been in the government's mind when it introduced investmentgrants in 1966, but it is debatable whether the fostering of this 'tax illusion' isconducive to a more efficient allocation of capital resources.

Quite apart from the possibility that firms might well pay insufficient regardto the effects of incentives on the profitability of new projects, it must also beborne in mind that, in practice, investment may well be restricted by limitationson the amount of capital available. In assessing the potential effectiveness ofinvestment incentives, therefore, some regard should be paid, not only to thevalue of the incentives available over the anticipated life of a project, but also totheir short-term effect on company liquidity. A recent econometric study, infact, concluded that the cash position is the major determinant of investmentbehaviour.' The short-term effect of incentives on the cash flow position ofcompanies is shown in Table 5. The plant: buildings expenditure ratio in thecase of mixed projects is assumed to be 3:1.

TABLE 5Per cent capital outlaiy recovered

It will be seen that cash grants effect a more rapid improvement in liquiditythan tax allowances. However, if one considers the position after tax savingsbecome available, the difference between the two systems is quite marginal.Moreover, no account has been taken in the table of the reduction in corporationtax on firms' initial profits. If we assume a 3:2 ratio of net profits to gross

'Agarwala and Goodson, 'An Analysis of the Effects of Investment Incentives on Invest-ment Behaviour in the British Economy', Economica, November, 1969.

After 12 months A fier 21 mont1s

Plant and MachineryPrevious System:

Ordinary Areas ... ... ... 20.0 29.0Development Areas ... ... ... ... 40.0 46.7

New System:Ordinary Areas ... ... 24.0Development Areas ... 40.0

Mixed ProjectPrevious System:

Ordinary Areas ... 15.0 23.9Development Areas ... 36.3 43.0

New System:Ordinary Areas ... - 20.1)Development Areas ... 8.7 41.6

investment (roughly the ratio for manufacturing in 1969),' the reduction in taxon the profits from a firm's existing operations would amount to 7.5 per cent ofgross capital expenditure. This additional boost to liquidity would seem to tipthe balance of short term advantage in favour of the new package. However,this presupposes that firms have sufficient profits from their existing operationsto be able to claim the tax allowances to which they are eligible in full. This isalmost certainly not the case over a large section of British industry at thepresent time. With a general return to more profitable trading conditions, thebenefits to liquidity arising from the new provisions should become moreapparent. It must be stressed, however, in comparing the new package with theprevious provisions, that even if one were to confine one's attention to itspotential short term impact on company liquidity, the improvement is quitemarginal. To the extent that companies pay any regard at all to the impact ofincentives on the ultimate profitability of capital projects, the overall conclusionwhich emerges from tue foregoing analysis is clear. In the case of the majority ofpotential projects, the changes introduced in the White Paper will act as a netdisincentive to investment, and particularly so in the development regions.

'National Income and Expenditure, 1970, uMSO, August 1970.

University College,Cardiff

THE NEW INVESTMENT INCENTIVES 105