Hamish McRae: Treasury troubles and global competition add to the conundrum of corporate taxation

'You get more money by cutting rates only if those rate cuts attract a lot of activity'

How do you make the UK a more attractive location for international business? Easy, you cut corporation tax rates. But how do you preserve revenues? That is trickier. And how do you cope with companies that have operations in many jurisdictions and want to make their profits in countries where taxation is lowest? Trickier still.

First, the overall headline tax rates. The background to the cut in the headline corporation tax rate from 30 per cent to 28 per cent in the Budget last month - and to this week's stories that the Treasury was changing its treatment of foreign tax dividends - was the growing pressure from lower tax rates across the EU. Whereas in 1997 Britain had one of the lowest rates of tax in Europe, now it is only middle of the pack. Two things have caused this to change.

One is that other countries have brought their rates down. The most extreme case is Ireland, which has dropped to 12.5 per cent, making Northern Ireland particularly uncompetitive. The other is that Europe has enlarged, bringing in new members that have sought to use low corporate taxation as a way of attracting inward investment.

As a result the average tax rate of the old 15 members has fallen from 38 per cent to 30 per cent, while that of the new 10 members is now only 20 per cent.

But of course corporation tax is not just a European issue; it is a global one. The pattern has been for large countries, with a sizable embedded corporate tax base, to retain fairly high levels of tax, while smaller countries have tended to have lower rates.

You can see the pattern of falling rates in the major developed and emerging countries, plus some interesting smaller ones, in the bar charts. These take into account both central taxation and local taxes. In no country I can find are overall tax rates higher now than they were in 2000. In some the fall has been quite dramatic: Poland from 30 per cent to 19 per cent.

Despite this fall in rates, the general pattern has been for the total tax take to remain pretty stable. The proportion of revenues from company taxation in the industrial countries as a whole has been pretty stable for a generation. In 1965 it was 9 per cent of the tax take; in 2004 it was 10 per cent (see pie chart). In the case of Ireland, however, cutting rates has been hugely profitable to the revenue. There has been so much inward investment that company taxation there now accounts for a much larger proportion of revenues now than it did ten years ago. But then Ireland's industrial base is much larger, as the major computer manufacturers and software houses have established production facilities there.

Thus you get more money by cutting rates only if those rate cuts attract a lot of activity that would not otherwise have come. That is why low company taxation works for Ireland or Poland in a way that it would not necessarily work for the US or UK. But since it does work for smaller countries, expect it to continue.

This is why Dubai has a zero corporation tax regime for all firms with the exception of oil companies and banks. The former pay 55 per cent on UAE-sourced income, which is understandable in the context of that industry, while the latter 20 per cent. Dubai is eager to build up a financial services industry so it will be a really interesting test case to see whether its taxation regime can help create a global financial centre from scratch. Given Dubai's success so far you would not want to bet against it but creating a financial services industry may be harder than creating, for example, a motor or a computer industry.

Given this variety of different rates there is huge pressure on companies to make their money in the "right" place. Unsurprisingly governments try to resist this. The UK has a slightly unusual practice of not taxing profits made in the UK when paid to a parent company abroad; the European courts have ruled that it is therefore illegal to tax profits made abroad when they are repatriated to a parent in the UK. In theory at least the Government faces the possibility of having to repay taxes illegally charged in the past. Possible changes in repatriation rules were mooted in both the pre-Budget report last December and in the Budget itself. Yesterday the Treasury pointed out that this was not news and that consultations on these matters had been running for a year.

Meanwhile the CBI deputy director-general John Cridland said: "This is a consultation we have been advocating for some time. An exemption for foreign dividends should lead to more companies basing their organisations here."

Merrill Lynch, commenting yesterday on this issue, reckons that since the aim is to be revenue-neutral, companies should not become too worked up about it. I think that is probably right but there are two twists here.

One is that the relationship between the corporate sector and the Treasury is rather fraught at the moment, partly because the Chancellor is distrusted and partly because he is not going to be in the job for much longer. Companies find they either cannot get decisions out of the Treasury or are none too keen on the ones that do come out.

The other is that the general background of global tax competition means that any change in tax arrangements is liable to destabilise the corporate world. We have the prospect of Barclays shifting its headquarters to Amsterdam if it succeeds in taking over ABN Amro, for the tax regime in the Netherlands is much more favourable to an international bank than the UK one. Equally significant, a few months ago HSBC warned that it might shift its headquarters overseas, as a result of the UK tax position. The danger is that the UK might be close to a tipping point, for if one huge bank went, others might follow. That cut to 28 per cent would not, of itself, be enough to stop it.

The big point here is to watch what companies do, not what they say. If international companies continue to base their operations in the UK, then whatever emerges will be a success. If UK ones move abroad, then it will be a failure. Perhaps the most interesting perspective of all, however, is to see this whole debate as an example of the way power is shifting in the world economy. Even large countries have to be careful in their relationship with big business, while small ones can benefit hugely by framing their tax systems to attract global capital. It is a good time to sit in Dublin or Dubai.