The Entrepreneurial Audit: Tax and National Insurance
Tax policy for the self-employed and micro businesses in the UK is an area that has received more attention than most, but which, paradoxically, is arguably in the greatest need of reform.
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This is the second article from our report The Entrepreneurial Audit which offers 20 policy ideas for government to strengthen self-employment and micro businesses in the UK.
The NICs dilemma
Few matters are more contentious or thorny than taxation. Yet most people can agree on what a good tax system should aspire to: it should be clear and straightforward, fair in the way it treats citizens, resilient to abuse, and free of loopholes to be exploited. We would also add that taxes should be progressive, such that those with the greatest capacity bear the greatest burden. These qualities hold as much for small business taxation as they do for any other domain.
Our foremost concern with the current system is that people doing the same work but under different guises can face widely different tax treatments. Nowhere is this more apparent than in the amount of National Insurance contributions (NICs) paid by employees and the self-employed. The present system breaks down as follows:
The self-employed pay two forms of NICs
- Class 2 NICs — £2.80 a week above earnings of £6,000 a year (although Class 2 is soon to be terminated)
- Class 4 NICs — 9 percent above earnings of £8,060 and a further 2 percent above earnings of £43,000
Employees pay one form of NICs and their employer another
- Class 1 NICs — 12 percent above earnings of £8,060 and a further 2 percent above earnings of £43,000
- Employer NICs — 13.8 percent of employee earnings above £8,112 a year
The self-employed therefore pay a lower proportion of their own income in contributions (9 percent instead of 12 percent), while having no equivalent of employer NICs paid on their behalf. To illustrate this with an example, a self-employed person earning £15,000 a year would pay £770 in NICs, whereas an employee doing the same job would see £833 deducted from their pay packet, with their employer adding a further £951 in NICs (see Figure 5). On top of this, the self-employed have the advantage of being able to deduct some expenses from both their NICs and Income Tax liabilities.
The size of this NICs differential causes three core problems. The first is the incentive it creates for false self-employment. Employers who treat individuals as self-employed contractors when they should be engaged as standard employees face considerable savings by not paying employer NICs. For a worker paid the median wage of £27,000, this equates to a windfall of over £2,600 every year. While workers who are misclassified as self-employed may themselves gain by paying a marginally lower NICs rate, they also lose valuable worker rights — such as access to holiday pay and employer pension contributions.
The second problem is that the NICs differential makes it difficult, if not impossible, to argue that the self-employed should have access to greater welfare protections, including Statutory Maternity Pay and Statutory Paternity Pay (see the next chapter for more detail on welfare matters). Many economists and tax experts already believe the self-employed receive more in social security benefits than the size of their contributions merit.
And third, the exchequer loses out on a large sum of money that could be channelled into public services. Indeed, there is increasing concern in the Treasury that the rise in self-employment, and in particular the growth of gig work enabled by platforms like Uber and Deliveroo, may serve to worsen the state of the public finances. According to HMRC, the Exchequer relinquished £2.85bn in the last financial year (2015/16) as a result of the self-employed paying lower NICs levies than employees.
Towards equal treatment
The argument that the self-employed should face a lower NICs burden usually rests on the claim that they take more risks, engage in entrepreneurial endeavours and bring new products and services to market. This will be true of some business owners, particularly those in the ‘Visionary’ tribe of our aforementioned typology. But not every self-employed person will fit these traits. Think of self-employed tradesmen and women in carpentry, plumbing and electrical work, whose job is a predictable, if highly-skilled, vocation.
A better case for the self-employed receiving special treatment is that they face higher tax compliance costs as a proportion of their turnover than large businesses. Another credible argument is that self-employment as a flexible form of work is critical to a dynamic labour market that can respond with agility to economic downturns. Yet both these claims, however true, are not enough to explain the extent of the tax advantage open to people who work for themselves.
To those who would argue a NICs rise would punish the self-employed, consider that the real winners from the discrepancy are the highest earners. While the self-employed hairdresser on £15,000 a year gains £63 in NICs savings, a self-employed IT consultant on £60,000 stands to benefit from £903, not including the £7,160 foregone in employer NICs. Although it may be uncomfortable, it is time for business advocacy groups to get behind the idea of NICs reform, and to put the long-term interests of their members ahead of minor short-term gains.
We see a number of options for how the NICs system could be restructured, all of which aim to level the treatment of employees and the self-employed:
- Option #1, Soft levelling — The self-employed begin paying the same personal NICs rate as employees (ie 12 percent rather than 9 percent), but employer NICs remain unchanged.
- Option #2, NICs merger — All forms of NICs including the employers levy are folded into a universal NICs, with the self-employing paying the same rate as employees.
- Option #3, Transaction tax — The same as soft levelling, but employer NICs are turned into a ‘transaction tax’ to be paid by any household or business using the services of any worker, self-employed or employee.
- Option #4, Payroll tax plus — The same as soft levelling, but employer NICs are reconstructed as a ‘payroll tax plus’, with employers paying a levy for all workers they employ including independent contractors.
Each of these proposals has merits and limitations, and clearly some do not solve all the problems of the current NICs discrepancy. The ‘soft levelling’ approach leaves employer NICs intact, which is the biggest headache for the Treasury and arguably the key driver of bogus self-employment. The NICs merger, meanwhile, would end most of the incentives to engage in false self-employment, while bringing in extra revenue for the exchequer, yet the immediate costs for the self-employed are almost certain to be too great to bear.
There is also another, more fundamental, option to consider: merging NICs and Income Tax altogether.
We recommend that the government and the Office of Tax Simplification explores each of these options in more detail, and arrives at a suitable proposal for removing the inconsistency between how the self-employed and employees are treated under National Insurance. In doing so, we should be mindful of causing ripple effects in the tax system, such as creating further incentives for incorporation. Business owners already stand to make sizeable tax savings by moving from sole trader status to limited company.
Recommendation #1 — Equalise the treatment of employees and the self-employed for National Insurance contributions
The government should seek to close the gap in National Insurance contributions paid by employees and the self-employed, noting that this is a driver of bogus self-employment and delays progress in extending more rights to business owners.
Modernising Business Rates
Alongside NICs, another tax in urgent need of reform is business rates, which is levied on most non-domestic properties including shops, warehouses, factories and offices. The stated purpose of business rates is to cover the cost of council services and the upkeep of infrastructure that local firms depend on.
Rates are calculated by multiplying the ‘rateable value’ of a property — its open market rental value — with a given ‘multiplier’ figure set by central government. For example, if a business property has a rateable value of £20,000, and the multiplier set by the government is 0.462, the business will pay £9,240 in rates (before any relief is applied). Local authorities currently keep up to 50 percent of the money raised in their area, but under new plans councils will be able to keep all of the proceeds and some authorities will be able to tweak their multipliers.
In the 2016 budget, the then chancellor George Osborne made several changes to ease the burden of business rates on small firms. Among his reforms were to raise the Small Business Rate Relief threshold from £6,000 to £15,000, and increase the higher rate threshold from £18,000 to £51,000. According to the government’s estimates, these measures will result in 600,000 firms being freed from paying business rates, while a further 250,000 businesses will see a reduction in their charges.
But as welcome as these reforms are, the business rates system is still beset with several flaws — some administrative and others more fundamental. Starting with the former, one issue is the infrequency with which revaluations of properties take place. Although a revaluation is set to take place this year, the last audit occurred nearly a decade ago in 2008. Delaying revaluations in this way may save businesses some pain in the short-term, but it stores up bigger tax hikes to be revealed in future years.
Another shortcoming of the system is that it is prone to appeals. Because the ‘rateable value’ of properties is partly based on the subjective viewpoint of surveyors, many business owners raise doubts about the accuracy of their rate bill. Others complain that the rateable value of their building has depreciated in the period since the last revaluation. A recent Communities and Local Government Committee report described the number of appeals as a ‘massive problem’ for the system, with estimates that almost 900,000 businesses have challenged their rates bill since 2010. Such appeals can take years to resolve and lead to high administrative costs for councils — a cost that is ultimately borne by the taxpayer.
Of course, revaluations themselves cost time and money. But there is a strong argument for conducting more frequent property surveys to limit the volume of appeals and ensure that businesses can absorb smaller, more frequent, tax changes over time.
Recommendation #2 — Undertake more regular property revaluations to ensure the business rates system is fit for purpose
The government should commit to undertaking regular revaluations of properties, which would make levies more accurate, reduce the number of appeals and allow businesses to absorb smaller tax hikes over time.
The more fundamental problem with business rates is that it takes little account of how much a business can afford to pay, since it is not based on the amount of turnover or profit a firm generates but rather the value of the property in which it resides. This creates severe difficulties during economic downturns, when market conditions worsen yet the amount that firms pay in rates remains unchanged. Consider that business rates raised half the revenue of Corporation Tax in 2007/08, but that this grew to two-thirds by 2012/13 when the economy was reaching a nadir.
Another underlying issue is that business rates struggle to capture the gains from e-commerce activity. The rates system was conceived long before the advent of the internet, at a time when high streets were crucibles of local economic activity and most businesses (at least B2C) needed a physical shopfront to trade goods and services. We now have a perverse situation where a multinational e-commerce trader with an out of town warehouse can pay a similar amount to an independent shop on the high street.
This points to the need for a more fundamental rethink of property tax for businesses. One option would be to transition to a ‘revenue rates’ system where tax liabilities are calculated according to turnover, or some other indicator of business performance. This would have the advantage of rising and falling in line with economic cycles, while capturing all businesses in a given area including online traders. It would also be more objective and therefore less prone to appeals, and would eradicate the peculiar incentive that business rates create to leave properties undeveloped.
However, this proposal comes with several technical challenges, not least the question of how the location of sale would be determined for companies engaging in internet trading. There may also be value in alternative proposals, such as for a Land Value Tax (LVT) that would be a levy on land rather than property, or a ‘point of exchange’ tax that would charge taxes at the point of delivery or purchase. The government and the Office of Tax Simplification should investigate different options for a root and branch reform of the business rates system, with any change designed to be revenue neutral for local authorities and the Treasury.
Recommendation #3 — Explore the scope for transitioning from a business rates to a revenue rates system
The government and the Office of Tax Simplification should consider whether business rates could be replaced with a levy based on firm turnover, or looking to the future, a levy based on the value of land (a Land Value Tax)
Streamlining tax administration
For most of the self-employed, it is not just the amount of tax they pay that is a burden but also the time required to comply with the rules. According to the Small Business Survey, of the non-employing SMEs who said tax was an obstacle to the success of their business, 60 percent pointed to the effort required in compliance, while 56 percent said the overall level was a problem. Although the UK’s tax system is one of the most robust in the world, it is arguably more complex than it needs to be as a result of myriad reliefs, exemptions and options open to tax payers.
The Office of Tax Simplification recently explored how small business taxation could be streamlined. Among their recommendations were to align filing and payment dates for different taxes like PAYE and VAT, to ensure that companies only have to provide information to one government department rather than many as is currently the case, and to have HMRC provide more support on evenings and weekends. They have also explored and critiqued tax models such as ‘look through’ taxation, which would tax business owners directly on company income (and therefore replace Corporation Tax).
Another tax change they have considered in detail is the concept of a SEPA, otherwise known as a Sole Enterprise with Protected Assets. This new tax form would give sole traders a degree of limited liability protection for their assets, removing the need to incorporate their business and take on added administrative burdens. In polling undertaken by Ipsos MORI, 78 percent of company owners agreed that gaining protection through limited liability was an important consideration in their decision to incorporate, with 60 percent pointing to tax savings. We believe the government should take seriously the idea of establishing a SEPA, however would urge that the limited liability protects the pension of business owners as well as their primary residence.
Another way to reduce tax compliance burdens for the self-employed would be to allow the smallest of companies to use cash accounting methods over accruals accounting. Cash accounting allows for the recording of income and expenses as and when money enters and leaves a business. In contrast, accruals accounting requires that income and expenses are recorded at the point they are incurred, regardless of whether the cash moves later. Accruals accounting can create cash flow headaches for small businesses as it may require them to pay tax on money they have yet to receive.
Not everyone is in agreement about the relative merits of cash accounting over accruals accounting. Some believe that accruals is less prone to abuse and gives shareholders a better picture of how a business is performing. The Office of Tax Simplification, however, notes that cash accounting gives sufficient detail for most small companies, particularly those with just one owner-director. Moreover, conceptually, most owner-directors tend to think about their businesses in cash terms rather than accruals terms. HMRC and the Treasury should further explore the scope and appetite for accounting practice reform.
Recommendation #4 — Consider extending the use of cash accounting to the smallest of companies
HMRC and the Treasury should reflect on the findings of the Office of Tax Simplification’s small business tax review, and in particular consider whether there is a strong case for allowing the smallest companies to use cash accounting methods.
What about Making Tax Digital?
By 2020, HMRC plans to have transitioned to a fully digital tax system. The aim is to create a ‘real time’ service that allows taxpayers to submit information on an ad hoc basis, and which gives them a more accurate and up to date assessment of their tax liabilities. Sole traders will no longer have to complete an annual self-assessment, but will be required to update HMRC at least quarterly with their details. This change has caused concern among some business and accountancy groups who believe it will create an added burden for the self-employed, particularly those lacking digital skills. While these fears are understandable, over the long run Making Tax Digital promises to make tax reporting more seamless for businesses, with fewer unexpected tax bills and more help in calculating liabilities (e.g. through a new service that pre-populates digital accounts with information provided by banks and pension providers). HMRC should continue to liaise with business groups to ensure the upcoming digital system fully accommodates the self-employed.
Calling time on Corporation Tax cuts
A final consideration for the government is where the relative burden of taxes should fall. How much should be raised through VAT and how much through Corporation Tax? How much through National Insurance and how much through business rates? These questions become increasingly open as we see the waning of hypothecated taxes designated to fund particular services. Business rates, for example, ostensibly exists to cover the cost of the local amenities that firms use in their area. Yet many doubt they will see the full benefit of their contributions.
The last government under Cameron and Osborne committed to a clear and consistent strategy of cutting Corporation Tax, which they saw as the surest way to support entrepreneurship and attract businesses to operate in the UK. The main rate fell from 28 percent to 20 percent between 2010 and 2015, and is set to fall to 17 percent by the end of the decade. Last year saw calls to reduce the rate of Corporation Tax even further to 15 percent, with the ex-chancellor saying at the time that such a move would show the world that the UK is “still open for business”.
But is the government right to focus so heavily on Corporation Tax? First, it only affects incorporated businesses making a profit. Second, the UK already had one of the lowest Corporation Tax rates in the OECD. And third, government surveys show that just 20 percent of small businesses who say that tax is an obstacle point specifically to Corporation Tax. As Table 1 shows, more important to most of the self-employed are VAT, business rates and National Insurance. Moreover, it is possible that the government recouped the funds lost in the Corporation Tax cut through its subsequent uplifting of the dividend tax and changes to the VAT Flat Rate Scheme.
If the government is to cut business taxes in future, we would urge them to focus less on Corporation Tax and more on relieving the levies that most of the self-employed find truly burdensome. An immediate step could be to shelve the proposed reduction in Corporation Tax from 20 to 17 percent, and use the funds instead to reduce the Business Rates multiplier.
Recommendation #5 — Lessen the fixation with Corporation Tax and concentrate future efforts on more burdensome levies
The new government should reconsider its commitment to reducing Corporation Tax to a new low of 17 percent, and instead aim cuts at more burdensome taxes such as business rates and VAT.
Zooming out to look at all forms of taxation — business and otherwise — there may also be a credible argument for rebalancing the overall tax burden away from earned income (ie from employment and entrepreneurial activity) towards unearned income (ie inheritances and capital gains such as property appreciation). Here the rationale is not technical but moral: earned income is the result of individual effort and ingenuity, whereas unearned income is typically born (although not always) from good fortune.
The tax blogger and barrister Jolyon Maugham speculates that a 2.5 percent annual charge on aggregate wealth of £1.3tn could yield enough to bring the top rate of Income Tax down from 40 to 30 percent, while achieving a revenue neutral outcome. In reality, a wealth tax is a political non-starter and, in any case, would be enormously difficult to implement in practice. However, there is merit in exploring, for example, whether a radical reduction in Income Tax or NICs could be paid for through a rise in Inheritance Tax or Capital Gains Tax. We plan to consider options for wealth tax reform in future research.
