By Helen Miller, Associate Director of the Institute for Fiscal Studies
Since 2008, 40% of the growth within the UK workforce has been generated from people working for their own businesses. Most of this has been through form of self-employment; these being unincorporated businesses. However, the number of owner-managers of companies, otherwise known as incorporated businesses, has doubled. Part of this change has been driven by growth in the so-called ‘gig economy,’ notably including jobs where independent workers are matched to customers using digital platforms operated by large companies.
The rise of independent working highlights many important policy issues which include the rights and protections available to the self-employed. While some are enjoying the flexibility that can come with independence, others are suffering the stress associated with precarious work patterns. These issues and a set of policy ideas were central to Mathew Taylor’s review, which advocated the simple and worthwhile policy goal of creating ‘good work’ for all.
Notes: The calculations assume total income generated before any tax is equal to £40,000 for each legal form. The self-employed pay less tax on the same income because they are charged a lower rate of National Insurance Contributions (NICs) and, most importantly, face no equivalent to employer NICs. Income tax payments are lower for an employee than for a self-employed person because the employee’s taxable earnings are lower as a result of employer NICs. A company owner-manager can take a salary equal to the NI secondary threshold and all post-tax profit as dividends, which are taxed more lightly than wages.
But there is a major, long-standing issue that is driving many of the trends that we’re seeing and that was explicitly outside the scope of Taylor’s Review: Tax. The UK places a hefty tax penalty on work that takes place through employment. The figure shows an example of how large the tax differences can be. Many new ‘businesses’ are being set up not because it is the most appropriate commercial archetype or the best way of arranging work, but to take advantage of lower taxes. This is unfortunately not conducive to an effective work economy. Nor is it fair that two individuals doing very similar work – two taxi drivers, say – should have such large differences in their tax bill simply because one has registered as self-employed.
A solution that is often proposed is to redefine the definition of self-employment, to recognise more of the currently self-employed as ‘employees’. This is at best a partial quick fix. Wherever there is a dividing line in tax, there will inevitably be people and companies who change their behaviour to remain on the beneficial side of it. More importantly, these tax differences had never been justified to begin with.
The government acknowledged in their response to the Taylor review that: ‘The small differences in contributory benefit entitlement no longer justify the scale of difference in the rates of NI contributions which are paid in respect of employees and the self-employed.’ Despite this, they have devised ‘no plans’ to deal with the tax differences. While this is disappointing, it is certainly not surprising. The government also announced a small increase in self-employed NICs last year but quickly reneged on it; the memories of that embarrassment are still fresh.
We probably shouldn’t expect a government who will tackle the tax differences until some common myths are eradicated. The above government quote directly refers to the myth that lower NIC rates reflect fewer social security benefits for the self-employed. In fact, the self-employed have access to almost identical government-funded benefits, including the same single-tier state pension.
Another existing myth is that lower tax rates are justified as the self-employed do not have access to the same employment rights as salaried employees. While this argument may seem enticing, it is, however, logically flawed. Unlike government-funded benefits, employment rights (such as holiday pay and sick pay) are paid for by employers. In so far as these rights make employment more attractive to the employee (relative to self-employment), they also make employment less attractive to the employer. Higher taxes imposed on employees cannot offset the effect of employment rights; they can push employers away from employment contracts and towards getting work done by self-employed contractors.
Since the tax differences are therefore not justified and are causing evident problems, the only solution is to dispose of them. Specifically, we should apply the same overall tax rate schedule to income derived from employment, self-employment and to running a company. Different income sources would still be subject to the varying combinations of income tax, NICs, capital gains tax and corporation tax, but an additional £1 of income should be taxed at the same rate regardless of how it is earned. Alongside overall rate alignment, we should adjust the tax base to ensure that genuine businesses don’t face a disincentive to invest. If the government additionally wants to boost specific activities – e.g. innovative start-ups – we could design measures that are better targeted, rather than simply giving tax breaks to all business owners.
In my opinion, a good work economy for all is one in which people’s choices over how to work are not driven by arbitrary tax differences. For that reason alone, we need to bust the myths about why the tax penalty imposed on employment exists and start a conversation about how to transition to a better way of taxing work.
As an added motivation, the relative growth in self-employment is forecast to reduce tax revenues by billions of pounds. The government may be ignoring tax for now, but the problems it causes aren’t going anywhere until we actively fix the tax system.