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IFS report says self-employed 'have unfair tax advantage'
by Susie Hughes at 12:42 03/02/17 (News on Business)
A report from The Institute for Fiscal Studies (IFS) has suggested that the self-employed benefit from an unfair tax advantage over their counterparts in employment.
It says that differences in the way the tax system treats the self-employed, owner-managers and employees are 'costly, inefficient and unfair'. it also cites the ability of company-owners to take income from their company by way of dividends rather than wages to receive 'even lower tax rates'.

The report has been criticised by representatives of the self-employed sector who fear it will reinforce misunderstandings about the nature of self-employment and again fails to take into account the differences between the two sectors.

The report says that although employees make up 85 per cent of the workforce, the tax system is much less favourable to those in employment than to the 15 per cent who work for themselves.

The report acknowledges that during the last eight years nearly 40 per cent of the growth in the workforce has come from the self employed and company owner-managers. But, it says, some of this may be due to growth in the so-called gig economy, but that is by no means the whole story.

It says that the tax differences are small at lower earnings levels but substantial for higher earners. It cites several examples:

  • At £15,000 (employer cost), tax on employees is £631 a year higher than if the income was earned by a self employed person and £818 higher than if earned by a company owner manager;
  • At £40,000 the differences are £3,442 and £4,502 respectively;
  • At £100,000 the differences are £7,365 and £8,035 respectively.

The IFS said: "Giving lower taxes to individuals who work for themselves is costly. The Office for Budget Responsibility estimates that rapid growth in the number of small companies will cost the Exchequer an additional £3.5 billion in 2021–22, relative to a world in which the small company population and employment grew at the same rate.

"It is inefficient because the tax system drives people to change their behaviour – to register themselves as a company rather than work as an employee, for example. And it is unfair because two people earning the same amount for doing similar work can pay different amounts of tax."

Freelancer group, IPSE, roundly condemned the report, describing its assertion as 'ludicrous'.

Chris Bryce, IPSE CEO said: “To suggest the self-employed are somehow operating to the detriment of other workers is ludicrous. It’s no coincidence that as the numbers of the self-employed have risen, we’ve drawn closer to full employment overall.

“The flexibility of the UK labour market is one of our strongest competitive advantages, which is particularly valuable as we negotiate our exit from the EU. Research from Kingston University showed freelancers alone – who make up around two in five of the wider self-employed population – contributed £109 billion to the UK economy in 2015.

“It seems that the IFS, like many others, have totally failed to recognise the huge differences between employment and self-employment. Working for yourself means taking on all the risk - you get no sick pay, no paid training, no employer pension contributions, no big company benefits, and no guarantee of another job when your contract is complete. Despite this, the IFS report suggests more punitive taxes should be applied to the self-employed.

“A raft of tax measures have been introduced over the past few years which specifically target this group. The restriction of tax relief on travel and subsistence expenses, the tightening of rules on intermediary reporting and the forthcoming changes to IR35 legislation in the public sector have all made life increasingly difficult for the UK’s self-employed workforce.

“The report comes at a time when the labour market’s unique flexibility, which helped the UK to weather the storm of the recession, is at risk. Businesses’ ability to react to peaks and troughs in demand is severely under threat as a result of shortcomings in the tax system and fundamentally flawed assumptions. IPSE agrees that the UK’s tax system is far from perfect and needs a total overhaul. Our system is based around a 19th century way of working and we need to start thinking for a 21st century world.”

In the report, IFS researchers set out how the labour market is changing, how employees, the self-employed and company owner-managers are taxed, and how the tax treatment can be made fairer and more efficient. This forms part of the forthcoming IFS Green Budget 2017, produced in association with ICAEW and funded by the Nuffield Foundation.

Key findings in the report include:

  • The labour market is changing. Most of the 31.1 million strong workforce are still in permanent employment positions. But since 2008, a quarter of the growth in the workforce has come from the self-employed, who now number 4.0 million. In addition, the number of company owner-managers has doubled since 2008 and now stands at just under 580,000.
  • Lower tax rates are not justified by fewer employment rights. Employees benefit from minimum wages, sick pay and holiday pay, for example. This has two effects. First, it makes employment more attractive to the employee (relative to self-employment). But, second, it makes it less attractive for companies to employ people as opposed to hiring a self-employed contractor. By making employment less attractive and self-employment more attractive, the tax system offsets the first effect but exacerbates the second effect.
  • The self-employed get a tax advantage equal to an average of £1,240 per person per year as a result of lower National Insurance contributions relative to employees. This cannot be justified by what are now only very slight differences in benefit entitlements. The self employed pay £3 billion a year in NICs. If they were treated just the same as employees they would pay £8 billion a year.
  • Company owner-managers can get even lower tax rates by taking income out of a company in the form of (more lightly taxed) dividends rather than wages. This is easy to do. Some can reduce their tax rates still further if income is retained in the company and later realised in the form of capital gains, which, for most owner-managers, attract generous entrepreneurs’ relief.
  • Across-the-board lower tax rates are a poor way to boost entrepreneurship. The difficulty and risk associated with entrepreneurship do not in themselves justify favourable tax treatment. There may be other reasons we are not be producing ‘enough’ entrepreneurial activity, in which case we should consider other policies to promote entrepreneurial behaviour. But lower tax rates for certain legal forms are poorly targeted, inappropriately distort choices and create opportunities for avoidance.
  • Leveling the playing field requires a two-part solution. First, the money invested in a business should be deductible from taxable income. This is important. It would ensure that investment is not discouraged and help many businesses. Second, each additional pound of income should then be taxed at overall rates that are the same for an employee, self-employed person or company owner-manager and regardless of whether it comes in the form of wages, dividends or capital gains.

Woolly thinking
Helen Miller, an associate director at the IFS and a co-author of the report, said: “There's a lot of very woolly thinking about how we should tax the self-employed and company owner managers relative to employees. The differences in entitlement to state benefits are now far too small to justify the lower rates given to the self-employed. And lower rates are not a good way to incentivise entrepreneurship.

"Changes in working patterns, including those related to the gig economy, make tackling current differences all the more important both to protect the public purse and to avoid giving incentives for big companies to treat people as self employed rather than as employees.”

Tricky business
Stuart Adam, a senior research economist at the IFS and a co-author of the report, said:
“The taxation of the self-employed and company owner-managers sits at the point where many different parts of the tax system meet. This makes it a tricky business because incentives are shaped by the interactions of taxes on wages, dividends, capital gains and corporate profits.

"Making changes to any one can be the policy equivalent of ‘whack-a-mole’; well-intentioned policies can lead to problems popping up elsewhere. To create a truly level playing field we must be bold and work towards a solution that sees the tax system for what it is: a system.”

Tax, legal form and the gig economy is a pre-released chapter from the forthcoming IFS Green Budget 2017.

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