Choosing how to tax citizens and businesses is the legitimate right of elected politicians. Deliberately opting out of the proper collection of tax is not.
Chancellor Kwasi Kwarteng’s backtracking on the enforcement of the so-called IR35 rules in his “mini” Budget raised a cheer from those happy to sidestep the proper payment of tax on employment. But by reopening opportunities to exploit tax rules it does nothing for growth and undermines the wider integrity of the tax system.
It is a longstanding feature of the UK tax rules to impose a lighter burden of tax and national insurance contributions (NICs) on the self-employed than on employees. There are arguments for — and against — this treatment, but as a policy choice it has consequences: individuals would prefer to be self-employed and those genuinely employed would like to look as if they are in fact in business.
It is not hard to find an alchemy to transform employment into a tax-favoured arrangement: a one-person company can be acquired at the click of a mouse. A contract of employment becomes the engagement of the company. The employment relationship disappears and the tax bill shrinks.
Such behaviour is an inevitable consequence of differential tax rates for broadly similar activities: in this case, an individual’s labour. Only employees pay the full rate of income tax and NICs. Those self-employed or operating through companies pay far less. Of course, the tax system has many such boundaries arising from legitimate policy choices, good or bad: the boundaries between resident and non-resident, between income and capital, between business and non-business use. But, as the current government is only too aware, borders have consequences. In tax, if boundaries are not maintained, they will be abused, tax revenues will fall and the wider legitimacy of the tax system eroded.
Policing the boundary between the self-employed and employed has not been easy. For more than 20 years the IR35 rules have been in place to tax off-payroll arrangements through the use of one-person companies as what they really are — without affecting the tax status of the genuinely self-employed or real businesses. But under those rules, employers had no obligation to monitor the status of their workers and workers had every motivation to claim the rules did not apply to them. As HM Revenue & Customs reported, before the 2017 changes only around 10 per cent of the tax due under IR35 was collected.
In 2017, the government shifted the obligation for determining liability and collecting tax to employers, without altering any liability for tax — just as the PAYE system does for all regular employees. Of course, the compliance burdens of businesses engaging off-payroll individuals were increased by this change, but the ability of many tens of thousands of individuals to claim a tax benefit due only to the genuinely self-employed was removed. Bogus arrangements were abandoned and tax revenues increased.
This was not a new tax charge in 2017 — just a better way of collecting liabilities that had been on the statute book since 2001. As the burden of enforcement shifted, a range of businesses that relied on non-compliance with the rules complained. Of course, they had a point, but businesses whose workers obtain a tax break cannot shirk some responsibility for ensuring that any benefits are properly due.
Tax policy purists argue that this privilege needs some levelling up — all individuals, however they provide their labour, should be taxed the same. The realist recognises that this privilege will be hard to shift, but in the meantime it has to be policed. As 75 years of experience with PAYE has shown, those best placed to manage the tax relationship between a business and its employees are those closest to it — the businesses themselves. Other choices are possible but impose greater overall costs and less efficient tax collection. And policing the IR35 rules has proved no different.
Despite this, on the pretext of a pro-business argument, Kwarteng has acted. He could not go so far as to abolish the underlying tax liability — to do so would be tantamount on giving up on PAYE and would cost many tens of billions. IR35 remains in place — and rightly so — but the chancellor has backtracked on its effective enforcement. Businesses and individuals can now quietly revert to the use of such arrangements for employees safe in the knowledge that enforcement of tax due will be at best halfhearted and in reality ineffective. With a green light for such arrangements in place, the chancellor’s own numbers show that at least £2bn a year of tax will go uncollected.
In bowing to pressure to abandon these rules, rather than continuing the hard work of making them work better, government has mistaken partisan lobbying for a legitimate business concern. It has seen an easy opportunity to appear pro-business, when in reality the only business that is being supported by this change is the business of the tax avoider.
This is not merely a nod and a wink to avoiders and evaders: it’s a “welcome here” sign.
A handout to tax avoiders is even less fair than a tax cut for the better off. A U-turn on the removal of the IR35 rules would be widely welcomed by those who care about the fairness of the tax system and the sustainability of the public finances.
Sir Edward Troup worked at HM Treasury and HMRC from 2004-2017. He was executive chair of HMRC 2016-17.