Burgeoning self-employed sector gives chancellor a taxing problem

The chancellor has plenty on his plate as he contemplates his first budget in only a month’s time: the uncertainties surrounding Brexit, a stubbornly high deficit and a health and social care system that looks like it might finally be buckling in the face of years of austerity. Yet he must not allow the urgent to crowd out dealing with longer-term structural problems.

On the spending side, the Office for Budget Responsibility suggested recently that health and social care spending might have to rise by tens of billions of pounds over coming decades. But we also have problems on the revenue side. Mounting spending pressures are matched not by a robust and growing tax base but by a tax take threatened from all sides.

Some of those threats are self-imposed. Continually increasing the tax-free personal allowance is expensive. A loss of revenue from petrol taxes has resulted from political timidity in the short run, but long-run technological change is likely to undermine that tax base, in any case. Then there are changes in the way we work.

Income tax and national insurance contributions account for getting on for half of all tax revenues. And the great majority of those taxes are paid by those of us in employment via our employers. The revenues arrive in the Treasury’s coffers pretty much automatically through the PAYE system. But that is changing as we change the way we work, and the consequences for the Exchequer could be profound.

It remains the case that 85 per cent of us workers are common-or-garden employees. Nevertheless, the growth in the numbers of self-employed and company owner-managers has massively outstripped growth in standard employment over recent years. Between them, they account for 15 per cent of the workforce but for 40 per cent of its growth over the past decade or so. Over that period, the number of company owner-managers has doubled.

Some of that might be to do with the “gig economy”, with online platforms such as Uber making it possible for people to work for themselves in quite new ways. It might be that people are feeling forced into self-employment by a lack of opportunities in the traditional sectors. It might be a flowering of the entrepreneurial spirit. Whichever it is, it presents the chancellor with a problem. In November, the OBR warned that the relatively fast growth in the number of company owner-managers is likely to cost the Treasury another £3.5 billion a year by the end of the parliament, on top of the costs already sustained from the doubling in their numbers.

How can having more self-employed people and more companies be costly? It’s because the tax system treats them rather more favourably than it treats employees. If a company is willing to pay £40,000 to get some work done, more than £12,000 of that £40,000 will go in income tax and national insurance contributions if it hires an employee to do the work. If it contracts with a self-employed individual, about £9,000 of tax will be due, falling to less than £8,000 if a company owner-manager does the work.

Those advantages come from the simplest operation of the tax system. Company owner-managers have access to additional, entirely legitimate, ways of managing their tax bills that are not open to employees. For example, they can manage when they receive income so as not to end up paying higher-rate tax. The data is clear. They do exactly that. They also can take advantage of a generous capital gains tax regime.

In the past, some of the difference between employees and the self-employed could be explained by the fact that the self-employed earned entitlement to fewer benefits and hence paid lower national insurance contributions. With the introduction of the single-tier state pension, that is no longer the case. The difference between employees and the self-employed in terms of benefit and pension entitlements is negligible.

Perhaps, then, the lower taxes compensate for the lack of employment rights, including paid holiday, employer pension contributions and so on. If the self-employed don’t get these and employees do, is it not reasonable to tax them less? Look at it the other way about, though, and this argument looks odd, indeed. Companies already have a big incentive to avoid the costs of employing people — holiday pay, minimum wage, pension contributions. The tax system just exacerbates those incentives. This argument makes no sense at all.

What about the need to encourage entrepreneurialism? There might be a role for government here. The market might produce too few new companies, but an across-the-board relief to more than four million individuals, the vast majority of whom are simply getting on with the respectable day-to-day job of driving a taxi, providing IT services or writing for newspapers, cannot be the right way to do that. More targeted measures would make much more sense.

The present system means that two individuals doing very much the same thing can pay very different amounts of tax. That is costly and unfair. It is also inefficient, because the tax system provides people with very clear incentives to change the legal form through which they work.

Change, of course, would be difficult to implement, because some people would end up paying more tax. But while we continue to offer a tax subsidy to people who choose to work under a particular legal form, we will continue to see more people take that course. The tax base will continue to erode. The rest of us will end up bearing the cost.

This article was first published by The Times and is reproduced here in full with permission. Paul Johnson is director of the Institute for Fiscal Studies. Follow him on @PJTheEconomist