Widening UK tax shortfall creates a nightmare for Philip Hammond

Posted on November 30, 2016

Philip Hammond is a worried man. The tax system is getting out of touch with the way people live and work, he says, leading to a hole in projected tax revenues from a rapid rise in the number of incorporated small businesses. The shortfall, set to grow to £3.5bn a year by 2020-21, is almost exactly the cost of the BBC and the chancellor warned that something must be done to protect the tax base.

The chancellor is right to be concerned. There was a 25 per cent rise in small incorporated companies in 2015 alone. Partly, this stems from developments similar to the “gig economy” in which companies increasingly trade services rather than hire people. But the self employed and small companies also pay less tax than employees for the same work. These tax advantages can be shared between those who want to buy the services and those who sell them. Savings on employer national insurance contributions — a 13.8 per cent payroll tax — are most important.

You have to feel some sympathy for Mr Hammond. It never used to be easy to switch between being an employee, self-employed or a director of your own company. Employment held advantages of security, defined benefit pensions and career progression for which many were prepared to pay a premium.

But any sympathy for ministers should be strictly limited. Their decisions have been just as important as changing work practices in raising the attractiveness of incorporation and self employment. National insurance raised just over half income tax revenues in 1979. After multiple stealth increases, it now raises 70 per cent.

Buy-to-let investors who pay the higher rate of income tax will see their ability to deduct interest payments from their profits curtailed from April, giving some an incentive to hold properties in a corporate structure that can still deduct interest.

The rise in the personal allowance from £6,475 a year in 2010-11 to £11,500 in 2017-18 along with an additional £5,000 dividend tax allowance provides ever bigger advantages for couples to pay themselves in dividends from a jointly owned company, giving some the ability to extract £33,000 a year from a company tax free.

To avoid admitting it was raising tax rates, governments since 2010 have been fond of withdrawing tax allowances and benefits from the better off. Child benefit, the personal allowance and pension tax relief on contributions are all tapered away at different levels of income, creating wide bands where the effective tax rate is about 60 per cent.

Incorporation allows those affected by these high rates, particularly those who have temporarily high incomes, to store money in their companies and pay income tax later at lower rates when their earnings are lower.

UK governments have been addicted to stealthy tax rises, have introduced crowd-pleasing initiatives to remove interest relief on buy-to-let properties and have been obsessed with creating a large tax-free allowance that a couple would be foolish not to seek to use. These create stark incentives for many to incorporate, if they can. No one should be surprised.

And you will have noticed that many of the examples apply largely to people on high incomes, exactly those who often have greater flexibility in the way they structure their work, can borrow and so do not need to take every penny of their earnings as income every year.

There is one final statistic that should occupy the chancellor. The Office for Budget Responsibility thinks that almost half the £60bn annual increase in income tax revenues he wants to collect by 2020 will come from 1.5 per cent of taxpayers with incomes over £150,000. They can really shift money about. He shouldn’t be worried about these revenues failing to materialise. He should be terrified.

chris.giles@ft.com

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