It may seem that when designing a tax system there is a natural order of things. First, we must decide on the aims, principles and underlying legal concepts. Only then do the practicalities need to be considered. But tax design does not work quite like that. Practicalities are more central than this description implies. Many accept that a broad concept of optimal taxation should include considerations such as administrative and compliance costs (Mirrlees Review, Tax by Design, page 38). I go further and argue that administrability should be central to the tax design process. Three of Adam Smith’s four famous canons of taxation are largely about administration. Tax administration is not an afterthought but goes to the heart of which concepts should be utilised.
One example of an area where we need to discard use of some legal concepts in order to achieve sensible and workable reform is around employment status. Distinctions between the employed, the self-employed and personal service companies have been muddied by changes in work practices. Case law developments from various areas of law plus specific legislation modifying employment law and taxation, in particular, have created further complexity. Yet we cling to these concepts for tax purposes.
There is general agreement that people providing services via different legal forms are taxed differently and pay different national insurance contributions and that this does not always reflect differences in the services being provided and the rights accruing. Whether the legal arrangements used arise from the requirements of the engager or the wishes of the service provider (and this varies), the tax system can distort commercial decisions, be a trap for the unwary, and create complexity and cost. The government sees some of the arrangements as reducing revenue it should be collecting. It could also be said that some taxpayers are paying more than they would have to if they were better advised. Either way, there is a lack of horizontal equity (Small business taxation (Claire Crawford and Judith Freedman), 2010; Taxing work and investment across legal forms: pathways to well designed taxes (Helen Miller and Adam Stuart), 2021).
The covid pandemic has exacerbated some of the differences. For example, directors of personal service companies who paid themselves by way of dividend found themselves at least partially excluded from schemes designed for employees paid through the PAYE system. One impact of this experience is that these owner-managers now argue vociferously that these dividends are really remuneration (whereas previously they denied this). This may be the perfect time to revise the rules to reflect what all agree to be reality (although those excluded from support schemes may not see it this way unless something is done to assist them first as urged by the PAC in January 2021 and the Treasury Committee on 15th February 2021). We know from the chancellor’s own statement when announcing coronavirus measures in March 2020 that the pandemic has highlighted disparities in the eyes of government, but the problems are not new: they have merely been highlighted by the new circumstances.
Much of the discussion of reform in this area focuses on categorisation of service and labour providers and attempts to improve clarity at the boundaries. It has been argued that one solution would be a new intermediate category of dependent contractors (Taylor Review, 2017). Another suggestion sometimes made is a statutory definition of the distinction between employed and self-employed. It seems to be taken for granted that the basic categories of employee and self-employed are fundamental organisational principles for a tax system. Alignment between categorisation of tax and employment law purposes as far as possible is seen as desirable by many and is current government policy. However, there is absolutely no reason why this should be the case. Nothing is set in stone. If the objectives of our tax system can be achieved more easily by moving away from distinctions that are used in other areas of law, which have different objectives, why should we be tied to those categories? Tax law and employment law have completely different purposes and trying to tie the two together may increase rather than decrease complexity and distortive incentives.
The employed/self-employed split for taxation was not the organising distinction when income tax was first introduced in the UK. It became important to the way we organise our tax system for mainly administrative reasons. There is no reason why we should not alter it again if that would serve our objectives more appropriately.
When Addington introduced his Income Tax Act in 1803, employees of firms and individuals were taxed under Schedule D case II (in much the same way as professions and trades). Only officers of government departments, municipalities and public companies were assessed under Schedule E, being the rules that have now transformed into those for taxing employees. Tax was deducted at source under Schedule E, but those under Schedule D had to pay their tax themselves if they were earning enough for this to be an issue. Many employees were moved into Schedule E from Schedule D by Finance Act 1922, following the decision of the House of Lords in Great Western Railway C v Bater [1922] 8 TC (‘The Birth of PAYE’ (John Jeffrey-Cook), Taxation, 1 May 2002). However, there was still no deduction at source for manual weekly wage earners. These earners, though undeniably employees for other purposes, were dealt with by special provisions in the Income Tax Acts. Employers and employee representatives giving evidence to the Royal Commission on Income Tax of 1920 opposed deduction at source for this group on the basis that a flat rate deduction would not represent the wage earners’ true liability and anything based on his actual circumstances would involve imparting too much information to employers and place too great a burden on them. Not until 1943, as World War II bought even more weekly wage earners into income tax, did what we now call the PAYE system begin.
So we see that in the past, there was no assumption that all those who might have been defined as employees for employment law or tort purposes would have been taxed in the same way as each other. Taxation of each group was based on administrative considerations regardless of their employment status for other purposes. We might not recognise those groupings as sensible now, but they served their purpose then. When they ceased to do so, tax law changed.
The idea that the employed/self-employed distinction is a fundamental concept on which our tax system must be based is relatively new. And if it no longer suits our objectives, we can move away from it. This has always been an administrative arrangement, not a principled one. Case law and legislation based on principals and agents and masters and servants, control and substitutability and mutuality – concepts that have been developed in many areas of law and not specifically for tax purposes – do not seem fit for purpose. Nevertheless, at the moment we are bending over backwards to retain our old concepts at the core and fit new ways of taxing new activities around these ideas. The result is confusion, much litigation and legislation of increasing complexity.
This does not need to happen. Instead of the IR35 rules trying to use existing case law on employment status to create a set of tax consequences that mimic the tax consequences for employees, we could have a rule that is related to more relevant attributes. Deduction of tax at source could occur when payments were made for work of various kinds without creating any implication, one way or the other, for employment law, tort or other legal purposes. Criteria would be based on administrative considerations. This would remove tax driven decisions about work arrangements and some, at least, of the financial incentive not to employ staff. The core administrative need for an efficient way of deducting tax at source would be met without distorting commercial decision making. Online platforms could be incorporated into this new system, an issue which the government and the Office of Tax Simplification have begun to explore already (The role of online platforms in ensuring tax compliance by their users (HMRC), 2018); Platforms, the platform economy and tax simplification (Office of Tax Simplification), 2018).
It will be objected that some labour and service providers have greater expenses than others and that provision must be made for these. In the past a system of cumulative withholding that required little intervention and adjustment at the year-end was important. The tax system would not have been able to cope with multiple adjustments for individually tailored allowances and deductions. This is one reason for the very limited deductions available to employees under our existing system. The advent of digital filing and personal tax accounts could change all this and make it feasible to change our substantive tax rules to give a more tailored approach. This would fit well with the removal of a sharp distinction between the employed and self-employed for tax purposes and recognise the reality of a spectrum of working arrangements more effectively. The narrow rules on deductibility for employees are an example of tax design with administration at its heart – but this is also tax design that can and should change if new technology leads us to a rethink. A combination of withholding, provision of data by third parties and interaction by the individual taxpayer with the tax authority through digital accounts is not only feasible but also a desirable way of reducing burdens and also encouraging taxpayer understanding of tax paid. Objections will echo those made in relation to bringing wage earners into deduction of tax in 1920, but solutions were found when this became necessary. Not only can technology assist but it should shape our thinking about reform.
What of national insurance contributions (NICs)? Although at one point there was some correlation between contributions and entitlement from the national insurance system, that has weakened to the point of virtual non-existence now, and the remaining differences could be removed fairly easily (Tax and employment status: myths that are endangering sensible tax reform (TLRC discussion paper), 2020), leading eventually to a tax and NICs merger. The division was an administrative convenience at one time but no longer serves this purpose. Employer contributions need to change fundamentally in any event to reflect changing work practices, greater use of automation and so on. If we can liberate the system from the straitjacket of the employed/self-employed divide it will become easier to find answers to these questions.
Lest this reasoning be considered unrealistic, note that, in addition to its work on platforms and income tax, the government is already consulting on a move away from principal/agent law for VAT. Given that this basic concept of contract law is not working well in a VAT context, the proposal is to develop different criteria for applying VAT to taxing digital platforms, based on modern business modes (see HM Treasury’s VAT and the sharing economy: call for evidence, December 2020). As with a move away from the employment status case law, this recognition that contract law is not necessarily the best basis for taxation is a first step to creating a level playing field in this area and ensuring that operations would not be dictated by tax considerations but be based on commercial decisions.
The purpose of this article is not to set out comprehensive solutions to the specific issues discussed, but rather to show the need to jettison concepts that no longer fit with our objectives and to recognise the role that administration plays in tax design. Social change combined with the Second World War resulted in the highly successful PAYE system we have now; the consequences of 21st century social and economic changes combined with a pandemic could lead us to an equally successful new administrative solution to current problems.
It may seem that when designing a tax system there is a natural order of things. First, we must decide on the aims, principles and underlying legal concepts. Only then do the practicalities need to be considered. But tax design does not work quite like that. Practicalities are more central than this description implies. Many accept that a broad concept of optimal taxation should include considerations such as administrative and compliance costs (Mirrlees Review, Tax by Design, page 38). I go further and argue that administrability should be central to the tax design process. Three of Adam Smith’s four famous canons of taxation are largely about administration. Tax administration is not an afterthought but goes to the heart of which concepts should be utilised.
One example of an area where we need to discard use of some legal concepts in order to achieve sensible and workable reform is around employment status. Distinctions between the employed, the self-employed and personal service companies have been muddied by changes in work practices. Case law developments from various areas of law plus specific legislation modifying employment law and taxation, in particular, have created further complexity. Yet we cling to these concepts for tax purposes.
There is general agreement that people providing services via different legal forms are taxed differently and pay different national insurance contributions and that this does not always reflect differences in the services being provided and the rights accruing. Whether the legal arrangements used arise from the requirements of the engager or the wishes of the service provider (and this varies), the tax system can distort commercial decisions, be a trap for the unwary, and create complexity and cost. The government sees some of the arrangements as reducing revenue it should be collecting. It could also be said that some taxpayers are paying more than they would have to if they were better advised. Either way, there is a lack of horizontal equity (Small business taxation (Claire Crawford and Judith Freedman), 2010; Taxing work and investment across legal forms: pathways to well designed taxes (Helen Miller and Adam Stuart), 2021).
The covid pandemic has exacerbated some of the differences. For example, directors of personal service companies who paid themselves by way of dividend found themselves at least partially excluded from schemes designed for employees paid through the PAYE system. One impact of this experience is that these owner-managers now argue vociferously that these dividends are really remuneration (whereas previously they denied this). This may be the perfect time to revise the rules to reflect what all agree to be reality (although those excluded from support schemes may not see it this way unless something is done to assist them first as urged by the PAC in January 2021 and the Treasury Committee on 15th February 2021). We know from the chancellor’s own statement when announcing coronavirus measures in March 2020 that the pandemic has highlighted disparities in the eyes of government, but the problems are not new: they have merely been highlighted by the new circumstances.
Much of the discussion of reform in this area focuses on categorisation of service and labour providers and attempts to improve clarity at the boundaries. It has been argued that one solution would be a new intermediate category of dependent contractors (Taylor Review, 2017). Another suggestion sometimes made is a statutory definition of the distinction between employed and self-employed. It seems to be taken for granted that the basic categories of employee and self-employed are fundamental organisational principles for a tax system. Alignment between categorisation of tax and employment law purposes as far as possible is seen as desirable by many and is current government policy. However, there is absolutely no reason why this should be the case. Nothing is set in stone. If the objectives of our tax system can be achieved more easily by moving away from distinctions that are used in other areas of law, which have different objectives, why should we be tied to those categories? Tax law and employment law have completely different purposes and trying to tie the two together may increase rather than decrease complexity and distortive incentives.
The employed/self-employed split for taxation was not the organising distinction when income tax was first introduced in the UK. It became important to the way we organise our tax system for mainly administrative reasons. There is no reason why we should not alter it again if that would serve our objectives more appropriately.
When Addington introduced his Income Tax Act in 1803, employees of firms and individuals were taxed under Schedule D case II (in much the same way as professions and trades). Only officers of government departments, municipalities and public companies were assessed under Schedule E, being the rules that have now transformed into those for taxing employees. Tax was deducted at source under Schedule E, but those under Schedule D had to pay their tax themselves if they were earning enough for this to be an issue. Many employees were moved into Schedule E from Schedule D by Finance Act 1922, following the decision of the House of Lords in Great Western Railway C v Bater [1922] 8 TC (‘The Birth of PAYE’ (John Jeffrey-Cook), Taxation, 1 May 2002). However, there was still no deduction at source for manual weekly wage earners. These earners, though undeniably employees for other purposes, were dealt with by special provisions in the Income Tax Acts. Employers and employee representatives giving evidence to the Royal Commission on Income Tax of 1920 opposed deduction at source for this group on the basis that a flat rate deduction would not represent the wage earners’ true liability and anything based on his actual circumstances would involve imparting too much information to employers and place too great a burden on them. Not until 1943, as World War II bought even more weekly wage earners into income tax, did what we now call the PAYE system begin.
So we see that in the past, there was no assumption that all those who might have been defined as employees for employment law or tort purposes would have been taxed in the same way as each other. Taxation of each group was based on administrative considerations regardless of their employment status for other purposes. We might not recognise those groupings as sensible now, but they served their purpose then. When they ceased to do so, tax law changed.
The idea that the employed/self-employed distinction is a fundamental concept on which our tax system must be based is relatively new. And if it no longer suits our objectives, we can move away from it. This has always been an administrative arrangement, not a principled one. Case law and legislation based on principals and agents and masters and servants, control and substitutability and mutuality – concepts that have been developed in many areas of law and not specifically for tax purposes – do not seem fit for purpose. Nevertheless, at the moment we are bending over backwards to retain our old concepts at the core and fit new ways of taxing new activities around these ideas. The result is confusion, much litigation and legislation of increasing complexity.
This does not need to happen. Instead of the IR35 rules trying to use existing case law on employment status to create a set of tax consequences that mimic the tax consequences for employees, we could have a rule that is related to more relevant attributes. Deduction of tax at source could occur when payments were made for work of various kinds without creating any implication, one way or the other, for employment law, tort or other legal purposes. Criteria would be based on administrative considerations. This would remove tax driven decisions about work arrangements and some, at least, of the financial incentive not to employ staff. The core administrative need for an efficient way of deducting tax at source would be met without distorting commercial decision making. Online platforms could be incorporated into this new system, an issue which the government and the Office of Tax Simplification have begun to explore already (The role of online platforms in ensuring tax compliance by their users (HMRC), 2018); Platforms, the platform economy and tax simplification (Office of Tax Simplification), 2018).
It will be objected that some labour and service providers have greater expenses than others and that provision must be made for these. In the past a system of cumulative withholding that required little intervention and adjustment at the year-end was important. The tax system would not have been able to cope with multiple adjustments for individually tailored allowances and deductions. This is one reason for the very limited deductions available to employees under our existing system. The advent of digital filing and personal tax accounts could change all this and make it feasible to change our substantive tax rules to give a more tailored approach. This would fit well with the removal of a sharp distinction between the employed and self-employed for tax purposes and recognise the reality of a spectrum of working arrangements more effectively. The narrow rules on deductibility for employees are an example of tax design with administration at its heart – but this is also tax design that can and should change if new technology leads us to a rethink. A combination of withholding, provision of data by third parties and interaction by the individual taxpayer with the tax authority through digital accounts is not only feasible but also a desirable way of reducing burdens and also encouraging taxpayer understanding of tax paid. Objections will echo those made in relation to bringing wage earners into deduction of tax in 1920, but solutions were found when this became necessary. Not only can technology assist but it should shape our thinking about reform.
What of national insurance contributions (NICs)? Although at one point there was some correlation between contributions and entitlement from the national insurance system, that has weakened to the point of virtual non-existence now, and the remaining differences could be removed fairly easily (Tax and employment status: myths that are endangering sensible tax reform (TLRC discussion paper), 2020), leading eventually to a tax and NICs merger. The division was an administrative convenience at one time but no longer serves this purpose. Employer contributions need to change fundamentally in any event to reflect changing work practices, greater use of automation and so on. If we can liberate the system from the straitjacket of the employed/self-employed divide it will become easier to find answers to these questions.
Lest this reasoning be considered unrealistic, note that, in addition to its work on platforms and income tax, the government is already consulting on a move away from principal/agent law for VAT. Given that this basic concept of contract law is not working well in a VAT context, the proposal is to develop different criteria for applying VAT to taxing digital platforms, based on modern business modes (see HM Treasury’s VAT and the sharing economy: call for evidence, December 2020). As with a move away from the employment status case law, this recognition that contract law is not necessarily the best basis for taxation is a first step to creating a level playing field in this area and ensuring that operations would not be dictated by tax considerations but be based on commercial decisions.
The purpose of this article is not to set out comprehensive solutions to the specific issues discussed, but rather to show the need to jettison concepts that no longer fit with our objectives and to recognise the role that administration plays in tax design. Social change combined with the Second World War resulted in the highly successful PAYE system we have now; the consequences of 21st century social and economic changes combined with a pandemic could lead us to an equally successful new administrative solution to current problems.
