Previously, in “Is Universal Credit the wrong approach?”, I proposed that a thoughtfully designed negative income tax system would be more effective in delivering UC’s stated aims. I believe UC is fundamentally flawed, primarily because it does not address the UK’s low and falling wages. The feasibility of designing incentives to make work pay into UC, in an environment with low and falling wages, may be logically flawed. This doubt exists in addition to the current uncertainty about UC’s technical feasibility. In this post, I set out how negative income tax (NIT), the proposed alternative to UC, would apply to the self-employed.
Recap of the negative income tax proposal
1. Income tax would be assessed on Comprehensive Realised Income (CRI).
2. An individual’s tax-free allowance would be calculated according to the number of hours worked. The value of each hour worked would be £20 and be capped at 40 hours per week (2,080 per year).
3. A single rate of tax would be applied to comprehensive realised income, By way of example, and for philosophical reasons, the single tax rate has been set at 50%,
4. Carers, the disabled, and the infirm would be credited with 40 hours per week by HMRC. This would release a payment of £800 per week (40 hours x £20/hour) to individuals falling in these categories. Any earnings would not disqualify recipients from this minimum income guarantee. However, earnings would be taxed at the marginal rate of 50%.
5. Job seekers would be paid according to the hours they work part-time, voluntarily in the charitable sector, and in work placements. These hours would be notified to HMRC by the placement providers using HMRC’s Real Time Information reporting system. Payments would be accordingly triggered at HMRC. The placements would not be compulsory – job seekers would have choice as to the number of hours and type of work they took on. The role of the DWP would be to find and arrange work placements in cases where the job seeker has been unable to do it for themselves.
6. The self-employed (sole-traders and partners), would be allowed a tax-free allowance equivalent to deemed hours of work. The imputed hours would be capped at 40 hours per week (or 2,080 per year), as for all other cases. The hours worked would be imputed by dividing the tax-adjusted earned profits by the standard value of an hour (£20) and multiplying the result by the marginal tax rate. This arrangement would be necessary since no third party could attest to the number of hours worked.
H(n) = m x Y(n) ⁄ c
H(n) are the imputed hours for the period (capped at 52 x 40 = 2,080)
Y(n) is the tax adjusted profit in period n
m is the marginal tax rate (set to 50% in the examples)
c is the standard value of an hour worked (set to £20 in the examples)
Stephen enters self-employment at the start of the tax year. His (tax-adjusted) profits for the year come to £10,000. He has no other sources of income.
His imputed hours for the year would be
H(n) = £10,000 x 50% / £20 = 250
Hence Stephen’s tax charge for the year would be
T(n) = 0.5 x £10,000 – 250 x £20 = £0
Stephen’s disposable income is hence £10,000 because his tax charge is zero. He has used up 250 hours of his annual allowance of 2,080 hours. He could have used the unused allowance to do part-time work and/or voluntary work. His income would have been supplemented had he done this.
Had Stephen also sold his house at a capital gain of £40,000, his income tax computation would be:
T(n) = 0.5 x £50,000 – 250 x £20 = £20,000
Hence his post-tax comprehensive realised income would be £30,000. He is charged no tax on earned income but is charged 50% on his capital gain (an unearned component of comprehensive realised income)