Self-employment and negative income tax

Introduction

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

Where

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)

Example 1

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)

 

Example 2

Anita enters self-employment at the start of the tax year. Her (tax-adjusted) profit for the year comes to £100,000. She has no other sources of income. Her imputed hours of work in year n are calculated as thus.

 H(n) = £100,000 x 50% / £20 = 2,500

The hours must be capped to 52 weeks x 40 hours per week = 2,080.

Her tax for year n would be:

T(n) = 0.5 x £100,000 – 2,080 x £20 = £8,400

Anita’s disposable income (take home pay) is hence £91,600. Her tax rate is 8.4% on her earned income. 

Had Anita also received rental income (i.e., unearned income) of £10,000 in the same year then her income tax computation would be:

T(n) = 0.5 x £110,000 – 2,080 x £20 = £13,400

Note that the unearned components of comprehensive realised income have again been taxed at a straight 50%. This feature, whereby an individual’s tax-free allowance is calculated on hours worked, assists in aligning the tax system with the “making work pay” agenda that underpins the government’s welfare reforms and UC.

NB. The parameters used in these examples, i.e., a working week capped at 40 hours, a marginal tax rate of 50%. and a standard hour set to £20, produces a tax-free allowance of £83,600 on earned income. This produces low average tax rates on middle earnings and is very generous by current standards. It is intended to incentivise. Of course, the average rate will approach the marginal rate of 50% as incomes rise.

Is Universal Credit the wrong approach?

“Work doesn’t pay” is the oft cited justification for Universal Credit (UC). It’s not clear that rolling up six separate benefits into one single payment will address this  problem, aka the unemployment trap. Wages in the UK are at best static and may have been falling in real terms over the last decade. Coupled with declining real wages has been the almost complete elimination of affordable council housing. Wages nowadays are insufficient to meet private housing rental costs which have soared due to shortages. So yes, it may pay claimants to remain on benefits, particularly Housing Benefit.

An alternative to UC is to integrate the tax system with benefits. Low earners, instead of paying income tax, would instead receive a generous negative tax payment. The incomes of low earners would be enhanced to the extent that they would no longer need benefits just to survive; in short, integrating tax and benefits could give low earners independence. But how can this be achieved? One framework to achieve this is a system of cumulative hourly averaging combined with comprehensive realised income (CRI) subject to a single rate of tax

Cumulative Hourly Averaging – the advantages

  • It rewards work – those who work will pay less tax on their comprehensive realised incomes

  • It can integrate benefits with tax – a generous negative income tax is facilitated

  • It supports flexible labour markets – the incomes of zero hours contract workers will be enhanced and less variable. There should be no need of a minimum wage.

  • It restores or strengthens the contributory principle.

Comprehensive Realised Income – the advantages

  • It addresses inequalities in wealth distribution – wealth transfers and other windfall gains are taxed at the same rate as earned income

  • It overcomes equitable objections to Inheritance Tax – legacies would be taxed according to the recipient’s circumstances and at the same rate as earned income

  • It reduces incentives to avoid tax – a single rate of tax can be applied to all sources of income

Cumulative Hourly Averaging – the Generalised Model

 The tax charge in period n would be calculated with the following formula:

T(n) = m∑Y(n) – c∑H(n) – ∑T(n-1)

where

T(n) = tax charge in period n

∑Y(n) = Cumulative comprehensive realised income received by the end of period n

∑H(n) =Cumulative hours worked by the end of period n

∑T(n-1) = Cumulative tax paid at the start of period n, and so ∑T(n) = T(n) + ∑T(n-1)

m = the marginal tax rate. I have used a single marginal rate of 50% applied to all components of CRI  without preference

c = the value of an hour of work. I have set this to £20 so as to produce a generous negative tax component which encourages work

 The Mechanics

Before illustrating how the tax calculation works, I have set out some parameters which I have used in the examples below. These are:

  • The standard working week has been set to 40 hours per week

  • The standard wage rate (or the value of an hour of work) is £20. Note this is an administrative value and has nothing to do with a minimum wage.

  • There is no minimum wage

  • A flat rate income tax of 50% applies to all components of comprehensive realised income without preferment. This is a limiting rate, meaning no one in work will pay tax at this rate however high their income.

  • Tax free personal allowances depend on cumulative hours worked and are valued at £20 per hour worked.

  • Tax free personal allowances are carried over to succeeding years, unlike the current “use or lose” system

  • No individual’s personal allowance can exceed 48 hours in a week

  • HMRC operates RTI (Real Time Information) so that incomes and changes in circumstances are reported as and when they occur.

 

Example 1

Freda starts work for 30 hours per week at £7 per hour (£210 per week). She has no other sources of income.

T(1) = = 0.5 x £210 – £20 x 30 = – £495

Freda will pay no income tax and instead will receive £495 under the negative tax mechanism. Her disposable income will thus be £210 + £495 = £705.  Not bad for a week’s work !

In the second week, Freda’s tax calculation is as follows:

T(2) = 0.5 x £420 – £20 x 60 – (-£495) = -£495

So again, Freda’s disposable income (take home pay) will be £210 +£495 = £705. Enjoy yourself, Freda. you deserve it! And so it will continue until Freda’s circumstances change.

Example 2

George starts work as a director of a large company. His monthly remuneration package comes to £60,000. His monthly hours of work are restricted to 208. He has no other sources of income

T(1) = 0.5 x £60,000 – £20 x 208 = £25,840

So George’s disposable income will be £60,000 – £25,840 = £34,160.

T(2) = 0.5 x £120,000 – £20 x 416 – £25,840 = £25,840

So long as George’s circumstances don’t change his monthly disposable income will remain at £34,160.

 

Example 3

Mark Anthony is a notorious playboy who has never done a day’s work in his life. His very rich father bequeaths Mark Anthony £500,000 in his  will. Mark’s tax liability will be:

T(1) = 0.5 x £500,000 – £20 x 0 = £250,000

In the second  period, Mark Anthony decides to do some voluntary work. He registers 30 hours with HMRC.

T(2) = 0.5 x £500,000 – £20 x 30 – £250,000 = – £600

Mark Anthony is rewarded for his voluntary work to the tune of £600 via the negative income tax mechanism. Work pays! Even unpaid work.

 

Example 4

Lois has a severe disability that limits the amount of work she can do in a week to 10 hours. She is paid £3 per hour (there is no minimum wage). HMRC credits Lois with 30 additional hours per week to compensate her for the hours she is unable to work through no fault of her own. She has no other sources of income. In week 1 her tax will be calculated thus:

T(1) = 0.5 x £30 – £20 x 40 = – 785

So Lois’s disposable income in week 1 will be £30 + £785 = £815. This is an example of how institutions can be used to compensate disadvantage.

In week 2, Lois receives a pay rise of £2 per hour to £5 per hour. Her tax calculation in week 2 will be

T(2) = 0.5 x £80 – £20 x 80 – (-785) = -£775

Lois’s disposable income in week 2 has risen to £50 + £775 = £825.  A pay rise of £20 per week has resulted in Lois’s disposable income increasing by £10 and the state subsidy falling by an equivalent amount.

Example 5

Tony is a homeless alcoholic, without work or income. He is offered 40 hourly work credits per week which will trigger weekly payments of £800 via the negative income tax mechanism provided he undergoes treatment for his alcoholism at a residential clinic. In Tony’s case, the  weekly payments are paid directly to the clinic instead of to Tony, Tony will need to price himself into employment when his treatment is completed, a task made easier absent a minimum wage.

Information requirements

HMRC will need to keep an up-to-date record of every taxpayer/claimant and changes in their circumstances. This is not as onerous or as intrusive as might at first appear; RTI, which requires employers to submit details of employee  hours and pay in “real time”,  has already been introduced. The road has already been dug.

 Here is a logical record of the information and processing that HMRC would need to collect and process for an employee. The particular employee shown in the record has had a particularly turbulent time, starting as a highly paid director, becoming unemployed, suffering disability, inheriting a sizeable estate, etc, all in six weeks!. The record is not intended to be of a typical employee but is illustrative of how income tax would work under cumulative hourly averaging with CRI .

Table of events

Conclusion

One thing writing this post has taught me is how difficult it is to design a safety net which both protects and incentivises.  A safety net  which is too generous removes incentives to return to, or to get into, work. A safety net built around stick and no carrot is cruel and damaging to individuals. I fear that Universal Credit, with its vicious sanctions regime and its heartless treatment of the sick and disabled, falls into this latter category. I venture to suggest that the negative income system outlined above, albeit with its fault lines, would be more effective than the proposed UC project should the latter ever go live. The system outlined above is certainly kinder than UC. Having said this, it may be that the proponents of Unconditional Basic Income win the day – UBI sidesteps the tension between incentive and protection. Perhaps this is the way to go.

Acknowledgement

It would be remiss of me not to acknowledge the brilliant work of Douglas Bamford in the field of taxation and philosophy. Douglas very kindly gave me sight of his then forthcoming book in advance of its publication. His ideas on cumulative hourly averaging have very obviously informed this piece, as has his idea of using comprehensive income as a tax base. His book is entitled Rethinking Taxation – An Introduction to Hourly Averaging. ISBN 9781907720918.

Any errors or sub-standard work contained in this piece are mine, and mine alone.

Addendum 2 September 2014

1. Quite rightly, it has been pointed out to me that the negative tax proposal outlined above does not say much about unemployment support. To answer this, I suggest work placements should be available for all jobless people, which they can choose to take up. There should be no compulsion as to participation or as to the type of placement. If a jobless person can arrange a placement of their choice, say in a museum, then so be it. The only requirement would be the readiness and agreement  for the placement provider to submit the hours worked to the HMRC as registered hours. The registration of hours worked each week under RTI reporting would then trigger a payment via the negative income tax mechanism to the worker in the same way as for other employees.

2. People who have caring responsibilities, either for children or for aged parents, should receive hourly credits equal to the standard working week  (40 hours according to the parameters used in my examples).

3. Profits on the sale of houses, even if a house in question is a Principal Private Residence (PPR), should be brought into the Taxable Comprehensive Realised Income calculation. Currently, the gain on sale of a PPR is exempt from taxation.

Defeatism and zero hour contracts

What are zero hour contracts? 

These are employment contracts that confer minimal rights on employees and place minimal obligations on employers. With these contracts, the employer sets the hours but the employee is only paid for the time spent performing his or her duties. If during the hours set by the employer, the employee is not given any work to perform, then the employee receives no pay. Essentially, a zero hours contract pays on an output basis but requires an employee’s input on a time basis. In short, the employer has bought the employee’s labour time for free.

What is wrong with them?

Frequently, an employee on a zero hours contract may be delivering more hours to the employer than he or she is being paid for.  For example, an employment contract may require an employee to be available to the employer for, say, 30 hours  per week. The same contract may say the employee will only be paid for time spent on directly producing the product or service. Under this arrangement, an employee may only be paid for, say, 5 hours of work in a week despite being under the employer’s control for 30 hours.

Is this lawful?

Apparently so, although a court  of law may deem otherwise should a case ever be presented. Employment law does not require an employer to provide work to employees.  Under a standard employment contract, the employer is obliged only to pay the agreed wages, not to provide work. So employees are paid for idle time under a standard employment contract, but not under a zero hours contract.

What is HMRC’s stance?

HMRC enforces the national minimum wage (NMW). At the time of writing, NMW is £6.19 but will increase to £6.31 in October 2013.  In enforcing the NMW, HMRC distinguishes between output based systems of employee remuneration and time-based systems. It appears HMRC views zero hours contracts as being output based.  Here is a quote from HMRC’s website on the matter:

If an employer sets the working hours and the workers have to clock in and out, this counts as time work, not as output work

Many zero hours contracts do not require an employee to attend the employer’s premises unless specifically called in. The pay of such employees will be viewed by HMRC as output-based.

When an employee is required to clock in, HMRC determines the contract to be time based.  Clocking in is a weak differentiator, in my view. An employee who clocks in one morning and is then sent home 5 minutes later due to insufficient work will be paid for 5 minutes at the NMW rate.  If so, then the difference between output-based pay and time-based pay will be very small, even insignificant. So even if there is a daily attendance requirement, the vast bulk of the employee’s wages may still arise from output, not time. So HMRC’s attendance criterion appears only to weakly differentiate between the two systems.

Is there a solution?

Despite the pessimism, even defeatism, emanating from HR and employment law practitioners. I suspect feasible and straightforward solutions exist. For example, HMRC could  strengthen its distinction between output-based and time-based systems of employee remuneration. If an employer places a requirement on employees to be available and on standby for, say, 30 hours per week then HMRC could mandate the employee be paid at NMW for 30 hours, even if there is no daily attendance requirement.

Enforcing the solution

Employers paying on output when in reality they are benefiting form unpaid employee time could be prosecuted by HMRC under NMW legislation.  Additionally, guilty employers could be ordered to make good the difference to HMRC. The employee victims could then receive their due payments, net of NI and income tax , via HMRC, perhaps through Universal Credit, if and when it is ever implemented. The table below provides a rough and ready example of how the underpayment for 10 employees might be calculated in a case where an employer incorrectly pays on output instead of time.

Zero hours table

To further deter unscrupulous employers, underpayment of wages could be made dis-allowable for tax purposes.