Evaluation of the UK Tax System and the Proposals of the Mirrlees Review
The first part of this paper assesses the canons of taxation, generally acknowledged as the benchmark for good tax systems, in order to determine its critical elements and to evaluate the extent to which the taxation system for small businesses in the UK conforms to its principles. According to the classical suggestion by Adam Smith, a good tax system should be judged by four broad standards: a. clarity and certainty to the tax payer; b. Low cost relative to yield c. convenience for the tax payer; d. Equity (i.e. the levying of taxes in a fair manner and according to one’s ability to pay). The taxation system for small businesses would be compared with these standards. The second part of this paper focuses on the recommendations of the Mirrlees review with a view to analyzing and discussing its level of conformity to the elements contained in the canons of taxation.
A. Canons of Taxation and the UK’s Taxation System for Small Businesses
The ‘canons’ of taxation proposed by Adam Smith in the 18th century have long been adjudged to be the standards by which good tax systems should be measured. In simple terms, these canons have to do with the equality, certainty, convenience of payment, and economy of tax collection (see MacKie-Mason and Gordon, 1997; Salanie, 2003). It is therefore pertinent to evaluate the extent to which the UK’s system of taxation for small businesses is consistent with these canons. Indeed, the issue of taxation of small businesses in the UK, and the merits or demerits of the system is one that has long generated controversy (Murphy, 2007: 3). However, there is a problem of interpretation as regards what constitutes a ‘small business’ given that the term’s heterogeneity also presents opportunities for debate (see Hertz, 1982); it is therefore necessary to contextualize the term in order to avoid confusion.
For the purposes of this paper, it is sufficient to adopt the qualitative definition of small business as one that “independent firms that are managed by their owners in a personalised way”, regardless of their levels of turnover or profit (Crawford and Freedman, 2008: 4). Indeed, the definition of small business may also take the number of employees into account, and in this sense Freedman (2003: 18-19) suggests that if small business is to be defined in terms of having less 50 employees, then it could be taken that almost 99% of all businesses in the UK are small businesses. Furthermore, the three most widely used legal forms for small businesses in the UK, as reported by Freedman (2003: 20), are sole proprietorship, partnership, and Limited Liability Company.
Table 1: Some Differences in Tax Treatment for UK Taxpayers
*Source: Crawford and Freedman (2008: 9)
There are a number of problematic issues that characterize the UK system of taxation for small businesses. Indeed, one of such issues has to do with the constant changes to small business taxation by government – a factor that arguably impedes small businesses’ capacity to make plans for the future, and also creates uncertainty and a general loss of confidence for small businesses (see PCG, 2007). These frequent changes may be a consequence of the notion that small businesses have special tax needs, which warrants frequent demands made on their behalf by politicians and other pressure groups for a variety of incentives, reliefs and concessions (Freedman, 2009: 155). Furthermore, the need for simplification of taxes is another important issue as it has been argued that a simple and neutral small business taxation system is more desirable than a more complex taxation system – even when such is designed to favour some categories of small businesses (Freedman, 2009: 171).
Nonetheless, one of the central issues to note about the taxation system for small businesses (particularly unincorporated business forms) in the UK is the full integration of business and personal taxation occasioned by their being subject to income tax, capital gains tax, and National Insurance contributions (Lay and King, 1998; Freedman, 2003).
The imposition of two distinct taxes on earnings (i.e. income tax and National Insurance contributions) can be argued to be largely unfavourable for small businesses particularly in view of the complicated and rather unusual and complex marginal rate structure that fluctuates between 40 percent to 60 percent, and then 40 percent to 50 percent (Insley, 2010). The barriers to UK small businesses brought about by taxation systems have also been recognized by the Office of Tax Simplification (OTS) which noted that the maintenance of two separate systems lead to “anomalies” that may create distortions in behaviour – leading to decisions that do not make commercial sense because they are wholly tax driven and complex (OTS, 2011: 13). There is also the controversy and discontent pertaining to the IR35 legislation which is perceived as placing unnecessary administrative burdens and uncertainties on small businesses and also creating opportunities for tax avoidance (see for instance Tyler, 2011). As such these shortcomings and ‘anomalies’ are arguably inconsistent with the canon of taxation that makes it imperative for tax liabilities and taxation systems to be clear and certain in order to avoid confusion, and for such systems to consider convenience of payment for taxpayers (Malcolm, 2009).
On another level, it has been pointed out that sole traders in the UK are not regulated by clearly spelt out legal provisions with regards to legal form, and the business lacks a separate legal personality. Accordingly, a sole trader’s personal and business assets are not differentiated and this has been identified as having serious implications for such tax rules that may necessitate comprehensive records of the business’s assets alone, discrete from personal assets. Furthermore, Crawford and Freedman (2008) point out a key structural problem in small business taxation that involves an absence of neutrality between businesses with different legal forms. Small-business taxpayers that have similar accretions in their earnings are taxed differently, which reveals a system that is fundamentally inequitable. Indeed, given that a considerable number of small businesses in the UK are sole-traders or unincorporated entities, government’s attempt to promote greater incorporation (as a strategy for improving growth) has been argued to further exacerbate the problem of inequity in the tax systems and engendered more complex problems. These observations provide a clear indication that the tax systems for small businesses lacking in equity – thus violating one of the fundamental canons of taxation that sets down equality as a major parameter of good taxation. Taken together, it would seem that the major issues with the UK’s system for taxing small businesses encompass problems such as complexity, inequity, inconvenience of payment and in some cases costliness; thus exposing the elements of the canons of taxations that the tax system fails to emulate.
B. Merits of the Mirrlees Review in relation to the Canons of Taxation
In response to some of the problems and controversies trailing the UK’s taxation systems, the Mirrlees review was instituted to examine the main elements and areas of concern, and draft proposals for improving the country’s tax systems. The proposals broad goals are to simplify the country’s tax systems and put structures in place to ensure coherence and equity. Some of these proposals include the merger of National Insurance contributions and Income Tax; abolition of stamp duties; allowance for corporate equity amongst others (see IFS, 2010). However in the context of this paper and the focus on small business taxation, one proposal that is particularly relevant is that which recommends a proper integration of corporation tax with personal taxes, as well as a harmonization of tax rates on company profits on the basis of the levels of profits. Also in this regard, an ancillary proposal by the Mirrlees review suggests that the tax treatment of employment, self-employment and corporate-source income should be aligned, and also the equalization of the marginal tax rates on earnings and different forms of capital income.
Taken together, the aforementioned recommendations by the Mirrlees review represent a significant attempt to improve the UK’s tax system’s conformity to the canons of taxation. For instance, a simpler integration of corporation tax with personal taxes would help eliminate uncertainty and inequity in the way that incorporated small businesses and their owner-managers are taxed by clearly establishing and calculating the differences between the taxes levied on the businesses’ profits and the taxes on the incomes (salaries or dividends) of their owner-managers. Also, the harmonization of tax rates on company profits according to their levels of profit may effectively resolve the problem of inequitable taxation that is said to characterize the UK’s tax system (see Insley 2010). Additionally, the problem of complexity and costliness in tax rates and tax collection may be addressed by the alignment of the tax treatment for broad categories of income sources particularly employment, self-employment and incorporated entities. To a large extent it can be argued that some of the changes proposed by Mirrlees review can have a positive effect on the taxation of small businesses in the UK – in line with the canons of taxation – specifically in terms of ensuring equity, certainty/clarity, and convenience of payment. This is more so as the majority of small business and taxation stakeholders and scholars are in agreement that radical reforms are necessary to stimulate growth of small businesses and encourage greater incorporation.
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