Are preferential tax rates for the self-employed justified?

Income earned through self-employment, or through running and working for your own company, is taxed at lower rates than income earned from employment.

The chart below shows an example of this. For a job generating £40,000, tax in 2021–22 is £3,300 (£4,400) higher if the job is completed through an employment contract rather than by someone who is self-employed (respectively, running their own company). 
 

The  tax differences arise mostly because employees’ salaries are subject to employer National Insurance contributions (NICs) whereas other incomes are not. Employer NICs are a tax on employment. Whether the cost is borne by employers or passed on to employees, employer NICs disincentivise employment in a way that they do not disincentivise self-employment. The tax advantages for business owners (i.e. the self-employed and company owner-managers) can be even bigger than the chart implies as they have more scope than employees to, for example, deduct work-related expenses from their income or split income with a spouse in a lower tax band.

As we explain below, none of the common arguments in favour of lower tax rates on business owners holds up. Levying lower taxes on the self-employed cannot be justified by differences in publicly funded benefits (the differences in benefits are far smaller than the tax advantages) or by differences in employment rights (which make employment more attractive to workers but less attractive to potential employers). 

It is sometimes argued that business owners should get lower tax rates because, compared with employees, they are more likely to be investing their own money or taking risks. The current tax system discourages risk-taking and some forms of investment. But lower headline tax rates are not the best way to stop this. Nor are they well targeted at boosting entrepreneurship.

Arguably the best argument in support of lower tax rates on business owners is that these groups are simply more responsive to tax rates, but that in itself is controversial and fraught with difficulties. We summarise these issues here. 

Self-employed and employees get almost identical state benefits

It is commonly argued that lower NICs rates for the self-employed reflect their reduced entitlements to social security benefits. But in practice, the difference in entitlements is far too small to justify the current tax advantages.

There are just two publicly funded ‘contributory’ benefits that employees can access but the self-employed cannot: contribution-based jobseeker’s allowance and statutory maternity / paternity / adoption / shared parental pay. The value of these reduced entitlements is small: we estimate that they would only justify setting the self-employed NIC rate less than 1 percentage point lower than the combined employer and employee rates. That is, the combined main rate for employees is 22.7%; differences in benefits would only justify reducing this to around 22% for the self-employed – still more than double the current 9% rate.

The difference in access to contributory benefits was more significant in the past (although still much smaller than the tax differences) but has shrunk as benefits have been extended to the self-employed. For example, employees used to accrue rights to a higher state pension in return for higher NICs payments, but this has not been true since April 2016.

The most significant disadvantage now faced by the self-employed in the benefits system comes from universal credit, which treats the self-employed as earning at least a certain amount (after a year’s grace period) – the ‘minimum income floor’ – even if they report earning less than that, and gives them correspondingly less support. But this difference is still significantly less than the tax advantage the self-employed enjoy.

Lack of employment rights doesn’t justify lower rates

A common – and understandable – misconception is that the self-employed should get lower taxes because they do not get employment rights, such as to the minimum wage, protection against unfair dismissal, and statutory minimum holiday, sick and redundancy pay. The logic behind this line of argument is incorrect. 

Employment rights are not a benefit given by the government to employees (i.e. they are not like state benefit entitlements), but a benefit that the government requires employers to give to their employees. They affect both sides of the labour market: employees and employers. Employment rights make employment more attractive (relative to self-employment) to the worker, but they simultaneously make it less attractive for employers to choose employees over the self-employed. Employment rights are not favouring employment over self-employment overall in a way that might justify an offsetting tax differential; they merely redistribute between the two parties within an employment relationship. Because of this, employment rights do not (and cannot) act to skew the labour market in favour of employment relative to self-employment. In contrast, our tax system does skew the labour market in favour of getting work done through self-employment. That is, it leads to more work happening through self-employment than would otherwise be the case. Overall, therefore, the result of preferential headline tax rates for the self-employed is to bias the labour market in favour of self-employment, not to level the playing field between employment and self-employment.

For further discussion of this issue, see ‘Tax and employment status: myths that are endangering sensible tax reform’.

Lower rates are poorly targeted at entrepreneurship

Lower rates of tax for business owners are often defended as a means to encourage investment, risk-taking and entrepreneurship.

People running their own businesses may be doing something fundamentally different from employees, including investing, employing others, innovating, taking risks and other such ‘entrepreneurial’ activities. It is important that the tax system not discourage such activities. At present, because of the design of the tax base – the definition of what is taxed – risk-taking and some forms of investment are discouraged. Lower tax rates mitigate but do not prevent these effects. The tax base could be reformed to mitigate them much more effectively even if tax rates were higher.

There are reasons for the government to actively encourage some types of activity. Broadly, these arise when there is a ‘market failure’ which means that the market will generate too little of a certain activity. For example, some businesses may underinvest in innovation because part of the return to investment flows to other firms which can learn from the new products or processes.

However, blanket reductions in tax rates for all the self-employed and company owner-managers are poorly targeted at addressing market failures. There are two reasons for this. First, the lower rates apply to everyone, and not only in cases where there are market failures. The business owner-manager population encompasses a large variety of business models: people using a business legal form include everyone from those running tech start-ups to taxi drivers, plumbers, local shop owners, IT consultants, doctors and lawyers; most are not running particularly innovative businesses. Second, even where there are market failures, the lower rates are not well targeted at alleviating them. The benefit of lower tax rates accrues disproportionately to those who make high private returns on their activities; those activities are likely to be viable even without support.

Business owners are more responsive to taxes

Arguably the best argument for taxing the self-employed and company owner-managers at lower rates than employees is that they are more responsive to tax. The more a tax reduces taxable income, the less revenue it will raise and the greater the loss of taxpayer welfare per pound of revenue raised. So it can be efficient to set lower tax rates for more responsive groups.

The self-employed and company owner-managers are more responsive to tax in part because they have more ways to manipulate their incomes to avoid tax and more scope to evade taxes, rather than just because of ‘real’ economic responses such as the amount of effort they put in. The first way to deal with this, therefore, is to reduce the options that the self-employed and company owner-managers have to sidestep paying taxes in full – for example, by taxing capital gains at the same rates as ordinary income. It would not be possible, however, to entirely eliminate the difference in responsiveness.

In principle, therefore, the greater responsiveness of business owner-managers could be used to justify some difference in tax rates (although not necessarily the current rate differentials). But any potential efficiency gains that arose as a result of applying lower rates of tax to more responsive groups would have to be weighed against the costs of differentiation, such as the additional complexity and the distortion to people’s choice of how to work. There are also clearly equity concerns over a policy of providing lower tax rates to one group at least in part because they can more easily avoid or evade tax.

The need for reform

In addition to being hard to justify, placing lower tax rates on business owners than on employees (and accepting a poorly designed tax base) creates three broad types of problem:

• Unfairness. People generating the same overall level of income can attract very different tax bills according to the legal form in which they work.
• Economic inefficiency. By distorting a range of decisions, including over how to work and which investments to make, the tax system ultimately reduces society’s aggregate output and well-being more than is necessary to raise a given amount of revenue.
• Administrative burden and complexity. The presence of boundaries in the tax system creates the need to devise, administer, comply with and police rules to determine when someone is self-employed and how income should be classified. These, in turn, impose costs by diverting officials, taxpayers, accountants and occasionally the courts from more productive activities.

For further discussion of the problems with the current tax treatment of different legal forms in which work is done and of possible improvements, see the following IFS report: ‘Taxing work and investment across legal forms: pathways to well-designed taxes’.

This article, and the underlying research report on which it draws, have been funded by the Nuffield Foundation, but the views expressed are those of the authors and not necessarily the Foundation. Visit www.nuffieldfoundation.org.