Labour governments record for small business

An analysis of Labour’s achievements with Small Business

With elections looming and everybody writing off the labour government, which way will the owners of small businesses vote? If you asked a labour spokesperson, they would undoubtedly spew out statistics about reductions of small business administration, the record number of company incorporations during their reign and efficiencies achieved at Companies House. However, an analysis of labour’s track record suggests they won’t win over small business.

The make up of the small business community

To understand Labour’s thinking on forming policy for small business, it is necessary to understand the makeup of the small business community. In 2003 there were 4 million small businesses defined as any business with less than 50 employees. Of these 95% had less than 10 employees and were defined as micro-businesses.

The majority of small and medium business will trade as a limited company whilst the types of micro-businesses can be further distinguished as sole traders and contractors or personal service companies.

Sole Traders
Many micro-businesses register as self-employed and trade as a sole trader because it has less complexity and administration than starting a limited company. Sole traders are typically small retailers, contractors in the trade, part time businesses and start-ups.

Contractors and Limited Companies
A large number of micro businesses provide personal consulting services and operate alone as one-person limited companies or as two-person limited companies in partnership with wives or husbands. This is a common way that small businesses are born, with individuals contracting their personal services with a limited company as the preferred choice for trading because of its tax efficiency. Such companies have come to be known as personal service companies or PSCs.

Labour’s small business issues

The most common complaint small businesses expounded when Labour took charge were the complex and heavy tax burdens and the pain of unnecessary red tape or administration that discouraged businesses to take on staff, and encouraged them to operate in the informal economy on a cash basis.

Another problem looming for Labour was a growth in PSCs being used by employees to reduce their tax by avoiding the PAYE system. Many companies providing services to contractors had emerged that encouraged PAYE employees to operate as a limited company. These service providers had become adept at mass processing a contractor’s income through a limited company as a shareholder, thereby making it easy for anyone to operate as a limited company and reduce their tax. This arrangement suited employers who technically did not employ their workers and had no statutory obligations to them. It was also aided and encouraged by recruitment agencies that were able to reduce their administration and employment responsibilities and offer better return for their contractors.

Abolition of Advanced Corporation Tax

Faced with these issues and the beginning of the boom time, in April 1997, Gordon Brown began by reducing corporation tax from 23% to 21%. In 1999 he abolished advanced corporation tax payments which meant that businesses no longer had to prepare accounts every quarter and calculate and make advanced payment of corporation tax to the HMRC or Inland Revenue as it was then named. This was a good start, reducing the administration burden of small businesses for preparing accounts from four times a year to once a year and greatly assisting small business cash flow. It also reduced a large administrative burden on the Inland Revenue.

Corporation tax tinkering and the introduction of IR35

In April 2000 a 10% tax band was introduced on company profits between £0 and £10k. This was tapered out over profits between £10k and £50k and therefore only benefitted companies with low turnover viz. micro-businesses.

In the same budget, the introduction of IR35 was announced. The aim of this legislation was to curb the use of personal service companies (PSCs) and stop disguised employees from incorporating and avoiding tax. The legislation was complex and poorly conceived which created uncertainty in the contractor market because the line between a genuine, self-employed contractor and an employee was not made clear.

It is significant that the introduction of this legislation was timed in conjunction with the decrease in corporation tax for micro-business. The government probably believed that the introduction of IR35 would stop disguised employees taking advantage of an even lower rate of corporation tax.

It is also likely that the government believed that the reduced corporation tax rate for low-profit businesses might even increase tax revenues by encouraging people out of the informal economy and onto the radar of the treasury. In 2002 the 10% rate was further reduced to 0%.

The results were a spectacular failure. Sole traders, were now incentivised to incorporate as a limited company to reduce their tax. IR35 was too complex to enforce effectively and the contractor industry merely changed the terms and conditions of employment contracts to keep contractors out of the legislation. The lower rate of tax served to encourage even lower earners such as receptionists and admin staff to incorporate and the contractor service provider companies just got stronger. The net result was a large loss in tax revenue for the government from the mass incorporations of sole traders and contractors.

Rethinking the nil rate of corporation tax

Instead of admitting it had made a mistake, Labour reacted angrily to the mass incorporation of companies between 2000 and 2004 complaining bitterly and perhaps, naively, that businesses should not incorporate for taxation reasons as opposed to commercial reasons. In 2005 they then introduced new legislation called IR591 that effectively nullified the 0% corporation tax band if dividends were distributed. They argued that this would achieve their aim of encouraging small businesses to reinvest their profits in their business and hence incorporate for commercial not tax reasons.

The calculation of corporation tax then became extremely complex. Thousands of hours were lost on accountants, the HMRC and business owners trying to variously figure out how to calculate the new corporation tax, communicate these changes and then change systems, administration procedures and forms etc.

Full circle - Back to where we were in 1998

The following year in 2006, the outcry caused by this complication caused Labour to reverse IR591 and the nil rate of corporation tax such that the corporation tax for small business was back to where it was in 1998 before Brown first stared tinkering with it. It was a terrible waste of energy and human intellect, introducing confusion and complexity, where exactly the opposite was required to create an environment friendly to small business. Brown’s corporation tax experiment had failed spectacularly only succeeding in encouraging mass incorporations.

The MSC legislation

Realising now that IR35 had failed and disguised employees were still a problem, Labour now introduced the Managed Service Companies (MSC) legislation in 2006. This time though, focus was on the companies providing services to contractors (service providers) and the recruitment agencies that were feeding contractors into their clutches.

In essence the legislation imposed an extra tax on the contractor who was found to be operating a limited company via a service provider that was managing or influencing and controlling the affairs of the contractors’ limited company. If the HMRC failed to recoup tax from the contractor they could transfer the liability to the owners of the service provider and failing that the liability could also be transferred to the recruitment agency if they had conspired to refer the contractor to the service provider. This legislation was very effective in curbing the use of limited companies but placed an added burden on contractors or any company offering personal services. Companies offering personal services now had to try and determine whether or not the accountant they were using was compliant with the MSC legislation or face the liability for an increased tax bill. In reality this was an unrealistic expectation that further complicated the life of genuine contractors and self-employed service companies, increasing their administrative burden and costs and served to discourage genuine business start-ups in this line of business.

Increasing Employers NI

Whilst Labour congratulated themselves for reducing corporation tax for small business, Brown gradually began increasing the rate of employers National Insurance from 10% to 12.8%. Distinguishing National Insurance from tax, Labour claimed not to be increasing taxes.

It provides a good example of a stealth tax, since small businesses now found their staff bills (normally the largest expense in a business) increasing. This could only further discourage business from taking on staff on their payroll and encourage the practice of informal trading by dealing in cash payments for work completed.

Flat Rate VAT

From 2002 Brown introduced the flat rate VAT scheme. This was win/win for all since it reduced the complexity of calculating VAT and increased the profits of many micro-businesses especially PSCs. The HMRC benefited since it reduced the complexity of VAT investigations and administration hence cutting costs. Flat rate VAT was a labour success story, mainly for certain micro-businesses.

The increase of Corporation tax

In 2008, Alistair Darling announced he would decrease corporation tax for large business by 2% whilst small business tax would increase by 2%. Once again small business got the raw deal and bore the brunt of government attempts to increase its tax base.

Companies House efficiencies

In the years labour has been in power, the efficiency of Companies House in administering and enabling the set up of limited companies has markedly improved. HMRC have increasingly enabled tax returns to be submitted online, hence reducing paperwork and administration. Labour are quick to claim credit for this but one cannot help but feel that these efficiencies are largely as a result of the progress of technology, (specifically data base systems on the internet) and were inevitable regardless of the party in power.

The increase in capital gains tax

In 2008, Darling increased the rate of capital gains tax on the disposal of a business by 80%. This was introduced as a means of taxing the private equity fat cats. The reality was it affected small businesses far more than large private equity. It in effect discouraged entrepreneurship and encouraged short-termism. Most punters regarded this as a step backwards.

Maternity and Paternity Pay

The labour government has more than doubled maternity pay since it came to power. The generous leave given to new parents by labour are hailed by most as a success but few realise the practical difficulties this causes small business. Staff of a small business are often stretched to the limit to keep the business ticking over. Having to support an unproductive employee for up to nine months can make or break a small business.

Conclusion

Labour started off well with the reduction of corporation tax and the abolition of advanced corporation tax. However, this progress was later marred by the debacle of Brown’s experimental tinkering with corporation tax, the concurrent increase in employer’s national insurance and the raising of corporation tax in 2007/2008. It is doubtful that labour achieved many of it aims for assisting small business, nor did they address the problems that small business complained about.

The attacks on the contractor sector of small business increased the red tape for small business and created barriers to entry for start-ups of personal service businesses. IR35 was a failure, introducing complexity and had to be further backed up by the MSC legislation which was effective in stemming disguised employees but introduced further complexity and burdens on contractors and personal services businesses.

The introduction of flat rate VAT was a success and together with the example of the abolition of advanced corporation tax provides a good case study of how legislation that reduces red tape for both businesses and HM Revenue and Customs, is the most effective.

There have undoubtedly been increased efficiencies in Companies House and HMRC mainly from investing in IT systems and processes that serve to cut down on paperwork. However, these efficiencies were inevitable given the progress in IT technology since Labour came to power.

The impression that small business is merely a secondary consideration to large business has been reinforced by Labour lowering corporation tax for large business by 2% increasing it by 2% for small business. This impression is reinforced by the increase in capital gains tax, the increase in maternity and paternity benefits which all impact small business much harder than large business.

Labours track record in trying to stem disguised employment illustrates how difficult it is to execute legislation for one sector of business that does not negatively impact other sectors. Perhaps future governance needs to distinguish between the types of businesses and their broad range of requirements before enacting new legislation.