Modelling the impact of taxation on the small-business economy: the NatWest/MBS tax index for the self-employed, sole-traders, and partnerships
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
Environment and Planning C; Government and Policy 1999, volume 17, pages 577 592
Modelling the impact of taxation on the small-business
economy: the NatWest/MBS tax index for the self-employed,
sole-traders, and partnerships
I* Poutziourts, F Chittenden, N Michaclas
Business Development Centre, Manchester Business School, University of Manchester,
Booth Street West, Manchester MI5 6PB, England; e-mail: I*.Pout/,iouris@fs2.mbs.ac.uk;
KChittenden@fs2.mbs.ac.uk; N.Michaclas@fs2.mhs.ac.uk
Received 2 November 1997; in revised form 14 April 1999
Abstract. The authors describe the development of a model for the evaluation of the tax affairs of UK
small unincorporated firms (with fewer than 20 employees). Alter a brief review of the literature
relating to small-business taxation, the main parameters of the NatWcst/Manchcstcr Business School
tax model for unincorporated businesses are established. Subsequently the model is employed to
evaluate smalt-business taxation from two angles. First, the authors offer a post-1999 budget analysis
of the impact of taxation on small-business owners and their employees. Second, the authors discuss a
set of proposals which have the potential to improve the neutrality of the tax system towards small-
business owners' decisions.
1 Introduction
Although taxation epitomises the intervention of the state in the operation of the market,
the perspective of small businesses has received limited research attention. Theory and
research methodologies have tended to be used to address issues of taxation at the
macroeconomic level, and microeconomic investigations have been restricted to the
large corporate sector which accounts for the majority of tax revenues accruing from
the business community.
This paper is based upon a substantial research project into the taxation of the UK
small-business economy, commissioned by NatWest (with technical support from
Grant Thornton). Two financial models have been built to measure the total tax burden
borne by small firms. Output from these models (model D for unincorporated firms,
and model E for small limited companies) is in two forms. First a tax index (set at 100
in 1994/95) is used to monitor, over time, the impact on the small-business sector of
the tax regime (that is, tax payments and the cost of compliance with the tax regime).
Second the model is used to estimate the value of tax revenues that accrue to the
Exchequer from the small-business economy.
In a recent paper (Chittenden et al, 1999a) we presented the structure of both
models, and showed how they may be employed to evaluate the impact of taxation
on small firms. In the present paper we present the development of an updated and
extended version of model D, which is used to evaluate the tax affairs of small
unincorporated firms in the context of the 1999 budget announcements. Drawing
upon these findings, a number of policy proposals are suggested which would improve
the economic efficiency of the tax regime for small unincorporated firms.
1.1 Taxation and small firms
Policymakers increasingly recognise the important contribution of small businesses to
the process of postindustrial development. Small businesses are agents of industrial
change and innovation, and vehicles for employment creation and economic growth
(Birch, 1979; DTI, 1996a; Fothergill and Gudgen, 1979). However, it is also recognised
that small businesses face a number of challenges if they are to progress from being578 P Poutziouris, F Chittenden, N Michaelas
micro firms (that is, firms employing fewer than 5 people) to being expanding small
businesses (ACOST, 1990; Aston Business School, 1991). One of the most consistently
cited 'barriers to growth' is the inability of these firms to access adequate types and
sources of finance (Storey, 1994), because the levels of information asymmetry and
agency costs are higher for such firms (Peterson and Schulman, 1987; Michaelas
et al, 1998; 1999). As a result of these constraints, it has been recognised (Bolton,
1971; Watson, 1990) that the taxation system could play an important part in ensuring
that small businesses are not unnecessarily disadvantaged by the 'finance gap'. To quote
Bolton (1971, page 192):
"Moreover what is required for the health of the [small firms] sector is an economic
and taxation system which will enable individuals to acquire or establish new
businesses out of personal resources and to develop these on the base of retained
profits. Without this no institutional financing arrangement can preserve the small
firms sector."
Historically, the impact of the excess burden of taxation on business activity has
been investigated in a number of studies (Devereux, 1991; King and Wookey, 1987;
Meade, 1978). More recently, research attention has increasingly been focused on the
impact of taxation on the small-business sector (Bannock, 1984; Bannock and Peacock,
1989; Chennells and Dilnot, 1999; Chittenden, 1991; 1994; Chittenden et al, 1996a;
1999a; 1999b; Davies et al, 1996, pages 119-120; Inland Revenue, 1998; Poutziouris
et al, 1998; 1999; Rees and Shah, 1993; Sandford et al, 1989; Watson, 1990).
1.1.1 The case for a small-business-taxation agenda
Bannock (1984) argues that taxes adversely affect the motives of small-business propri-
etors and entrepreneurs in starting, developing, and expanding their business ventures.
First, taxation tends to have an asymmetrical impact on the risk - reward ratio, as poor
business performance and failure is tax free, whereas success and profits are taxed.
Second, given the widespread view that risk capital for new, young, and growing small
businesses is mainly generated through internal sources (personal savings, retained
profits, and relatives and/or friends), taxation reduces the amount of funds which
small-business entrepreneurs can invest in their ventures. Third, given the growing
complexity of the tax system, and government regulation in general, small firms suffer
disproportionately from the bureaucratic burden of completing tax returns and collect-
ing taxes from their employees and customers (compliance costs), and are less likely to
be able to afford good tax-planning advice.
2 Data and methodology of the study
The NatWest/Manchester Business School (MBS) tax model (model D) was developed
with the aid of financial data from 4695 real businesses, in order to consider the tax
affairs of the UK unincorporated-small-business economy (that is, sole traders and
partnerships employing fewer than 20 people). The model may be used to examine the
monetary level of taxes (income, national insurance, and uniform business rates) and
also the costs of compliance with the tax system: in other words the estimated cost to a
small business of acting as a collector of PAYE (pay as you earn) and VAT on behalf of
the government, and of administering their own tax affairs. Taxes deducted from
employees earnings, that is, income tax and national insurance contributions, are
also included as these affect the costs of employment.
For the 4695 unincorporated businesses in the database, the number of employees
had to be estimated. These estimations are based on a large database of UK small firms
taken from Lotus OneSource Database (One Source Information Services Inc., http://
www.onesource.com/company/company.htm). A total of 37323 small businesses (smallModelling the impact of taxation on the smatt-busincHH economy 579
limited companies with fewer than 100 employees) were classified into different sectors
and turnover bands and the average numbers of employees within each of these turn-
over bands were calculated. Then, with the aid of national statistics (ONS, 1997a), the
ratio of full-time to part-time employees across sectors was estimated and this was
applied to the unincorporated sample firms to estimate the number of full-time and
part-time employees across sectors and turnover bands. These estimates were applied to
the sample firms used in the NatWest/MBS tax model. It should be noted here that
estimates of part-time and full-time employees are based on incorporated businesses,
whereas the Nat West/MBS tax model presented in this paper is focused on unincor-
porated businesses. Nevertheless, with the use of data from an extensive postal survey
(Poutziouris et al, 1999) we compared the number of part-time and full-time employees
in incorporated and unincorporated businesses and found that there were no significant
differences. Data on employees* remuneration has been based on the lowest decile gross
weekly earnings taken from the New Earnings Survey 1997 (ONS, 1997b),
The NatWest/MBS tax model is an integrated scries of Excel (Microsoft Corpora-
tion, Redmond, WA) worksheets which exploit financial data of sample firms (4695
unincorporated businesses that arc representative of a large random sample of 48000
such businesses^). The tax position of individual owners and employees is computed
and these results aggregated at a business-unit level; and on a sectoral and micro-
economic basis.
A stratified sample was built by randomly selecting firms to represent four employ-
ment-size bands (0, 1 - 4, 5-9, and 10- 19 employees) and nine business activities. The
objective was to assemble 150 businesses within each of the 36 cells (9 sectors x 4 size
bands). As table 1 shows, this selection criterion was met in all but seven of the cells.
In order to minimise the bias arising from averaging the tax position of sample
firms in each cell of the database, a number of industry sectors have been amalga-
mated in order to increase the sample size in the cells. The nine sectoral activities were
aggregated into four major industrial groupings, comprising production (agriculture
and mining, manufacturing); construction; distribution (that is, retail and wholesale
trades, transport, and communications); and services (hotels and restaurants, finance,
business services, and other services). Table 2 shows the size and sectoral distribution
of the model D database.
Table 1. Number of businesses across sectors and size bands.
Sector Number of employees
0 1-4 5-9 10-19
Agriculture, forestry, and mining 150 150 150 150
Manufacturing 150 150 150 150
Construction 150 150 150 88
Wholesale and retail trade 150 150 150 129
Hotels and restaurants 150 150 150 150
Transport and communication 150 150 150 150
Finance 37 23 23 4
Real estate and business services 150 150 150 150
Other 150 150 150 41
(1)
The 4695 sample firms were randomly selected from a larger database of 48 000 NatWest
customers. Statistical inferences suggest that the 4695 selected firms are representative of the
larger database. Variables included in the model are the 1996/97 figures for: tangible net worth,
total debt, interest paid, profit before interest and tax, retained cash flow, total assets, total
liabilities, turnover, interest cover, and gearing.580 P Poutziouris, F Chittenden, N Michaelas
Table 2. Distribution of sample firms by industrial group and size bands.
Sector Number of employees
0 1-4 5-9 10 - 1 9 total
Production 300 300 300 300 1200
Construction 150 150 150 88 538
Distribution 300 300 300 279 1179
Services 487 473 473 345 1778
Total 1237 1223 1223 1012 4695
2.1 Modelling the taxation of small unincorporated firms
The taxes considered are those borne by the majority of ongoing businesses. Thus
inheritance tax, capital-gains taxes (these are normally rolled over by businesses that
continue to trade), and excise duties (such as those charged on cigarettes and alcohol)
have been excluded. Capital allowances are not estimated as, over the accounting life
of assets, this cost will be incorporated in the provision for depreciation. The taxes
considered in the model comprise income tax, National Insurance contributions
(NICs), and Uniform Business Rates. Also included are estimates of the costs that busi-
ness owners incur as collectors of PAYE, NIC, and VAT on behalf of government, and
in the administration of their own tax affairs (for example, in completing the tax return
for the business or the owner). The different taxes and compliance costs are estimated
as follows:
2.1.1 Income tax and National Insurance contributions
Income tax and NIC rates in force during the tax year under consideration are applied
to owners' accounting profits and the annual salaries of employees.
Table 3. Uniform Business Rates (UBRs) as a percentage of turnover (source: SBRT, 1993).
Turnover band (£) UBR costs Businesses working UBR costs used in
(% of turnover) from home (%) tax models (% of turnover)Modelling the impact of taxation on the sinall-business economy 581
per employee across different business-size bands, as illustrated in table 4. The PAYE
and NIC compliance costs estimated by the Inland Revenue (1998) are presented in
column 2. These figures are higher than the costs applied in the tax model (presented
in column 4). In the 1999 budget it was announced that where businesses collect PAYE
of less than £1000 per month (previously £600) from their employees, they will be able
to make these payments to the Inland Revenue once each quarter instead of monthly.
According to government figures* this will cut small-business PAYC-comptiance costs,
by an estimated 15%. This reduction is reflected in the PAYE and NIC costs presented
in column 4.
Tahle 4. Pay As You Earn (PAYE)-rclatcd and National Insurance contributions (NIQ-rehUed
compliance costs per employee per year (source: Inland Revenue, 1998),
Number of PAYE and NIC Decrease in PAYE and NIC
employees compliance costs (£) compliance costs (%) compliance costs
(Small Business Service data) applied in tax model (£)
1-4 288 15 244.8
5-9 143 15 121.6
10-49 89 89.0
50-99 58 58.0
2.1.4 Costs of complying with VAT payment
Compliance-cost estimations are based on the results of Sandford ct al (1989), who
express compliance costs for administering VAT as a percentage of turnover across
different size bands as shown in table 5. The Sandford ct al (1989) indices have been
adjusted for inflation, and the results, used in the tax model, are presented in column 3.
In previous versions of the tax model (Chittenden et al, 1999a), the figures for VAT-
compliance costs, were based upon SBRT (1998) data. In the SBRT study, respondents
were asked to estimate their compliance costs as a percentage of turnover. Thus, the
SBRT estimates were based on the beliefs of small business owner-directors, and it could
be argued that these estimates were overly high. Sandford et al (1989) calculated com-
pliance costs by measuring the costs incurred by small firms in administering VAT.
These costs included the value of time spent in compliance by partners, proprietors,
qualified accounting staff, and other staff as well as fees to professional advisers and
other costs. The sum of these costs was then expressed as a percentage of taxable
turnover, and this results in considerably lower estimates of the costs of compliance
with VAT.
The publication of the Inland Revenue (1998) report of compliance costs for PAYE
has made it possible to compare the impact of the SBRT data, the Sandford data, and
Table 5. VAT-compliance costs.
Turnover band (£) Turnover band VAT-compliance costs
adjusted for inflation (£) (% of turnover)
< 20499 0 3 999 1.94
20500-49999 34000-82999 0.78
50000-99999 83 000-165999 0.52
100000-499999 166000-832999 0.42
500000-999999 833000-1664999 0.26
1000 000 - 9 999 999 1 665 000 -16 649 999 0.04
^10000000 ^16650000 0.003582 P Poutziouris, F Chittenden, N Michaelas
the latest Inland Revenue results (prepared by the Centre for Fiscal Studies at the
University of Bath). This comparison shows that, when applied to the NatWest/MBS
tax models, the Sandford study compliance figures (when adjusted for inflation)
produce results that are much closer to the Inland Revenue data, than are the SBRT
results. This does not imply that the SBRT data, which present the views of business
owners, are inaccurate. In fact the SBRT data show that business owners believe that
the costs of compliance with government regulations are higher than they turn out to
be when measured in a structured way. As a result of this conclusion, for all com-
pliance costs except PAYE (for which the Inland Revenue 1999 data are available) the
inflation-adjusted Sandford results have been used in the NatWest/MBS tax models.
2.1.5 Owners' taxes compliance costs
Compliance costs for owners' taxes (schedule D income tax) are of two kinds: hours
spent on tax work and fees paid to advisers. In the tax model these costs are calculated
with the aid of the Sandford et al's (1989) estimates of schedule D (that is, business
owners) income-tax-related compliance costs, in which compliance costs are expressed
as a percentage of taxable profits (see table 6). In the light of the recent introduction of
the self assessment tax regime, there is a need for up-to-date research into current
levels of compliance costs with this element of the tax system.
Table 6. Schedule D income tax compliance costs.
Income band Income band Compliance costs
(taxable profit, £) adjusted for inflation as % of income
^7499 ^12492 6.79
7 500-14999 12493-24984 3.87
15 000-29 999 24985-49967 2.93
30000-49 999 49968-83 279 1.49
^50000 ^83 280 1.65
2.2 Grossing up direct taxes and compliance costs: the weighting system
A weighting system has been applied to transform the average tax position (in terms
both of direct taxes and of compliance costs) for firms in each of the 16 cells (see
table 2 above) of the database to reflect the tax position of the equivalent segments of
the small-business economy. For the calculations, the latest statistics available from the
Department of Trade and Industry (DTI, 1996b) were used for the distribution of
unincorporated firms across size bands and sectoral activities, as shown in table 7.
Having introduced the mechanics of the model, in the remainder of this paper we
report on the application of the model to the evaluation of small-business taxation
policy. In section 3 we consider the impact of taxation on small firms in recent years.
Indices of the impact of taxes on sole traders and partnerships are calculated so that
the taxes paid by small firms can be measured on a consistent basis over time. These
indices include the impact of the 1999 budget announcements. Drawing upon these
findings, in section 4 we consider proposals that could improve the neutrality of the tax
regime for small firms, present estimates of the impact of these possible changes on the
tax indices for unincorporated firms, and estimate the impact of the changes discussed
on government revenues. In section 5, the likely impact of these changes on the
behaviour of small-business owners is critically reviewed. We conclude that if the
proposed measures were to encourage business owners to expand their firms, rather
than to withdraw profits for the purposes of private consumption, they would promote
investment-led economic growth.Modelling the impact of taxation on the small-business economy 583
Tuble 7. Number of unincorporated businesses in the United Kingdom by size of business and
industry (source: DTI, 1996b).
Sector Number of employees Total
0 14 5 9 10 19 :>>!()
Agriculture, mining, and forestry 169 242 31725 4 534 1 843 183 207 527
Manufacturing 188 744 31 610 8219 3426 1 046 233045
Construction 725 884 39 96 J 5 671 1919 349 773 784
Wholesale, retail, and repairs 268 701 118715 27 519 9 567 2006 426 508
Hotels and restaurants 41530 57 627 19 830 8 532 2536 130055
Transport and communication 164040 15 789 3 665 1 460 418 185 372
Finance 33 703 3 100 832 326 124 38085
Business services 395 917 54 564 12 964 7 125 4852 475422
Hdueation, health and social work 240 746 17 920 11901 9447 5981 285995
Other 265 254 31388 6 351 2003 512 305 508
Total 2493 761 402 399 101486 45 648 18007 3 061301
3 The NatWest/MBS index of the taxation of small unincorporated firms
The profitability data for the 4695 businesses in the tax model (see tabic 1) has been
utilised to establish an index of the impact of taxation on small unincorporated firms.
The impact of the tax regimes in force since 1994/95 (when the index was set at 100)
has been calculated in order to detect any trends that may be evident in the incidence
of the tax rules applying to small firms. Throughout this exercise, the profitability of
the firms has been held constant, at the 1996/97 level, so that any effects caused by
changes in tax legislation could be isolated.
Although the fiscal regime has been fairly stable between 1994/95 and 1998/99, if
the changes announced in the 1999 budget were introduced immediately a large fall in
the index would result. As shown in figure 1, the index falls from 97.2 in 1998/99 to
91.8 as a result of the 1999 budget announcements. The main reasons for these changes
are the introduction of the £0.10 income-tax rate and the alignment of the starting point
Tax index
M Owners' Uix.cs compliance
M PAYE, etc compliance
El VAT compliance
• Uniform business rates
m Employees NIC
m Employees income tax
M Employers NIC
• Owners' NIC
0 Owners' income tax
1994/95 1997/98 1998/99 budget 1999
Figure 1. The N a t West/MBS tax index for unincorporated firms.584 P Poutziouris, F Chittenden, N Michaelas
for employees' NICs with the personal income tax allowance. Both of these changes are
important for small unincorporated firms. Many business owners report relatively low
earnings, and employees in this sector are often part-time workers or are relatively
poorly paid (Storey, 1994, page 180). In these two important respects the latest budget
may be seen as helpful to many small unincorporated businesses and their staff.
In the next section we consider some possible changes to the tax regime that could
be introduced which would improve the neutrality of the tax system towards small
unincorporated businesses. The implications of these proposed changes for small firms
themselves, and for government tax receipts, are also considered. Given the failure of
recent attempts to stimulate additional productive investment [for example, the Busi-
ness Expansion Scheme (see Storey, 1994, page 317)] we have limited our discussion to
measures which have the potential to improve the efficiency of the tax system and so
could have a substantial positive impact on the growth potential of small businesses.
4 Fiscal policy in the context of small-business economics
It is acknowledged that over the past two decades the United Kingdom has been
developing a tax regime that is generally supportive of commercial activity (OECD,
1992; Stanworth and Gray, 1991, page 95). However, there are some crucial aspects of
the tax system that have to be adapted to the realities of an economy in which small
firms account for more than 50% of nongovernment employment. The NatWest/MBS
tax model for the self-employed, sole traders, and partnerships has been used to
evaluate the impact of the UK tax regime on business owners' decisions. Four particular
aspects of the current tax rules have been considered: the VAT-registration threshold;
the impact of the PAYE system; the distribution of UBR; and implications of income
tax for the retention of profits.
4.1 Encouraging sales growth: the VAT-threshold debate
Evidence suggests that the VAT-registration threshold acts to restrain the growth of
microbusinesses (those employing fewer than 5 staff). A recent survey conducted by the
SBRT (1998) found that, overall, 15.3% of VAT-registered firms say that VAT compli-
ance is a "significant" problem for them, and that 18% of nonregistered businesses
intentionally forgo growth in order to keep their turnover below the VAT-registration
limit.
When VAT was introduced in 1973 the VAT-registration threshold was set at £5 000
turnover, and this has been increased regularly to its current level of £51000. At £51000
of annual taxable supplies it is very much higher than is the case in most of the rest of
Europe, where some countries require registration for VAT virtually as soon as a busi-
ness is started. Raising the threshold has provided benefits both for government and
for businesses. However, recently there have been indications of increasing concern
about the effect of the threshold on competition between registered and unregistered
businesses (SBRT, 1998).
Responses to the Customs and Excise consultation document "Review of VAT
registration threshold" (HM Customs and Excise, 1999), suggest that distortion of
competition is a real problem; that VAT registration imposes unfair administrative
and financial burdens on business; and that the registration threshold acts as a barrier
to growth and employment. Of those respondents who felt that the current VAT regime
adversely affects business decisions, the majority indicated that this distortion is because
of the very existence of a registration threshold. A total of 41% of the responses indicated
that an increase in the VAT-registration threshold, in line with inflation, was their
preferred option; 22% argued in favour of increasing the threshold by significantly
more than inflation—the most popular figure being £100000; 5% suggested freezingModelling the impact of taxation on the small-business economy 585
the threshold at the current level; 30% expressed their support for a reduced threshold;
2% favoured the introduction of a multithreshold system; and 51% said that they were in
favour of introducing further administrative or financial easements.
At the moment, small businesses registered for VAT face a competitive distortion as
they have to compete with the unregistered microfilms who are free from the red tape
related to VAT and are able to quote competitive prices to clients who wish to avoid
paying VAT (mainly private consumers). Increasing the VAT-registration threshold to
£100000 would decrease the number of firms facing such a competitive disadvantage.
Furthermore, increasing the VAT-registration threshold would reduce the administrative
burdens that business owners face in the early years of trading and this, in turn, would
lead to the creation of additional growth and employment. However, such a change
would lead to a decline in VAT receipts.
Figure 2 shows the extent to which businesses currently avoid operating close to the
VAT-registration limit. The number of firms in different turnover bands, based on 1996
financial accounts of a database of 87282 limited companies with a turnover of less
than £35 000, arc plotted and the distribution of firms across turnover bands shown.
All the data used were gathered from the Lotus One-Source Database of UK firms.
3000
2500
2000
1500
| 1000
500
0 rrrrrrTTx~r-rrrrrrrrrrrrrri rrrrrt~rrrr-rrTxrrTTrriT'TinrTTT-rri"i-rrTnrrrrrT7''n1l
0 40 80 120 160 200 240 280 320
Turnover 1996 (£ thousand)
Figure 2. Number of firms in turnover bands in 1996 (source: Lotus OncSource Database).
Using the NatWest/MBS tax model D, we estimated that increasing the VAT-
registration threshold to £100000 would reduce the costs of compliance to the small
unincorporated business sector by £334 million. Approximately 321000 businesses
would be able to deregister as a result of this change (see table 8). The net loss in
VAT receipts would be about £1429 million. It should be noted here that the figures
refer to the whole of the small-business sector (that is, both incorporated and unin-
corporated businesses). However, as Customs and Excise staff and resources could be
shifted to other, more remunerative duties, the net cost to the Treasury would be
Table 8. Number of VAT-registered businesses and net tax declared (source: HM Customs and
Excise, 1998).
Turnover (£) Number of VAT- Net tax declared
registered businesses (£ million)
< 50 000 515 000 370
50 001-60000 85 000 322
60 001-70000 73 000 313
70 001-80000 62000 292
80 001-90000 54000 262
90 001-100000 47000 240
Total (50001-100000) 321000 1429586 P Poutziouris, F Chittenden, N Michaelas
somewhat lower. The main stumbling block would be the need to negotiate this change
in the VAT threshold with the European Union.
4.2 The impact of the PAYE system on job generation
Small firms contribute disproportionately to employment growth (Bannock and Daly,
1994), when compared with their larger counterparts. Moreover, the capacity of micro
and small firms to generate employment remains intact even when the economy turns
down. However, the appointment of new staff creates additional cred tape' as small-
business owners have to comply with PAYE regulations.
These costs of operating the systems of PAYE, income tax, and National Insurance
on behalf of government are incurred by all firms, but fall more heavily on smaller
firms (Sandford et al, 1989; SBRT, 1996). Recent evidence from the Inland Revenue
shows that the cost of operating the PAYE system deters some small firms from taking
on their first employees (Inland Revenue, 1998). The first employee will cost a small
firm approximately £5.50 a week in paperwork (Inland Revenue, 1998). In contrast, for
a large company, this cost is less than £0.10 a week per employee.
The merger of the Contributions Agency and the Inland Revenue, which is pres-
ently underway, will reduce these costs and, according to the Inland Revenue survey,
many business owners are strongly in favour of this change. However, the complete
merger of income tax and NIC is unlikely even though this would improve transpar-
ency of the tax system, making tax planning more straightforward and improving the
quality of business decisions. If NIC were abolished, the lower income-tax rate would
have to increase from £0.10 to £0.13 in the £, the standard rate from £0.22 to £0.43 and
the higher rate to £0.61 in order to balance the government's books. In reality, the
effective income-tax rate is a long way from the 'historically low lOp rate' of income tax
announced in the 1999 budget (Chittenden et al, 1999a).
To encourage employment, small businesses should be compensated for administer-
ing PAYE by a deduction from the income tax and NIC which they collect on behalf of
the government. One solution would be for small-firm employers to deduct from the
taxes collected for government a sufficient proportion to compensate for the regressive
nature of these compliance costs.
The deductions that businesses would make from the sums collected under PAYE
collected on behalf of the government are shown in table 9. It is estimated that the
implementation of this proposal for unincorporated firms would cost the Treasury
approximately £208 million per annum.
Table 9. Cost of compliance with pay as you earn and National Insurance contributions per
employee per year (adapted from Inland Revenue, 1998).
Number of Compliance costs Proposed deduction Resulting compliance
employees applied in tax per employee costs after NatWest/MBS
model (£)a per annum (£) proposal (£)
1_4 244.8 195.5 49.3
5-9 121.6 72.3 49.3
10-49 75.7 26.4 49.3
50-99 49.3 49.3
a
See table 4.Modelling the impact of taxation on the small-business economy 587
4.3 The distribution of the UIIR regime
The UBR is unpopular amongst small firms as it affects the smallest businesses
disproportionately. UBR represents around one third of the total tax burden of sole
traders and partnerships, and 10% for small limited companies, UBR is based upon
rental values, and these are higher per square foot for the smallest premises.
This position is exacerbated because about one third of the small-business sector
comprises retailers, and in this sector the rental values for small units are especially
high. In addition, unlike most taxes, UBR is payable whether a business is profitable or
not. The performance of small firms is more volatile than is that of larger businesses,
so they are more likely to suffer trading losses from time to time (Cosh and Hughes,
1994). The UBR increases the size of these losses. The impact on small firms is miti-
gated only by the fact that about 70% of the smallest businesses operate from home,
and therefore do not pay UBR.
Figure 3 shows the extent to which the UBR is more expensive for smaller firms.
As a proportion of annual sales turnover, UBR is about five times larger for firms with
turnover of less than £50000 per annum than it is for businesses with sales between
£500000 and £2 million.
Figure 3. Costs of Uniform Business Rates as percentages of annual sales turnover (source: DoE,
1995).
The government made a manifesto commitment to return control of local taxation
back to local authorities, so reform of the UBR may have to wait until this more
fundamental change takes place. However, there is strong support from business
representatives such as the British Chambers of Commerce (BCC, 1999, page 23) for
maintaining central control over the setting of the UBR. At the same time, it is
recognised that there is a need to reform the UBR in order to remove its dispropor-
tionate impact on smaller firms.
One possible solution would be to exempt small firms from UBR on the first £1000
of rateable value (Conservative Party Small Business Election Manifesto, 1997). Such a
measure would benefit those firms occupying premises with a rateable value of less
than £18 000, whose UBR liabilities would be reduced by up to £450 per year. The
Department of the Environment (DoE, 1995) estimates that 93% of all small businesses
in commercial premises would benefit, and that about 140000 small firms would be
completely exempt from UBR as a result of this change.
4.4 Income tax and the reinvestment of profits
Small businesses tend to be undercapitalised; and this is especially true of young firms
that have not been trading for long enough to build up retained profits (Cosh and588 P Poutziouris, F Chittenden, N Michaelas
Hughes, 1994, page 58). Evidence of this undercapitalisation may be seen in the fact
that very many small businesses rely upon extended trade credit to finance their
operations, even though this is acknowledged to be one of the most expensive sources
of business finance (Chittenden et al, 1998; Mian and Smith, 1992).
Unfortunately, the phenomenon of undercapitalisation is further exacerbated by the
tax system. First, business owners are taxed on all of their profits—whether these are
withdrawn for consumption or reinvested in the business. Second, the owners of
unincorporated businesses pay tax at the marginal rate (possibly as high as 40%) on
business profits. This contrasts with the position of small limited companies which,
from April 2000, will enjoy a Corporation Tax rate of just 10%) on the first £10000 of
retained profits and a maximum small-companies corporation-tax rate of 20%>. Third,
a number of fiscal incentives tempt business owners to take money out of their
businesses (through pension schemes and Individual Savings Accounts which are
subject to privileged tax treatment). As a result the income-tax system has created a
bias against the reinvestment of profits in the owner-managed firm (Bannock and
Peacock, 1989, page 100). The resultant tendency towards short-termism means that
many successful owner-managers fail to build up the wealth in their businesses that
would provide capital for further growth when economic conditions permit, or would
ensure survival during lean periods of trading (Watson, 1990).
In addition, a cross-sectional analysis of the balance sheets of small businesses
reveals that working capital (current assets minus current liabilities) requires as much
investment as do fixed assets (Chittenden et al, 1998; Cosh and Hughes, 1994, page 35),
and yet the current tax system provides no relief for investment in current assets such
as stocks and accounts receivables (debtors) (Chittenden, 1994, page 181).
In summary, the present tax regime offers few incentives for owner-managers to
plough money back into the business, either through investment in working capital or
through retention of profits within the business. In fact reinvestment in unincorporated
businesses has to be made out of posttax profits, with tax being paid at the business
owners' marginal income tax rates. Therefore we propose that business owners (the
self-employed, sole traders, and partnerships) should be provided with improved incen-
tives to invest by the introduction of a "tax free allowance of £5 000 or 25%) of profits
left in the business each year (whichever is higher)". In order to ensure that this does
not become a mechanism for wealthy individuals to shelter their income from taxes,
this relief would be capped at the level of £100 000 of profits each year.
Respondents to a survey of members of the Federation of Small Business (Poutziouris
et al, 1999) indicated that one in three small-business owners would be willing to retain
more profits in order to take advantage of the proposed tax-free allowance. According to
small-business owners, these extra retained profits would be used to enhance efficiency or
growth through the purchase of new technology and equipment; for marketing activities
to increase sales; or to repay borrowings, thus increasing the financial resilience of their
businesses.
Based on the assumption that only one in three small-business owners would take
advantage of the NatWest/MBS proposal for a tax-free profits allowance, this tax relief
would cost £2042 million. The proposed tax-free allowance for retained profits would
reduce the cost to business owners of increasing their equity investment in their firms
through retaining profits. Encouraging equity investment by business owners should
lead to a higher level of output from their firms. Using the NatWest/MBS tax model,
we estimate that in order to take advantage of this tax allowance, £3333 million of
profits would have to be reinvested in unincorporated firms.Modelling the impact of taxation on the small-business economy 589
5 Conclusions and recommendations
The introduction of the proposed changes to the current tax rules applying to small
businesses in the United Kingdom offers the prospects of encouraging additional
economic activity through the combined elfect of removing existing disincentives to
growth created by the PAYE and VAT systems and creating new incentives for business
owners to expand their firms,
Figure 4 illustrates the combined impact of the above initiatives on the small-
business sector and the cost to the government of introducing these changes. The
benefit to small-business owners in terms of the reduction in income tax and national
insurance on retained profits will be £2042 million; the reduction in compliance costs
as a result of extending the VAT threshold will amount to £334 million; and the
compensation to small-business owners for the collection of PAYE will amount to
another £208 million. UBR paid by small unincorporated businesses will fall by
£1109 million. Furthermore, the small-business economy would also benefit from these
measures as a result of the estimated £3333 million increase in retained profits as
business owners are encouraged to reinvest in their firms in order to take advantage
of their tax-free retained-profits band.
Reduction in PAYE-compliancc costs
Reduction in VAT-compliancc costs
Reduction in Uniform Business Rates
Reduction in owners' National Insurance
Contributions
Reduction in owners' income tax
Improvement in retained profits
-2700 -1700 -700 300 1300 2300 3300
Reduction in tax burden Increase in investment
(£ million) (£ million.)
Figure 4. Impact of the NatWest/MBS tax model proposals for sole traders and partnerships.
Thus, the total benefit to the unincorporated-business sector would be £3693
million in the form of a reduced tax burden and £3333 million as increased investment.
The cost to the government, however, would be much lower than the benefit to the
businesses. This is primarily because the £1109 million reduction in UBR paid by small
unincorporated businesses would cost the government nothing, because the proposed
changes should be self-financing as the burden would be shifted to larger businesses
through an increase in the rate of UBR payable by them. Reduction in tax: revenues as
a result of the NatWest/MBS tax model proposals would amount to £1850 million
(£208 million reduction in PAYE receipts, £492 million reduction in owners' NIC, and
£1150 million reduction in owners' income tax). Additionally, the net loss from VAT
receipts would be £1429 million; however, as noted above, this would be the total
reduction in VAT receipts from the whole small-business sector not just from unincor-
porated businesses. Furthermore, as Customs and Excise staff and resources could be
shifted to other, more remunerative, duties the net cost to the Treasury would be
somewhat lower. Yet, even if we allocate all the net loss in VAT receipts to the590 P Poutziouris, F Chittenden, N Michaelas
unincorporated-business sector, the total cost to the government resulting from the
NatWest/MBS tax model proposals would amount to £3679 million which is still
considerably lower than the total benefit to the small-business sector of £7026 million
(£3693 million reduced tax burden plus £3333 million increase in investment). This
provides a good illustration of the deadweight costs of the tax system.
The tax-related subsidy proposed would act, at least to some extent, as a counter-
balance to the present position in which business owners are effectively encouraged to
withdraw profits from the business and to use debt finance because it is 'subsidised'
through the treatment of interest as an allowable expense for tax purposes [this is
known as the 'debt-tax shield' (for a discussion of these issues see, for example De
Angelo and Masulis, 1980; Myers, 1977)]. The proposed tax-free allowance for retained
profits would reduce the cost to business owners of increasing their investment in their
firms through profit retention. A s noted by Hilten et al (1993) subsidising equity
investment by business owners should lead to a higher level of output from their firms.
It is known that business owners have a strong preference for funding growth from
retained profits (Chittenden et al, 1996b; Cosh and Hughes, 1994; Michaelas et al,
1998; 1999), so the question is whether tax incentives can be used to encourage business
owners to reinvest in their own firms at the expense of withdrawing profits for personal
consumption. On this issue academics are currently divided (Hilten et al, 1993; Storey,
1994). However, research conducted with the Federation of Small Businesses indicates
that a substantial minority of business owners (over one third) would do so (Poutziouris
et al, 1999). The introduction in the 1999 budget of the 10% rate of corporation tax on
the first £10 000 of small-company profits, which will come into force from 1 April 2000,
would seem to indicate that current government thinking is moving in this direction.
Acknowledgements. The authors wish to express their thanks to NatWest for funding this
research project and for providing anonymous research data comprising a random sample of
48 000 unincorporated businesses, and to Grant Thornton for providing advice, and for checking
the calculations in both of the databases. The views expressed are not necessarily those of the
sponsoring organisations.
References
ACOST, 1990 Enterprise Challenge: Overcoming Barriers to Growth in Small Firms Advisory Council
of Science and Technology (The Stationery Office, London)
Aston Business School, 1991 Constraints on the Growth of Small Firms Department of Trade and
Industry, 1 Victoria Street, London SW1H 0ET
Bannock G, 1984, "Taxation and small business in the EEC: some facts and some issues"
International Small Business Journal 3(2) 56-61
Bannock G, Daly M, 1994 Small Business Statistics (Paul Chapman, London)
Bannock G, Peacock A, 1989 Governments and Small Business (Paul Chapman, London)
BCC, 1999, "An entrepreneurial budget: the BCC's 1999 budget recommendations", Association
of British Chambers of Commerce, 22 Carlisle Place, London SW1P 1JA
Birch D L, 1979 The Job Generation Process (MIT Press, Cambridge, MA)
Bolton J E, 1971 Report of the Committee of Inquiry on Small Firms Chairman J E Bolton,
Cmnd 4811 (HMSO, London)
Chennells L, Dilnot A, 1999, "The IFS green budget", Institute for Fiscal Studies, 7 Ridgemount
Street, London WC1E 7AE
Chittenden F, 1991, "Taxation", in Bolton 20 Years On: The Small Firm in the 1990s Eds J Stanworth,
C Gray (Paul Chapman, London) pp 76-111
Chittenden F, 1994 A Study to Determine the Effects of Introducing a Cash Flow Base for the
Corporate Taxation of Small Limited Companies PhD thesis, Faculty of Economic and Social
Studies, University of Manchester, Manchester
Chittenden F, Poutziouris P, Watts, 1996a, "Taxing expansion", November, NatWest Bank, Small
Business Services, Level 10, Drapers Gardens, 12 Throgmorton Avenue, London EC2N 2DLModelling the impact of taxation on the smutt-buHinesn economy 591
Chittenden i\ Hall G, Hutchinson l\ 1996b, "Small firm growth, access to capital markets and
financial structure: review of issues and empirical investigation" Small Business Economics
8 59 «67
Chittenden F, Poulziouris \\ Michaelus N, 1998 The Financial Management and Working Capital
Practices in UKSMEs, published by Manchester Business School in association with the
European Regional Development Fund, NatWest Bank and KPMG
Chittenden F, Poutziouris P, Michaelas N, Watts Tt 1999a, "Taxation and small firms; creating
incentives for the reinvestment of profits" Environment and Planning C: Government and Policy
17 271-281
Chittenden F, Poutziouris P, Michaclas N, 1999b, "The impact of the 1999 budget on the small
business economy", NatWest Bank, Small Business Services, Level 10, Drapers Gardens,
12 Throgmorton Avenue, London EC2N 2DL
Cosh A, Hughes A, 1994, "Size, financial structure and profitability", in Finance and the Small
Firm Eds A Hughes, D J Storey (Routledge, London) pp 18-63
Davies G, Diinot A, Giles C, Walton D, l996,"Options for 1997: the green budget", Institute for
Fiscal Studies, 7 Ridgcmount Street, London WCIE 7AE
De Angclo H, Masulis R W, 1980, "Optimal capital structure under corporate and personal
taxation" Journal of Financial Economics 8 3 - 29
Devercux M, 1991, "The IFS corporation tax model", Institute of Fiscal Studies, 7 Ridgcmount
Street, London WCIE 7AE
DoE, 1995, "The impact of rates on businesses: an analysis of the impact of non-domestic rates
costs on different types of businesses", IFF Research Ltd for the Local Government Research
Programme, Department of the Environment, Transport and the Regions, Eland Mouse,
Brasscndcn Place, London SWIE 5DU
DTI, 1996a Small Firms in Britain Department of Trade and Industry, I Victoria Street, London
SWIM OET
DTI, 1996b Small Medium Sized Enterprise Statistics for the £ZK Government Statistical Service,
Department of Trade and Industry, 1 Victoria Street, London SWIM OET
Fothcrgill E, Gudgcn G, 1979, "The job generation process in Britain", Centre for Environmental
Studies, London
Miltcn O van, Kort P M, Loon P J J M, 1993 Dynamic Policies and the Firm: An Optimal Control
Approach (Springer, Berlin)
MM Customs and Excise, 1988, "Review of VAT registration threshold", July, MM Customs and
Excise, New King's Beam House, 22 Upper Ground, London SE1 9PJ
MM Customs and Excise, 1998, "Review of VAT registration threshold", July, MM Customs and
Excise, New King's Beam Mouse, 22 Upper Ground, London SE1 9PJ
MM Customs and Excise, 1999, "Review of VAT registration threshold—summary of
representations", March, H M Customs and Excise, New King's Beam House, 22 Upper
Ground, London SE1 9PJ
Inland Revenue, 1998, "The tax compliance costs for employers of PAYE and national insurance
in 1995-96", report by the Centre for Fiscal Studies, University of Bath, Bath
King J, Wookey C, 1987, "Inflation: the achilles heel of corporation tax", research report 9, Certified
Accountant Publications, 29 Lincoln's Inn Fields, London WC2A 3EE
Meade J, 1978 The Structure and Reform of Direct Taxation (George Allen and Unwin, London)
Mian S L, Smith C W, 1992, "Accounts receivable management policy: theory and evidence"
Journal of Finance 48(1) 169 - 200
Michaelas N, Chittenden F, Poutziouris P, 1998, "A model of capital structure decision making
in small firms" Small Business and Enterprise Development 5(3) 246 - 260
Michaelas N, Chittenden F, Poutziouris P, 1999, "Financial policy and capital structure choice in
UK SMEs: evidence from company panel data" Small Business Economics forthcoming
Myers S, 1977, "Determinants of corporate borrowing" Journal of Financial Economics 4 147-176
OECD, 1992 Taxation and Small Businesses (OECD, Paris)
ONS, 1997a, "Labour market trends", volume 105, number 4, April, Office for National Statistics
(The Stationery Office, London)
ONS, 1997b, "New Earnings Survey", April, Office for National Statistics (The Stationery Office,
London)
Peterson R, Shulman J, 1987, "Capital structure of growing small firms: a 12-country study on
becoming bankable" International Small Business Journal 5(4) 10-22
Poutziouris P, Chittenden F, Michaelas N, 1998, "The financial economies and tax affairs of UK
high technology small firms", WP385, Manchester Business School, Manchester M15 6PB592 P Poutziour
Poutziouris P, Chittenden F, Michaelas N, 1999, "Evidence on the tax and investment affairs of
small firms" Small Business and Enterprise Development 6(1) 7-25
Rees H, Shah A, 1993, "The characteristics of the self-employed: the supply of labour", in
Employment the Small Firm and the Labour Market Eds J Atkinson, D J Storey (Routledge,
London) pp 317-327
Sandford C T, Godwin M, Hardwick P, 1989 Administrative and Compliance Costs of Taxation
(Fiscal Publications, Bath)
SBRT, 1993 NatWest SBRT Quarterly Survey of Small Businesses in Britain 9(1) Small Business
Research Trust, 45 Clydesdale Close, Isleworth, MiddxTW7 6ST
SBRT, 1996 NatWest SBRT Quarterly Survey of Small Businesses in Britain 12(1) Small Business
Research Trust, 45 Clydesdale Close, Isleworth, MiddxTW7 6ST
SBRT, 1998 NatWest SBRT Quarterly Survey of Small Businesses in Britain 14(1) Small Business
Research Trust, 45 Clydesdale Close, Isleworth, MiddxTW7 6ST
Stanworth J, Gray C (Eds), 1991 Bolton 20 Years On: The Small Firm in the 1990 's (Paul Chapman,
London) page 95
Storey D, 1994 Understanding the Small Business Sector (Routledge, London)
Watson R, 1990, "Employment change, profits and directors' remuneration in small closely held
UK companies" Scottish Journal of Political Economy 37 259-274
p © 1999 a Pion publication printed in Great BritainYou can also read
