Why the small business tax rate should rise

SMALL BUSINESSES are battling a declining economy, the prospect of stagflation and ongoing problems with accessing credit. But they've now been told that the small business rate of tax should be going up, not down. They might well feel it never rains.

The view comes from the Institute of Fiscal Studies in its latest Green Budget report. The annual publication received much attention in the press but one item escaped the radar - small business tax.

In short, the IFS said reducing the rate in April for profits up to £300,000 would encourage more company incorporations - an outcome the government should be trying to avoid.

The think tank instead suggested the government should lift the rate because it would be "one way to reduce the distortion within the current system". It added this could have been done politically if presented as part of a wide efficiency drive.

But do small business taxes need to go up? The context is worth reviewing.
The current rate of 21% will be cut to 20% following an announcement in last year's Budget - the first under the coalition government.

It was pitched as part of the government's effort to improve enterprise and growth and came alongside the intention to cut the main rate of corporation tax.

This is against a history of the small business rate moving unpredictably. Between 1995 and 2002 the rate went from 24% to 19%. In 2008, as budget deficits became an issue, it was back up at 21%. Labour also toyed with a 0% band for profits up to £10,000, which was abolished in 2005.

One of the IFS' key arguments is that small business would benefit from consistency in the approach to taxation after many years of change.

Advisers agree. Small business is feeling pushed from pillar to post and uncertain about where the next change will come from.
However, tax experts point out that the upcoming cut is part of the readjustment after the 2008 rise and there was every reason to expect that.

George Bull, head of tax at Baker Tilly, said: "Corporation tax is a burden on business. Therefore when business is finding survival difficult reducing their costs increases the likelihood of survival and secures jobs for the future. That has got to be right."

But the big problem for the IFS is that it believes cutting the rate will only encourage more incorporations. That means a change in status, and a change in the tax burden - but no resulting change in economic activity.

And that contradicts the government's intention of encouraging new business formations and more entrepreneurship.

Experts concede that a lower rate will encourage new incorporations but they also doubt that a single percentage point cut will do much harm - not nearly as much as Labour interventions which caused hundreds of thousands of new incorporations before abolition of the special rates.

However, the IFS' larger point is two-fold. Firstly, incorporations create a loss of national insurance. Secondly, the bigger question: why should the unincorporated end up facing a bigger tax burden?

"The UK system has provided a long-running tax incentive to be a small
incorporated firm, which distorts the choice over organisational form," the IFS said.

"There is no compelling reason for the tax system to encourage one legal form over another...income derived by operating either a small company or an unincorporated business should face the same tax burden."

Some experts agree but caution against making the argument based on what may or may not happen to national insurance.

The self employed pay 8% on profits up to £43,875, and 1% on anything above that. They could pay 50% on income too.

Those running an incorporated company have to balance corporation tax rates on profits with further tax on any dividends that are drawn and declared through the self assessment system.

Dividends are free of national insurance but there may be employer's contributions. Tinkering with the national insurance is difficult because they are not easy calculations to make.

However, experts do see scope for levelling the playing field between unincorporated and incorporated - though not through raising tax rates.

Chas Roy-Chowdhury, head of tax at the ACCA, sees the issue as "equalising the position for unincorporated" companies. A change is needed in their status to improve their tax position. This might be through the creation of a special arms' length corporate body, but the idea would need work.

"Tax would stop playing a critical part in the process of company formation," he said. "Any tax increase is not the right approach in the current climate," he added.

In many senses the discussion is academic. The small business rate will be cut. But the issue of fairness between incorporated and unincorporated will rumble on, and government would do well to formulate its strategy soon.