Individual Business Taxation - Essay Example

Individual Business Taxation Assignment What is the key structural question which is discussed in this chapter and why is this question important? The main structural issue discussed in this chapter is how small, owner-managed businesses are taxed. It addresses the structural issues related to business activity in owner-managed businesses. The key structural question is how to treat taxation for employees (unincorporated) and how to treat incorporated businesses in the small business spectrum. The dilemma of how to treat these two different persons in terms of taxation arises because in the small business sector some activities of self employed people may be economically similar to those of the employed (Crawford & Freedman, 2008). Similarly, some activities of the incorporated may be economically similar to those of the unincorporated small businesses. These activities may be similar in economic terms but they are different legally and in terms of rights and obligations. Crawford and Freedman suggest that these different types of entities could be treated in the same way for tax purposes, but it may not be achievable to do so in a straight forward manner because differences in legal forms between such entities have significant practical implications on taxation. Some of the treatments of taxation of employees and self-employed people may be based on receipts and tax rates. Providing the same tax treatment in relation to receipts may not be possible because receipts vary in nature (Crawford & Freedman, 2008). Business receipts cannot be equated to employees’ receipts. Business receipts need to be treated under rules that may derive profit figure. Furthermore, receipts of companies still require to be deducted for the payment of salaries or shareholders’ dividends. In terms of similar tax rate across the small business spectrum, aligning tax rates to on different levels of income across the incorporated and unincorporated small businesses requires the analysis of tax charged at both corporate and personal level. This is structurally difficult. The second reason why it is not possible to treat the two types of entities similarly in terms of tax rates and receipts for taxation purposes is because there is a trend in which labour is taxed differently from capital. Higher taxes are often levied on labour than on capital. This causes differentials in tax treatment for different small businesses. Due to this differential in tax rates, there is an incentive of reduced taxes for converting labour income into capital income if possible (Crawford & Freedman, 2008). Incorporation of a small or big business leads to higher scope of conversion of labour income such as employment earnings into income from capital such as capital gains and dividends. This conversion of income leads to changes in tax consequences without any change of economic activities. If such tax consequences are considered undesirable, the special tax rules may be developed to overcome the legal characterization that causes the differentials (Crawford & Freedman, 2008). In this case, legally incorporated businesses may be treated as unincorporated. The key question comes clear when employment income is considered as labour income and income from incorporated business and self-employment may be considered as labour income, capital income or income derived from the risk of entrepreneurship. It is difficult to measure the income from risk or entrepreneurship, and it is not clear whether it should be treated as labour or capital income for tax purposes (Crawford & Freedman, 2008). As noted earlier, labour income attracts higher tax than capital income, but in small businesses managed by the owner (entrepreneurial business) it is difficult to attribute the income to either labour or capital. This forms the basis of the key structural question of chapter 11. This question is important because it enables tax authorities to determine the base of their taxation for small businesses. It is a necessary step to solve structural problems arising from small business income taxation. Treating income as capital income leads to reduced taxes. Therefore, political and economic factors may be used by small businesses to re-characterize what could be labour income as capital income. To avoid these deficiencies, it is necessary to find an answer to the key structural question. There have been great differentials between personal and corporate tax rates as well as taxes on earned income rates between employed and the self-employed. Incorporated businesses and self-employed attract lower tax rates; hence the number of self-employed and incorporated businesses have increased because incorporation leads to the conversation of highly taxed labour income into lowly taxed capital income. 2. What approaches have been tried or proposed to address the tax implications of the differential tax treatment. It has been observed that there is a tax incentive for a business to incorporate because incorporation gives businesses the opportunity to convert labour income which is usually highly taxed to less highly taxed capital. This structural perspective of the tax system gives small businesses tax incentives when they incorporate. Similarly, the self-employed enjoy lower taxes than the employed. The first step in addressing the implications of such tax differentials is to neutralize the tax system across various legal forms based on commercial factors. The need for such neutralization of the tax system arises due to the fact that the choice of legal form does not always affect business efficiency, but create unnecessary costs for revenue authorities and businesses. One of the approaches that have been proposed to address the tax implications of the differential tax treatment is to deter or prevent incorporation. For example, Murphy (2007) suggests that the small businesses can be prevented from incorporating by increasing minimum capital requirement for incorporation. This would mean that many small businesses remain unincorporated and pay the same income tax as personal income tax, and avoid re-characterization of labour income into capital income. This approach may be challenged by political opposition and difficulties in achieving a suitable minimum capital requirement. A neutral tax system can also be achieved through the pass-through treatment in which incorporated firms are treated as unincorporated firms. Such a treatment should be made mandatory in order to achieve neutrality across various corporations without aligning the treatment of employed and self-employed in terms of NICs. NICs may also be integrated with income tax in order to achieve alignment across the board. In this case, the income of owner-managed business would be treated as labour income regardless of whether they were paid through salaries or not. This approach leads to the alignment of labour income with capital income for owner-managed small businesses. The pass-through treatment may also be made optional. This treatment is already practiced in the U.S. This method, if implemented successfully, is capable of aligns different legal forms and increases the opportunities of tax advantages through the use of one form instead of another. A system like that of the UK which has lower corporate tax rate than income tax rate makes the pass-through treatment only attractive to companies if they were making losses. Another approach that has been tried in other countries is the adoption of special rules for the treatment of income earned by “active” shareholders. In the UK, such shareholders’ income is usually treated generally as labour income which attracts high tax rates. The special rules create allowances for the investment of financial capital in the business. In Sweden, closed held corporations’ distributions are attract reduced tax up to the imputed return on the shares’ acquisition price. Tax implications from differential tax system in the UK can also be addressed by aligning effective tax rates across all legal forms through a contrary approach to the current system. While maintaining the current structural system, the UK may tax labour income at the same rate as capital income as a matter of achieving equity (James, 2014). The UK has already moving in that direction since the changes in Budget 2007 were announced. The changes lessened the distortions in choice of legal form. Income tax and NICs may also be integrated in order to eliminate the tax differentials. The NICs paid by the self-employed can also be aligned with the rates paid by employees. Although this approach could exclude employer contributions, it is one of the best ways to eliminate some of the differentials between employees’ NICs. The differentials in tax system may also be overcome through radical reforms that deviate from the current UK corporation tax system. To implement such radical reforms, concerned bodies should give deep thought to various structural issues affecting the UK tax system. A good proposal in this perspective is to tax unincorporated businesses on their imputed business asset returns at the capital income tax rate. Another approach is to avoid providing special tax and provisions for small businesses. The OECD suggests that giving special tax treatment and provisions for small businesses should be justified by market failure and other objectives such as income distribution and economic efficiency. Based on the size of the firm, the rational for tax preferences for small businesses is challenged by certain problems. Countries need to decide what problems are affecting small businesses first before extending special tax favours to them. If indeed there are problems, a neutral tax system should be maintained and direct expenditure may be used to pursue the objectives of small businesses. It is more helpful to provide special relief to businesses through direct expenditure than through tax system. 3. Assuming profits/income of £25,000 and £75,000 update Tables 11C.1 and 11C.2 using 2014-15 tax and NIC rates and discuss the implications of the historical trends for individuals who are employed or self-employed. Table 11.C.1. Tax and NICs to be paid in the UK, in 2014-2015, by legal form, £25,000 income/profits per annum Employed Self-employed Incorporated Salary/Earnings 23461.67 25000 £9,874.71 For calculation purposes only £25,000.00   £10,000.00 Income Tax £2,692.20 £3,000.00 Class 1 Employee £1,615.40 £3,000.00 NIC Class 1 Employer £1,857.71 £2,070.00 NIC Class 2 £143.00 NICs Class 4 £2,111.55 Corporation Tax $586.00 Dividend Tax £0.00 Total Tax and NI £6,165.31 £5,254.55 £5,656.00 Net Receipts £18,834.69 £19,745.45 £19,344.00 Total Tax and NI as a % of gross income/profits 24.66% 21.02% 22.62% Increase in net receipts compared to employed £910.76 £-401.45 Employees opt out rebate £30.58 Employers opt out rebate £74.26 Table 11.C.1. Tax and NICs to be paid in the UK, in 2014-2015, by legal form, £75,000 Employed Self-employed Incorporated For calculation only Salary/Earnings £67,893.71 £75,000.00 £9,874.71 For calculation purposes only £75,000.00   £10,000.00 Income Tax £23,157.48 £15,000.00 Class 1 Employee £1,157.87 £172.81 NIC Class 1 Employer £7,989.33 £125.29 NIC Class 2 £143 NICs Class 4 £1,157.87 Corporation Tax £12,974.94 Dividend Tax £3,679.86 £16,354.91 Total Tax and NI £32,304.68 £16,300.87 £16,952.89 Net Receipts £42,695.32 £58,699.13 £58,047.11 Total Tax and NI as a % of gross income/profits 43.07% 21.73% 22.60% Increase in net receipts compared to employed £16,003.81 -£652.02 From the figures above, it is clear that the calculated total tax of self-employed and incorporated is higher than the total tax for the employed. For example, employed people earning £25,000, the employed pay higher total tax rates than the self employed and the incorporated (24.66%, 21.02% and 8.36% respectively). Employed people earning £75,000 also pay more tax than the self-employed by £16,003.81. The incorporated also pay more total tax than the self-employed by £652.02. In terms of percentage, the employed pay a very high tax rate (43%) followed by the incorporated (22.60%) and the self-employed (21.73%). Clearly, the employed pays nearly double the rates paid by the self-employed and the employed combined. Furthermore, the more income you earn, the less it becomes costly to become self-employed in terms of taxes. This motivates the employed to move to self-employment where tax rates are the lowest. Considering the historical trends for individuals who are employed and those who are self-employed as shown in table 11C.2 of chapter 11, it is clear that the tax rates for the employed have been higher than those of self-employed since 1996. However, the tax for both groups has been increasing over the years, perhaps reflecting the annual inflation rates and changing economic situations of the country. The trend has been similar in all groups such that when the tax rates of the employed decrease, those of the self-employed also decrease, and if the tax rates of the employed increase, those of the self-employed also increase. The graph in 11C.3 derived from table 11C.2 indicates that the proportion of gross income paid in tax and NICs has always been higher for the employed with a relatively flat line graph, followed by lower rates of the self-employed which has also been relatively flat until 2008/09 when the rates for self-employed started to decline as the rates of incorporated increased. As of 2014/15, the total proportion of income paid in tax and NICs for incorporated has gone higher than the rates of the self-employed. Therefore, the self-employed rates have become extremely attractive for people seeking cost saving alternatives in their investments. Due to these trends, there are various implications. For instance, the employed may read the trends and realize that things are not changing for them for a very long time. They observe their rates remaining very high compared to the rates of the self-employed, and they tend to opt out of the employment sector to become self-employed. Because the tax rates are stably high for employed and low for the self-employed, self-employment and incorporation becomes attractive to the people. Such historical trends are relied upon by various financial advisers and decision makers to make decisions regarding investment (Weltman & J.K. Lasser Institute, 2004). Financial investors will always advise their clients that self-employment has been attracting very low tax rates through favourable NICs, so their clients will rationally prefer to invest in self-employment and become owners of small businesses instead of being employed. 4. In your opinion, is there a need to address the differential tax treatment referred to in this chapter? In my opinion there is need to address the differential tax treatment in UK because it leads to the question of equity. Different tax rates for labour income and capital income in the United Kingdom has led to differences in corporate tax and income tax for individuals. It also causes differences in taxes incurred by self-employed and taxes incurred by the employed. In particular, labour income attracts higher income than capital income. Since incorporated businesses earn capital income such as dividends and capital gains, they tend to pay lower tax than unincorporated entities which earn labour income (James, 2014). Similarly, employed people earn labour income while self-employed earn capital income. Therefore, the employed pay higher taxes than the self-employed. For the sake of equity, such differentials in tax rates are not fair for businesses that earn labour income including employed people. There is need to address this differential system in order to respond to the concerns of communities. When corporations pay fewer taxes due to the structural problems of the tax system while the members of local communities pay more taxes through labour income tax, the community feels that the tax system is being unfair (James, 2014). Therefore, a neutralized tax system will ensure that all members of the community including individuals and corporations are satisfied with the tax system. If everyone trusts the tax system for offering a neutralized tax system, people will be more willing to pay taxes and incidences of tax avoidance will decline significantly. Another justification for the need of addressing the differential treatment of tax is that it prevents people from moving out of the employment sector to become self-employed. It reduces the rates of turnover in companies and government institutions of the country. If this happens, government taxes in the long run will reduce and the private sector will be flooded, earning little income for the economy. The reason why people would leave employment to become self-employed is because they pay a higher tax rates when they are employed than when they are self-employed (James, 2014). Therefore, people tend to become self-employed in order to enjoy the benefits of tax reduction. However, this will be detrimental to the economy in the long run. A neutralized tax system will ensure that all sectors of the economy are treated equally and given opportunity to compete fairly at equal terms. Differentials in tax treatment also offer tax incentives to incorporated entities (MacKie-Mason and Gordon, 1997). Unless there are situations of market failure and size disadvantages, offering tax incentives is not beneficial in the spirit of open market competition. Small businesses that are disadvantaged in terms of size can be boosted through tax incentives, but general differentials will not benefit the economy. It is important to provide other non-tax incentives such as subsidies instead of tax invectives in order to boost the economy through the rise of small businesses. The only thing that differentials can achieve is to encourage small businesses to continue investing, but other sectors of the economy, namely the employment sectors, suffer through the loss of employees who leave jobs to become self-employed. Differentials in tax treatments should therefore be reduced or completely eliminated. In my opinion, differentials in tax treatment also cause difficulties in computation of tax revenues by the government and the individuals and corporations filing for tax returns. If one base of taxation is used across all legal forms, it becomes easier to estimate and compute the total taxes raised by the public and corporations. Using the same tax rate for different legal forms also makes it easier for the tax authorities to determine the total income and corporate tax earned in the country. As a result, the country’s budgeting activities becomes easier and faster. It also reduces complexities and errors in the country’s tax system. Lastly, differentials in tax treatment of the employed and the self-employed tend to create a disincentive for employees to perform poorly at the workplace. When people are not motivated, their job performance decreases. Tax reductions through the neutralization of tax treatment can encourage employees to continue working harder for their organisations and achieve organisational objectives and perform better. If employees feel that they are being treated equally as the self-employed people, they will be motivated to perform better in order to compete with other businesses effectively. References list Crawford, C., & Freedman, J. (2008). Small business taxation: A special study of the structural issues surrounding the taxation of business profits of owner managed firms. Oxford: Oxford University Centre for Business Taxation James, S. (2014). The Importance of Fairness in Tax Policy: Behavioral Economics and the UK Experience. International Journal of Applied Behavioral Economics, 3(1), 1-12. MacKie-Mason, J., and Gordon, R. (1997). How much do Taxes Discourage Incorporation? Journal of Finance, 52, 477-505. Murphy, R. (2007), Small Company Taxation in the UK: A Review in the Aftermath of the ‘Arctic Systems’ Ruling, Tax Research UK. Weltman, B., & J.K. Lasser Institute. (2004). J.K. Lassers small business taxes. Hoboken, N.J: John Wiley & Sons. Read More