Summary of the Frontier Economics Reports

Frontier:
Frontier Economics was founded in 1999 by a team of highly experienced consulting economists. It's chairman is Baroness Sarah Hogg, who was Head of the Downing Street Policy Unit from 1990 to 1995. The director responsible for the two reports that Frontier produced for the PCG is Dan Elliott. Dan specialises in design of regulatory instruments, tariff issues, micro-economic and financial modelling, investment appraisal and contract negotiation. A recognised expert in the economics of utility regulation, he focuses particularly on transport and water. Recent work includes an influential report on Common Carriage in the water industry and acting as an adviser on the renegotiation of InterCity rail franchises

The two reports covered the market for contracting services - looking especially at the issue of competition - and the quantification of the tax effects of IR 35.

Contracting services and competition
The first report considers the market for contracting services and addresses the degree of competition between small contractors and large contractors. The analysis in the report is based on the results of a survey of contractors drawn mainly from PCG members, which generated over 450 responses. Much of the focus of the report is on the IT sector, where many of the small contractors operate that will be affected by IR35. The conclusions are, however, applicable to the other sectors where small contractors are found.

Underpinning the analysis is a view of how the contracting services market operates. Discussions between Frontier and many contractors and experts in the sector shows indicated that the markets in which these small contractors are operating are not segmented according to the size of the contracting firms offering services. Hence small contractors can be observed working for the same clients, doing the same type of work as larger service providers.

The survey was designed to establish whether this is in fact the case and to provide information regarding the strength of competition between the different sizes of contractors. The survey responses were principally from IT and engineering but also covered financial services, media and education. The survey indicates that the majority of small contractors have only one fee-earning employee and an average turnover of around �82,000 per annum. In terms of the number and size of projects and clients, the survey confirms that small contractors worked on many projects for clients of a range of different sizes, including very large clients. Further, they regularly work in larger teams with other contractors of different sizes. Official statistics reveal that small IT firms (under �250,000 turnover) are a significant force in the sectors in which they operate, and for some products account for around 50% of total UK turnover. Therefore, small contracting firms have a substantial presence and by working for the same clients, provide a form of indirect competition for large contractors.

The Government has argued that small contractors do not compete with larger contracting firms. Sarah Walker, for the Inland Revenue has said that it is:

"unrealistic to suggest �that the workers who will be affected by this legislation ever compete on equal terms with larger companies".

The justification for this unsubstantiated assertion appears to be that large firms offer a wider range of services than any small firm. Frontier demonstrate that this statement is based on a fundamental misunderstanding of what it means to be "in competition" or what defines a "market" in the context of competition analysis. It is like saying that the corner food shop does not compete in food retailing with the local Tesco because Tesco also sells electrical goods and clothes.

Frontier concludes that small contractors provide active and direct competition to large contractors, particularly on smaller projects. The survey results indicate that this is the case. Five out of six small contractors indicate that they compete against medium or large contractors. By contrast, client employees are considered a much less significant competitive influence. When small contractors have won work in competition against large contractors the key factors were deemed to be cost and skill / experience.

Frontier's results indicate that, far from representing disguised employment, the contracting services "market" is an efficient response both to the short-term nature of demand for these skills and to skills shortages in sectors such as IT. There is also active competition between the small contracting firms affected by IR35 and large service providers operating in the same areas, who are unaffected by IR 35 . This, combined with the significant market shares accounted for by small contractors in certain sectors indicates the likelihood that an increase in costs resulting from the IR35 could have a material impact on the functioning of competition in these markets.

In addition, while the Government's original estimate of the number of businesses affected by IR 35 was 33,000 to 66,000 (in its Regulatory Impact Assessment), using official data based on SIC codes Frontier have concluded that the actual figure is likely to be much higher, in the range of 100,000 to 150,000 businesses.

Tax impact
The Government has highlighted the fact that many small contracting firms pay a high percentage of their earnings as dividends, and thus pay lower NICs than would be the case as employees. The Government implies by its statements that these individuals are not paying their "fair share" into the National Insurance Fund. However, Frontier considers that such comments about "fair shares" are extremely misleading. Although contractors may pay reduced NICs they will pay significantly more tax in total as a result of their increased earnings, taking into account NICs, Income Tax on salary and dividends and Corporation Tax on profits. Given the fact that specific UK tax revenues, including NICs are not hypothecated (put aside for specific purposes), Frontier concludes that it seems unjust to suggest that these people are in some way avoiding their fair share of the tax burden.

Frontier consider that the Government's partial analysis of how much an individual would pay in different sorts of taxes under different rules and in different employment situations does not constitute a correct analysis of the impact of the tax proposals nor of its impact upon competition in contracting markets. Frontier's estimates show that IR35 will have a significant impact on the tax burden on small contracting businesses. Most importantly, Frontier finds that IR35 does not place contractors on a level footing with employees of their clients and their large competitors. It in fact results in a significantly higher tax burden than is placed on employees and the contractors' competitors.

Using the data from their survey of contractors Frontier note that their estimate of the average tax impact, when applied to the Government's estimate of 50,000 individuals affected, results in a predicted increase in NICs of �233m (�180m Employers NICs plus �53m Employees NICs) and a total tax increase to the Exchequer of �265m. These figures are very close indeed to the Government's estimate of an increase in NICs of �220m given in its RIA and of total revenue to the Exchequer of �300m, which confirms that the quantitative results of the Frontier survey must be broadly consistent with the figures which the Government has been using in its own calculations.

However, using the Frontier view that the true number of individuals likely to be affected by IR35 lies in the range 100,000 to 150,000 Frontier estimate the total cost to small contractors of the proposals to lie in the range �530m to �790m.

Frontier note that Government Ministers have referred to small contractors currently paying as little as 21% tax on their income. Frontier's analysis shows that this is not the case. The Government's figures are based on inappropriately comparing taxes paid to the gross income of contracting firms, before allowance for costs. This is not a fair comparison with the taxes paid on employment income, which excludes the costs of running the business that are met separately by the employer. Instead of the overall tax rate of 21% cited by the Government, Frontier calculates that the typical small contractor, pre IR 35, paid around 27% in taxes and NIC. Frontier shows that IR35 does not create a level playing field but, rather, raises the average tax rate on small contractors, who are affected by IR 35, to 38% compared to 32% incurred by larger firms.

Frontier concludes that the provisions of IR35 are excessive, even given the disputed objectives of the original proposals. IR35 would result in, at one extreme, a fall in post tax incomes on the part of small contractors of approximately 15% or, at the other extreme, would require a similar increase in the level of fees charged by such firms in order to maintain post-tax earnings. Either of these outcomes (or any point in between) can be expected to have a significant detrimental effect on competition in these contracting markets, by disadvantaging small contracting companies and providing a corresponding competitive advantage to their larger competitors, thereby impacting on the supply of or demand for the services of small contractors.