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.
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