The Birth of PAYE

The greatest change to the collection of income tax since 1803 was a remarkable success, says JOHN JEFFREY-COOK FTII, FCA, FCIS, ATT.

SIXTY YEARS AGO, on 5 May 1942, the expression 'pay as you earn' was first used in the House of Commons (Hansard column 1251). It was coined by G S Summers, the Member of Parliament for Northampton, in the second reading debate on the Finance Bill 1942 to describe a current earnings basis of deduction, in contrast to the collection through employers of the previous year's liability, introduced by the Finance (No 2) Act 1940. But this is to start in the middle: let us begin at the beginning.

The idea of collecting tax by deduction is an old one. After the dissolution of the monasteries (1536-59) by Henry VIII and later monarchs, the pensions paid to former monks and nuns were subject to the annual tenth of 1534, either at source (deduct and retain) or by withholding (deduct and remit), depending on whether the payer was assessable.

Public offices and employments

When Addington reimposed Pitt's disappointing income tax of 1799 he introduced in the Income Tax Act 1803 two brilliant changes: Schedules A to E and deduction of tax at source. Schedule E (section 175) covered specified offices and employments 'and every other public office or employment of profit of a public nature': Schedule E tax was assessed on the employer who was entitled to deduct it from the employee's salary. Civil servants and public officials have therefore always had income tax collected by deduction. Other employees were assessed directly under Schedule D, Case II (section 84).

Income tax was abolished in 1816, but Peel's Income Tax Act 1842 reimposed it, repeating these provisions virtually unchanged.

Railway company employees

Under section 5, Income Tax Act 1860 the assessment of the profits of railways (times change!) was transferred from the General to the Special Commissioners. Under section 6 they were also to assess the railway companies for 'the duties (sic) payable under Schedule E in respect of all offices and employments of profit held in or under any railway company'. The company could recover the tax by deducting it from the 'fees, emoluments or salary of each such officer or person'. In the case of Attorney-General v Lancashire and Yorkshire Railway Co [1864] 10 LT 95 the company successfully claimed that manual workers such as engine drivers, porters and skilled mechanics were not within Schedule E; they were directly assessable under Schedule D, Case II if they earned more than the £100 annual exemption which then applied, and the company did not have to pay Schedule E tax and collect it from them under the 1860 Act.

Schedule E on all employments

The arbitrary distinction between manual and clerical railway workers went unchallenged for 60 years. However, in Great Western Railway Co on behalf of W H Hall v Bater [1922] 8 TC 231, the House of Lords by four to one agreed with the company that Mr Hall, a clerk, did not in 1917-18 hold a public office or exercise a public employment within Schedule E, so collection under the 1860 Act did not apply. (Mr Justice Rowlatt's definition in that case of an office is being included in the Tax Law Rewrite project's draft Income Tax (Earnings and Pensions) Bill, clause 6: see exposure draft no 6, May 1999, clause 4.1.3 and exposure draft no 12, December 2001.)

Because of this judgment, the Government amended the consolidated Income Tax Act 1918 by section 18, Finance Act 1922, moving employments from Schedule D, Case II to Schedule E so that the pay of all civil servants, public employees and railway employees became subject to deduction of income tax if their income was sufficient.

Income tax stamps unpopular

During the First World War deduction of tax from earnings was suggested, but trade union hostility frustrated its adoption. Following Snowden's crisis Budget of 1931, manual wage earners were permitted to spread each half-yearly payment of tax over 13 weeks if they so desired by affixing income tax stamps to a card supplied by the collector, but this was neither popular nor successful.

Higher taxes to wage war

The outbreak of the Second World War in 1939 necessitated sharp increases in taxation. Income tax assessed rose from £296 million in 1937-38 to £1,125 million in 1942-43. The number of taxpayers increased greatly due to decreased personal allowances and higher wages. The extra tax due to the decrease in allowances was to be repaid as post war credits 'after the war'; in fact the last were not repayable until 1973! In addition, many women worked for the first time to support the war effort. The result was that many people of modest means became liable for income tax and could not cope with making large payments every half year.

From 1937 the Chancellor of the Exchequer was Sir John Simon who later became editor in chief of Simon's Income Tax, published by Butterworths in 1948. When Winston Churchill became Prime Minister in May 1940 he made Sir John Lord Chancellor.

Weekly collection in arrears

The new Chancellor of the Exchequer, Sir Kingsley Wood, introduced an embryo tax deduction scheme in his first Budget on 23 July 1940.

Under section 11, Finance (No 2) Act 1940 and the Deduction of Income Tax (Schedule E) Regulations 1940, the basis of assessment was unchanged but, in the case of manual employees who were assessed on actual earnings for each half year, the tax for the six months to 5 October was collected from their wages commencing the following February, and that for the six months to 5 April from the August. Non-manual employees were on a preceding year basis and their deductions started earlier, on 1 November during the year.

When earnings fell, or fluctuated seasonally, employees suffered hardship, although the net weekly pay could not be reduced below £2 for a single person, £3 for a married man, £4 for a married man with one child and £5 for a married man with two or more children. If an employee changed employers, deductions ceased until he was traced to his new job: much tax remained uncollected in such cases.

Current earnings basis needed

These difficulties prompted suggestions for a current earnings basis, whereby an employee would be allowed each week free pay equal to 1/52nd of his allowances, and the employer would deduct tax at the reduced and standard rates according to a table. However, if wages fluctuated, and each week was treated independently, allowances not used one week could not be used the following week, so there would be millions of over-deductions for the Revenue to repay after the year end.

These problems were discussed in a White Paper of April 1942, 'The Taxation of Weekly Wage Earners', Cmd 6348. The Association of Inspectors of Taxes and the Inland Revenue Staff Federation produced proposals, but on 9 June the Chancellor indicated his dislike of a Revenue pressure group.

Intense activity continued behind the scenes and the Revenue, under its chairman, Sir Cornelius Grigg, and secretary, S Paul Chambers, later chairman of ICI, devised a new system that cleverly introduced the cumulative concept. By 19 July 1943 it was put to the ministers directly concerned, and employers' and workers' organisations were consulted.

The Institute of Taxation

The Institute of Taxation (founded 1930) had a long article in the Financial News of 23 August 1943 that pointed out that Canada had been the first country to introduce a 'pay as you go' scheme some months earlier and that the United States had introduced one from 1 July.

There was widespread press reporting of The Institute of Taxation's proposals which even suggested co-ordinating income tax with social security. Three Institute council members, Edward Boyles, Gilbert Burr and William Craven-Ellis MP, put in a tremendous amount of work including meetings in the committee rooms at the House of Commons.

Death in the morning

Unfortunately, on the morning of 21 September 1943 when he was due to announce the breakthrough, Sir Kingsley Wood suddenly collapsed and died at his London home: he was 62. Perhaps the excitement was too much for him! The following day R Assheton, the Financial Secretary to the Treasury, announced the details and the publication of a White Paper 'A New System for the Taxation of Weekly Wage Earners', Cmd 6469, 20pp; it cost 4 (old) pence. The new Chancellor was Sir John Anderson, who had been chairman of Inland Revenue 1919 to 1922 and Governor of Bengal 1932 to 1937 where he survived two assassination attempts. His name is best remembered for the 'Anderson shelter', erected in millions of gardens to give protection against air raids.

Weekly wage earners only

The new proposals were to apply to all weekly wage earners and not to manual workers alone, but it excluded those for whom special arrangements already operated, such as civil servants and railway officials. Manual workers, who would have paid by 5 April 1944 only two months of their 1943-44 income tax, were to be forgiven the remaining 10/12ths; non-manual workers who started paying their 1943-44 income tax on 1 November 1943 were to be forgiven the remaining 7/12ths. Both the Canadian and United States systems had allowed similar write-offs. The tax forgiven was set against the post war credits for 1943-44, which took care of about half of the cost of £250 million.

Extension to all

The proposals were well received and the main criticism was that taxpayers whose wages were not calculated weekly were to be left out of the scheme and receive no write-offs. As a result Anderson reluctantly extended the scheme to all incomes and pensions up to £600, ignoring overtime. By the time the Wage Earners Income Tax Bill became the Income Tax (Employments) Act 1943 on 11 November, the Chancellor had agreed, under pressure, to extend the scheme to all Schedule E taxpayers. This was enacted by the Income Tax (Offices and Employments) Act 1944. Summers' expression 'pay as you earn' became popular, but it was not used in the legislation until the 1970 consolidation.

For administrative reasons, the armed forces were not brought in until 1947-48. Temporary Crown servants of all kinds, civil servants and the armed forces were to be compensated where they had made an overlapping tax payment and the Act had deprived them of a tax holiday that they were expecting.

Public relations exercise

About one million employers and 16 million employees had to be taught what to do. Four-and-a-half million copies of a threepenny guide were sold. Farmers and farm workers had special guides. The preparation and printing of forms and tables almost monopolised the output of the printing trade for many months.

Flying squads of income tax officials were mobilised, ready to go anywhere to explain the new pay-as-you-earn plan. The Revenue even ran a competition for its members to produce model talks to be circulated to tax districts as illustrations, not to be slavishly copied: the prizes were £10, £5 and £2.10s (£2.50). In one of his books, British Budgets in Peace and War 1932-1945, Basil Sabine, an Inspector, records that Revenue staff 'visited factories, talked to workers and management, held meetings and answered questions. It was an example of service to taxpayers, the goodwill from which still survives': he was writing in 1970.

Figure 1 - 1944-45 notice of coding

Notices of coding

Most coding notices were issued in January 1944 and tax offices struggled with the mass of appeals. Revenue staff put in heavy overtime. The busiest offices had queues of callers while open, and only after 4 pm could the staff begin to deal with their heavy post.

Figure 1 shows a 1944-45 notice of coding. The restriction of allowances for own house related to Schedule A tax which was payable on the net annual value of property whether occupied or let: air-raid shelters were exempt under section 17, Finance Act 1938. Schedule A was abolished in 1963-64. The earned income allowance was ten per cent; the reduced rate was 6s 6d (32.5 per cent) on £165 and the standard rate 10s (50 per cent). Surtax, at rates up to 9s 6d (47.5 per cent), was not collected by pay-as-you-earn. Code numbers ran from one for no allowances, to 100 for allowances £791 to £800, in steps of £5 in the most used range (£61 to £250) and £10 elsewhere. New employees without a code number received an emergency code.

Tax deduction cards

Despite the difficulties, the Revenue sent employers most of their deduction cards in time to operate the scheme from 6 April 1944.

Figure 2 (below) shows a 1944-45 weekly tax deduction card P9; the second half of the year was on the back. There was also a monthly card, P11. The weekly cards moved from a horizontal to a vertical format. The single instruction card for employers, printed in blue, also measured five inches by eight inches.

To reduce coding problems with the spread of pension schemes, employers could arrange to show on tax deduction cards the figure of pay after deducting allowable contributions.

An employer with only one employee received a simple form of tax deduction card, and those with only a few employees received merely the tax tables for each code number involved. In addition, employers such as building contractors could, with advance approval from their local Inspector, operate the 'Clayton scheme', which allowed three weeks' deductions on a non-cumulative basis, with adjustments every fourth week.

Employers gave leavers a certificate P45 which enabled the next employer to pick up the cumulative figures, but an employee who wished to keep his previous pay secret from the new employer could arrange this with his tax office.

Figure 2 - 1944-45 weekly tax deduction card

Two early changes

In the early years only two important changes were made. Originally, Schedule E assessments were to be made after the year end in all cases, even where the system had operated correctly, because the approximation inherent in the code numbers and tables would produce a small underpayment to be carried forward. It quickly became the practice (enacted in section 30, Finance Act 1948) not to issue assessments in such cases: this cut the number needed by 85 per cent.

The second change was to reduce the size of the tax tables, which covered all 100 codes, at pay up to £2,000 a year, every week. In March 1944 the British Tabulating Machine Co Ltd had produced simplified tables for the many users of Hollerith punch card accounting equipment. It produced a table one-sixtieth of the size of the official tables. In 1947, the Revenue followed suit and introduced a Table A, showing free pay for each code, and a separate Table B showing tax payable on the balance (whatever the code); their bulk was much reduced, and the number of codes could be increased to 160, reducing the inherent approximations.

An instant success

Thanks to the efforts of all concerned, the scheme was an instant success, and in its first year it collected £540 million, an increase of £100 million over the previous year. Pay-as-you-earn did not change fundamentally for many years and coped with the constant alterations to the personal tax system. One of the earliest was the introduction in 1948 of the special provisions to tax benefits received by higher-paid employees with a defining figure of £2,000; this had increased to £8,500 by 1979-80 but has not changed since. Forms P11D were born.

Earned income relief was increased in 1952 to two-ninths on income up to £4,005 and then one-ninth on the next £5,940, a maximum relief of £1,550 on earnings of £9,945 or more, until Tony Barber abolished it from 1973-74. At the same time, the standard rate of 7s 9d in the £ (38.75 per cent) was replaced by a basic rate of 30 per cent. Surtax was replaced by higher rates of income tax which were collectible by pay-as-you-earn.

As allowances increased, codes became one-tenth of the total net allowances: if these were £1,927 the code was 192. Over the years, codings were simplified and needed changing less often by giving relief for life assurance premiums and mortgage interest by deduction when paying them, and abolishing reliefs for children, dependent relatives, housekeepers, and most recently, married couple's allowance for those born after 5 April 1935.

More recent changes

More recently, fundamental changes have been made to pay-as-you-earn. Tax deduction cards have become deductions working sheets. Besides gross pay and pay-as-you-earn, they now have to record National Insurance contributions, statutory maternity pay, student loan deductions and tax credits; they may also show statutory sick pay. Code numbers became known as codes because they have a suffix letter A, H, L, P, T, V or Y to show how the employer should adjust them to take account of Budget changes. The prefix D means that tax is to be deducted at the higher rate, while a K code is a negative code, applied where taxable benefits and other income exceed allowances.

The original Regulations, S R & O 1944/251 as amended over the years were consolidated in SI 1973/334 and again in SI 1993/744. The Tax Law Rewrite project is currently rewriting them to complement the Income Tax (Earnings and Pensions) Bill due to be introduced in Parliament in November: exposure draft number 12, paragraph 23.

One wonders whether Sir Cornelius Grigg and Paul Chambers would recognise the system they so successfully spawned in 1943; they would certainly be horrified to see how complex it has become.

John Jeffrey-Cook, on behalf of the Company of Tax Advisers, is keen to collect historical tax documents for preservation in the Tony Arnold Library of The Chartered Institute of Taxation. He can be contacted on 01444 471751, e-mail: guild@jeffrey-cook.fsnet.co.uk.

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