Pavlovian tax

GOOD BOY RUFUS, who's a good boy then? Now when I speak to my dog like this he wags his tail, rolls over on his back and waits for his chest to be rubbed. And when I acquired him,  the rescue home informed me that he was quite partial to a little corned beef as a treat. As soon as he sees a tin he starts to smack his lips; the Pavlovian response. Without starting a great philosophical or religious debate in Taxation , I would like to suggest that we humans are basically just another type of animal. Naturally, we like to believe that we are more advanced than dogs, although it does occasionally occur to me, when I put Rufus on his lead after a run in the park, whether he is thinking to himself, 'I wonder when he is going to be old enough to feel safe walking down the road without needing to be attached to me? Can't he find his own way home?'

Anyway, we all have our own little wants and needs and when we hear the dinner gong — or the corned beef tin being opened depending on your personal preference — we tend to come running. Lately, I have started to wonder how many people in government or HMRC have actually owned a dog.

K9s and P35s

In their press release of 30 January, HMRC say that they 'have evidence that there has been some abuse of the online filing tax-free incentive payment available to employers with fewer than 50 employees. At the same time, some employers have made claims as a result of sending returns in error. We are reviewing returns where no tax and National Insurance has been deducted during the tax year to check if the payment is due'.

One of the conclusions of the Review of Payroll Services by Patrick Carter in 2001 was that HMRC should 'take advantage of the opportunities provided by information technology'. Large employers should have to file online and for small employers 'the review concludes that both an incentive and a sanction would be necessary to persuade them to make the switch from paper'.

Table 1. Online filing incentives

Large companies (i.e. more than 250 employees) were legally obliged to pay and file online from April 2004 and, as promised, a 'carrot' was dangled in front of smaller companies, whereby they would receive an annual incentive payment as shown by Table 1 . No corned beef then, but an acceptable amount of tax-free money evidenced by the fact that the number of employers filing online has increased exponentially, as shown by Table 2 .

Table 2. PAYE end of year returns filed online

Apparently there were 1,850,000 small employers as at October 2005. Possibly some new 'e-filers' may have have submitted their PAYE returns online anyway, but bearing in mind the increase over and above the previous year and the fact that only 11,000 large employers filed online, it seems that with 50% of small employers now submitting their returns this way there has been a huge 'Pavlovian response' to the tempting £250 morsels that HMRC dangled in front of them. If we were to assume that all of the small employers were entitled to the £250 incentive, the total cost to the Exchequer for 2004-05 could be £225,000,000. Now, while you could buy an awful lot of corned beef with that, it is not in fact hugely different from the Government's expectation of the costs included in the Treasury's 2005 Budget publication as shown by Table 3.

Table 3. Estimated cost of incentives

There are no estimates of costs for 2008-09 and 2009-10, but if we take the £200 million cost in 2007-08, based on the £150 online filing incentive for  2006-07 return as a guideline, we could perhaps estimate the costs for 2008-09 and 2009-10 as £130 million and £100 million respectively. So something in excess of £900 million has presumably been allocated for the five-year period.

HMRC's 'beef'

So it seems clear that the incentives — as they were designed to — have clearly influenced taxpayer behaviour. Whether they realised the full extent of the Pavlovian response that the incentive would cause or whether they were taken by surprise is unclear (presumably not, in view of the Exchequer's estimate), but HMRC have apparently 'risk assessed' the PAYE end of year returns.

The department states that:

'in some cases, instead of “self-serving”, some employers asked to receive their tax-free payment as a cheque for £250 as was their right under the rules of the scheme. During the processing of these claims, we found that in some cases the £250 was not due. There are predominately two ways in which such a situation could arise. One is an abuse of the rules of the schemes and the other is a mistake by the employer. We will be checking the cases we identify in our review to make sure that the tax-free payments go only to employers who are entitled to them.'

I assume that the 'mistake by the employer' scenario covers situations where there were no tax credit payments, PAYE income tax or National Insurance liabilities, nor earnings between the lower earnings limit and the earnings threshold that would have created a benefit entitlement. The submission of an end of year return would not be necessary in such cases, but presumably the employer may have believed that the fact that he has submitted a 'nil' end of year return online would be enough to entitle him to the incentive payment.

This is not the case as Regulation 1 of the Income Tax (Incentive payments, etc.) Regulations SI 2003 No 2495 restricts the definition of a 'small employer' to those who are required to maintain a deductions working sheet to record income tax, National Insurance or tax credit information.

HMRC have declined to go into the exact nature of the abuses that they have uncovered, but one presumes that some taxpayers were found to have taken rather more of the 'opportunity' afforded by the Government in its 2005 Budget document than perhaps they should have.

When the incentive payments were first announced, there was some press coverage of the idea that schemes could be 'split' or multiple employers created to increase the number of returns required.

Another possibility could relate to making payments to an employee (perhaps a relative), which HMRC believes may not be commercially justified and has been made simply to 'crystallise' a small qualifying PAYE liability.

But supposing that a director had withdrawn company profits by dividends historically; if he now pays himself a small salary to create a small tax liability or National Insurance benefit entitlement, does this constitute an 'abuse'? Similarly, suppose a spouse had previously assisted with the business records, but had been unpaid (perhaps because he was already employed elsewhere); would payment of a small salary now be an abuse of the rules?

The Income Tax (Incentive payments, etc.) Regulations SI 2003 No 2495 are widely drawn in this regard and state that 'an incentive payment shall not be made where (a) a small employer has been established; (b) employs employees; or (c) makes payment of PAYE income; wholly or mainly for an impermissible purpose'. An employer is established for an 'impermissible purpose' if (amongst other things) it was established to obtain an e-filing incentive. Whilst this might clearly cover situations where an employer has been created specifically to bring a PAYE scheme into existence, does it cover pre-existing employers? Presumably so, as the regulations say 'established', 'employs' or 'makes payment'. It seems likely that one or two small employers who have exhibited a Pavlovian response to the incentive are going to be disappointed.

Déjà vu?

Does this all sound strangely familiar? Without raking over the whole story, encouraging e-filing is starting to remind me of the Government's decision to 'encourage entrepreneurship' by introducing a nil-rate band. Ignoring warnings that that this would mean that many businesses would incorporate simply as a tax-saving exercise, the Government subsequently introduced a non-corporate distributions rate to try to stem the loss in corporation tax, finally throwing in the towel last year. Presumably the nil-rate band and non-corporate distribution rate are filed somewhere in the Treasury's basement in a drawer marked 'seemed like a good idea at the time'. On the other hand, perhaps it did encourage entrepreneurship. Many enterprising people heard that tin being opened and responded by forming a limited company. (See Table 4 .)

Table 4. Annual rate of incorporations    

Incorporations, running between 200,000 and 225,000 from 1998-99 to 2001-02, were 325,000 in 2002-03 when the nil-rate band started. Perhaps we should be proud that our 'nation of shopkeepers' still has the entrepreneurial skills to see an opportunity and grasp it with both hands. It will be interesting to see whether the incorporation level changes following abolition of the nil-rate.

Of course, it is not just entrepreneurs who are on the look out for the main chance; we are all at it! A 2002 survey of a sample of 37,000 property sales showed that 548 properties were sold at a price between £240,001 and £250,000, yet only 61 were sold for between £250,001 (when a 3% stamp duty charge kicks in) and £260,000. Similarly, business profits apparently 'peak' just below the £15,000 'three-line accounts' limit and again just under the VAT registration limit. Arbitrary thresholds, sudden changes in tax rates and payments can all 'incentivise' our Pavlovian taxpayers one way or another.

We ain't nothing but hound dogs

I am afraid that Rufus is a hound. If he sees a rabbit it is as though a switch has been thrown in his brain. Everything else turns off and away he goes. Fortunately for rabbits, the sound of his collar rattling warns them of his approach, and the chase usually ends in disappointment. Well it does for Rufus; presumably it ends more in relief for the rabbit!

Perhaps Rufus can show us that there is a lesson that can be learned both by Government and by taxpayers. If the Government is going to bang the dinner gong or emerge rabbit-like from its burrow, various hungry parties are going to come running! If you think about it, they would be mad not to, wouldn't they? Especially as everyone else is running in the same direction. But the lesson that Rufus would like taxpayers and the Government to learn is that if you do decide to run, just be prepared for a little disappointment at the end of the chase; the other party's intentions may be somewhat different from your initial impression.

That the Government does not seem to have learned this lesson, Rufus puts down to a lack of dog ownership by Treasury Team members, which we understand is as shown by Table 5 , indicating that dog-owners appear to be in a minority. For those non-dog-owning members, Rufus says that he is available to demonstrate Pavlovian responses for the price of a tin of corned beef.

Table 5. Treasury Team dog owners

Rufus is not a chartered accountant or tax consultant, although strangely he can be contacted by e-mail at accounting@rufusthedog.com .

The views expressed in this article are Rufus's own.

Issue: 4048 / Categories: Comment & Analysis , Admin , Income Tax