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KEY POINTS
- PAYE was introduced in 1944.
- The effect of changing work patterns.
- The new National Insurance and PAYE Service.
- Benefits of real time information.
- Improving the system for all parties.
The idea of collecting income tax by withholding income was originally piloted by Churchill’s Chancellor, Sir Kingsley Wood, in 1940/41 to replace annual and half-yearly tax collections. The Treasury needed to find a way to finance the war while keeping control of inflation.
The April 1941 Budget saw increases to personal taxation that added two million new taxpayers and was the first time in British history that the majority of the population were liable for tax.
With a higher individual tax burden and swathes of people who had never had to budget before to pay their income tax, a system by which tax could be deducted at source provided the much needed solution.
Automatic tax
PAYE was fully introduced in 1944, but sadly for Wood he didn’t live to see its operation: he collapsed and died in September 1943 on the day it was to be announced in Parliament.
By the end of January 1944, however, 15m people, anyone earning £100 a year or more, had received notices telling them their code number for the year upon which their cumulative tax deductions would be based.
This system of estimating the annual tax liability to be spread across the year remains with us today, largely unchanged, and has served the country well. But the demographics have changed. In Sir Kingsley Wood’s time, work patterns were fairly static.
Jobs were often for life with part-time, flexible working and multiple employments very much the exception. This meant that the in-year estimation based on the tax code generally equated to the actual annual liability.
Collection of employee and employer National Insurance contributions (NICs) first entered the PAYE system in 1975. Adding the non-cumulative calculation of employee and employer NICs to the cumulative deduction of tax had its advantages as it was a system already familiar to employers, but it undoubtedly added significant complexity.
By the mid-1970s, the PAYE system was described as having become ‘a paper chase of gigantic proportions’ and in 1978 the Board of Inland Revenue compared it to ‘a vintage Rolls-Royce, which the Revenue laboriously if not lovingly maintains’ (Hood, 1985, page 15).
PAYE was computerised in 1984. Cards that recorded annual tax information were replaced by 12 regional databases that stored the tax records of individuals based on the location of their employer.
Splitting the databases in this way was not by design: the PAYE records of UK taxpayers were simply too huge to accommodate in any single system at that time.
The databases had no automatic data feed between them, so individuals with more than one concurrent employment or with multiple pension sources often found themselves dealing with different tax offices in different parts of the country to try to bring together their information through sending messages on paper between tax offices.
Attempts to collate information about individuals’ different sources of income within a year were arduous both for the Inland Revenue in locating and sharing data with itself and for taxpayers who generally bore the brunt of having to supply the information needed to reconcile their annual tax calculation.
Enter technology
To manage the burgeoning workload and increased burden on employers, the Revenue turned to IT solutions. Employers had, in fact, started using software to manage their side of the PAYE task as early as 1954 – the first employer to use payroll software was Lyons Corner Houses.
Electronic data interface (EDI) provided the means for payroll bureaux and employers to make returns over a secure computer network from 1998 and the impact was immediate.
While originally intending to make end of year returns easier, the real benefits for business were felt in the process for managing starters and leavers where the speed of transactions meant that coding notices (P6 and P9s) reached employers within hours instead of weeks. Built-in validation also meant that data was of better quality than anything before.
EDI was a huge success but had one pitfall: it required investment by the employer to put in place and so was only viable for bigger employers and payroll bureaux.
By 2000, the Revenue had developed its online capability and could receive returns directly over the internet. Crucially, this capability could be built into payroll software, enabling all employers to use the service.
In his review of payroll services in 2001, Lord Carter highlighted the benefits of this move online and the results were astounding: the acceptance rate of employers’ end of year returns rose from 46% (paper) to 96% (online) in one year.
The success of online filing for employers, the need to keep up with the ever increasing workload generated by PAYE, and Lord Carter’s review, in which he said that both HMRC and employers needed to make better use of information technology, prompted a growing trend towards online services:
- Different dates for filing paper and online self assessment tax returns were introduced in 2008 which have seen an increase year on year to 77% of all self assessment returns being filed online in 2010.
- Most employers will have to file in year and end of year PAYE returns online by 2011.
- Some 70 million returns were made online last year across all regimes for which HMRC has responsibility.
- The HMRC website received 99 million visits in a year.
- The content of HMRC’s website is rated as the highest in government.
The movement of PAYE services online is continuing with notices of coding (P2s) for agents of self assessment customers due to move online from this autumn. But there is still a long way to go: individual communications are still largely paper-based.
Overall, PAYE really is a wonder of the 20th century and remains the most sophisticated withholding system in the world. It has enabled the collection of billions of pounds of tax and NICs each year from millions of employees, without them ever needing to make a return.
It revolutionised the role of the employer into the main tax operator through which everything happens in a year: the calculation of tax by reference to the code, the deduction and payment of tax, as well as the continuation of cumulation through movement by individuals between jobs.
It transformed the Inland Revenue’s (now HMRC’s) relationship with employees, meaning that the department only receives information about an individual’s pay, tax and NICs after the end of the tax year unless there is a change of employment in year. PAYE could not function without employers and it is a core function of any business that has staff.
This article must also acknowledge the role that tax agents play. Without their expertise, employers need to develop their own capability to meet their obligations and keep abreast of changes in legislation and process.
In the absence of payroll agents, tax compliance costs would increase and resources would be diverted by businesses from other economic activities. Up to 50% of all employers use an agent or a payroll bureau to fulfil some or all of their payroll obligations.
Too much pressure
Despite the success of online filing by employers, PAYE as a system was struggling to cope with changing work patterns. The system had been designed for an era when people didn’t move freely between jobs or have complex remuneration packages with benefits and expenses.
The demographics really started shifting in the early 1990s and this shift has been gradual but steady ever since.
The consequence of these changes has placed ever growing strain on PAYE in its ability to maintain cumulation throughout the year and get the annual tax right.
And with HMRC receiving information about individual employees only after the end of the year, gaps in employment history, problems with data quality, the proliferation of non-cash benefits and expenses, multiple concurrent employments and/or pensions would often only come to light months, sometimes years, after the event.
These all contributed to an increased workload from sorting out in year movement of records and issuing of codes to end-of-year reconciliation, that HMRC struggled to manage.
The difficulties of the PAYE system also coincided with a period of administrative challenge in the mid 2000s for HMRC. Operational targets, particularly relating to PAYE open case clearance (checking that year-end pay and tax details are correct), were de-prioritised and missed.
Open cases for tax and non-match items for NICs (where the respective systems could automatically reconcile the taxpayer’s account for the year) still needed to be worked manually and HMRC fell into arrears with a backlog in excess of 17m unreconciled tax cases by the end of 2007/08.
An open case left unreconciled in one year could mean that tax allowances were not correctly allocated between an individual’s employments or pensions in a later year.
The solution
Abolishing PAYE was never an option. Despite the problems, it is important to remember that what PAYE does has much in its favour. It is relatively cheap for the government to administer, it collects large amounts of money with little leakage and it places little or no burden on the 39m or so ordinary working people for whom the payments withheld from their wages equals the tax they should pay.
This contrasts with many other countries that require tax returns from most or all of their adult populations.
In 2006, HMRC began a business transformation programme that aimed to deliver a more efficient and effective PAYE process, which would benefit both taxpayers and HMRC.
Through the creation of the new National Insurance and PAYE Service (NPS) which holds NI records as well as those for earnings and tax, it transformed the way in which PAYE processing is managed. The new system supports HMRC in collecting the right amount of tax, at the right time, from the right people, more efficiently by:
- Improved resolution at first point of contact: to have a single PAYE taxpayer record containing all pay and tax data, enabling more enquiries to be resolved at the first point of contact.
- Improved accuracy: the availability of a single record and increased automation, improving accuracy levels, so more taxpayers pay the right amount of tax at the right time.
- Improved speed of response: increased automation for all PAYE processing, to speed up taxpayer service
Reduced taxpayer contact: to hold comprehensive notes on taxpayer contact and all taxpayer data in one place to reduce contact levels for both taxpayers and HMRC.
The new system was launched on 29 June 2009 and created a single record for a taxpayer holding all their PAYE pay and tax details which can be viewed and worked on in any HMRC location.
In building NPS, HMRC undertook the largest training exercise at the time in Europe (and the biggest ever in the UK) with more than 28,000 staff in 650 sites learning how to use the new system. More than 54m records (for 39m taxpayers) were moved over from the old system.
Problems
The transition proved to be something of a rocky road. The system, as with many large IT projects, suffered some teething problems with data mismatches, which then issued incorrect coding notices for a large number of taxpayers in January and February.
Bringing together records from the disparate databases into one system revealed for the first time the extent of the problem that had built up over time.
In autumn 2010, HMRC ran the end-of-year reconciliation process for the first time using NPS, reconciling taxpayer accounts for the years 2008/09 and 2009/10.
By the end of the process around 5.6m taxpayers had received repayments and 1.1m notices of underpayment had been sent.
All were issued automatically by NPS (under the previous system all over and underpayments had to be processed clerically), increasing speed and accuracy compared to the previous process.
HMRC paid back around £1.9bn in repayments (in October 2010 it was issuing 65,000 cheques a day), but also had to recover some £1.1bn. It applied a temporary £300 tolerance to arrears while working the 2008/09 to 2009/10 years, foregoing around £160m in back tax.
HMRC faced a barrage of criticism at the time. Some of it was unfair: an end-of-year reconciliation is an inherent part of the PAYE system, not a case of ‘HMRC getting their sums wrong’.
But, as the minister responsible for HMRC, I was conscious that many taxpayers were not getting the service they expected. These problems with PAYE had a knock-on effect on HMRC’s service delivery. The contact centres came under huge pressure and response times for correspondence lengthened considerably.
HMRC are now getting back on track with PAYE and while they continue to handle some 60m calls and 74m letters a year, this is no mean feat.
The department has undergone a rigorous stabilisation programme to ensure that NPS functions as intended and this has improved the accuracy of tax codes from 80% in 2010 (2010/11 codes) to around 98% in 2011 (2011/12 codes).
HMRC have also been improving their service standards in 2011 with a stronger service in call centres and in reduced response times for correspondence.
HMRC are confident they will have cleared their eight-year open case backlog and by 2013 will be reviewing only three years: the tax year just finished, the tax year under way and looking forward to coding for the next.
Cases that cannot reconcile automatically will have reduced – thanks to NPS – down to a more manageable 3.5m a year. Coding accuracy will remain high at around 98%.
That said, there will always be some taxpayers who do not pay the right amount of tax under PAYE because a tax code reflects an estimate of liability and cannot always be right for everyone.
Tax code adjustments are needed particularly when new sources of income or new benefits in kind become known after the end of the year. In addition, both HMRC and employers make mistakes in administering the system.
Consequently, there is a need to reconcile and sometimes correct some taxpayers’ affairs after the end of the year.
HMRC will be better equipped to deal with taxpayer enquiries, on the basis that cleaner data will reduce many unnecessary calls, although PAYE will never be able to get it right in all circumstances.
The next chapter
Real time information (RTI) will modernise PAYE for the 21st century and be another huge step forward for the effectiveness of its operation in a modern world.
The ability to receive information in year about employees’ earnings and tax means that working age benefits and the new universal credit, will be supported by up-to-date and accurate earnings information, so that benefits can properly reflect the claimant’s current financial position.
The transition to RTI will take around three years as the legacy processes are gradually replaced and employers take the opportunity to review and streamline their payroll processes.
Responses to HMRC’s consultation on RTI reflected the improvements the system aims to offer. While some initial reactions to the idea of RTI were that it could actually be 12 times or 52 times the amount of work, HMRC have reassured employers that this is not the case – most of the information is already collected via payroll activity.
Employer submissions will be fully automated and integrated into payroll software so there will be no end of year peak of work. April and May will feel no different to other months in the year.
Employers have recognised that RTI will help them to organise their work more efficiently and also avoid any build up of debt.
Essentially, under RTI, the process of sending pay and tax details to HMRC will be integrated with the payroll process, saving duplication of effort and eliminating the risk of transcription errors. As PAYE information will flow into HMRC through employers’ normal payroll functions, many of the separate activities they were previously obliged to fulfil solely for tax and NI purposes will be eliminated. This will save in excess of £200m a year in employers’ administrative burdens.
Over time, current year work will also be simpler. Payroll software will integrate the payroll process with reporting to HMRC and the administration associated with employee joiners and leavers will be streamlined once RTI has been fully adopted by all employers.
The P45, approaching its 70th birthday, will in time be given its own P45 and be able to retire with grace.
Changing world
These changes promise not only to improve the operation of PAYE for employers, but are the keystone to managing successfully the complexity and frequency of changing work patterns and working arrangements in the modern world.
HMRC, rather than receiving PAYE data after the end of the year, will be much better placed to identify when PAYE is collecting the wrong tax and make the necessary adjustments to correct this.
They will have the information that will help them cut back tax credit error and fraud, estimated at around £300m a year, and to reduce occurrences of tax credit overpayments.
But while a significant step can be made towards the PAYE goal of in-year accuracy, RTI will not be able to deliver this for all and reconciliation will always be an intrinsic part of the PAYE process.
Although the move to RTI means HMRC will be able, in future, to correct and update codes in a more timely and accurate way, situations will always arise when the actual liability for the year does not match the tax withheld, for instance when employer-provided benefits start, stop or change in-year, although instances of under and overpayments at the year end will be fewer and smaller in value overall.
In the UK we still have the age old problem of a 60 year-old culture that shields most taxpayers from having to think about their tax, but perversely wants them to understand what is going on when it does not reconcile. So PAYE improvement does not stop here.
I believe that HMRC need to think about how they can better communicate and get better understanding with taxpayers so they can help HMRC to get it right. I also believe the tax agent community can help and do more for their clients.
My vision for PAYE
PAYE is essentially an opaque system which tries to get it right for the taxpayer with minimal taxpayer involvement.
I want to reform the taxpayer experience of PAYE so that British taxpayers know what they need to do to get their tax right immediately, so that it is easy for them to engage with the system and build a greater degree of awareness and understanding of how the system works and where they need to get involved to ensure it works properly for them.
I would like PAYE to be more accessible and transparent. The last budget announced that HMRC would consult in the autumn to explore how the administration of the personal tax system can become more transparent for individual taxpayers.
As a starter, a new online personal tax calculator and phone app to enable people to calculate both the annual tax and NI they can expect to pay and their overall effective tax rate will be launched by HMRC next April. Work on other options for the consultation is under way and more information will be available soon.
Tax agents play an important part in the relationship between HMRC and taxpayers and I want to build on the varied role they play so that these interactions can be seamless and mutually beneficial.
HMRC published a consultation at the start of the summer: Establishing the Future Relationship Between the Tax Agent Community and HMRC.
The aim of this is to transform the relationship by recognising tax agents as valued and trusted business partners, putting control of basic transactions in their hands, understanding agent engagement with HMRC to identify agents who need support and the minority who are complicit in rule breaking, and making it easier and cheaper for unpaid agents to do business with us.
Again, we can learn from international experience such as the strong relationship built with tax agents by the Australian Tax Office.
I want to build on the successful partnership HMRC has with employers and pension providers to maximise the accuracy and quality of the data held on individual employees and pensioners and to improve the service that HMRC deliver. HMRC intend to capture this in a new strategy for employers on which they have started engaging with the employer community.
HMRC have a taxpayer-centric strategy that says that they will design their services and interventions around the needs and behaviours of taxpayers.
This is the foundation for designing the future for PAYE, where it works efficiently reducing both the cost to the taxpayer in running it and to taxpayers in getting the right result .
This is our ambition and what we will work towards. The next step in this journey will look at how we can achieve it and build on the capability that RTI will give us. It is on this next chapter that we will be consulting on this in the autumn.
David Gauke MP is Exchequer secretary to the Treasury
