HMRC has confirmed, as ContractorCalculator reported yesterday, that it does not hold the information required to calculate the effectiveness of, and return on investment (ROI) on, its IR35 enforcement activities. But when we consider its broader role in collecting taxes and enforcing the UK’s tax laws, should everything HMRC does be reduced to a simple cost-benefit equation?
Let’s look at the facts that would ideally be available to Chancellor George Osborne and his Treasury advisers when considering the IR35 alternatives proposed in the Office of Tax Simplification’s (OTS) interim report on Small Business Taxation. The Chancellor wants a solution that simplifies the system, yet is also revenue neutral. So, to help his decision making, we can turn each option into a simple equation:
Extra revenue = T – C, where T = the extra tax collected and C = the cost of collecting the extra tax.
In an ideal world, for each of the three options proposed by the OTS, we could do some basic maths and see which option gives the highest extra revenue.
But unfortunately it’s not quite that simple. The Chancellor also needs to factor in probabilities. i.e. The chances of winning or losing cases. That gives us an equation that looks something like:
Expected revenue for a case i = T(i)p(i) – C(i)[1-p(i)], where p(i) is the probability of winning case i.
But here’s the thing. First, we know that HMRC only started keeping ‘cost centre’ style records from April 2010. That means that ten years of IR35 enforcement has gone effectively unrecorded, which means among other things that no time series data can be used to underpin probability models.
Second, what the maths won’t show are the behavioural factors, such as how taxpayers like contractors will change their behaviour in the light of any new rules. And it’s the behavioural factors that introduce uncertainty to our return on investment models when applied to HMRC.
Why so? Well, it’s easy for those of us working in the contracting sector to become focused on profit and loss. We know that if our costs are less than our income, then we are making a profit, and that having higher costs than income is unsustainable for a business; eventually it will run out of cash to fund the loss and go out of business.
But the same rules don’t necessarily apply to everything HMRC does. We mustn’t forget that the taxman’s role is to collect revenues and police our tax laws. They have to make people pay. The UK’s criminal justice system and the police service costs a great deal more than revenue generated by fines. But a significant element of law enforcement is creating a deterrent to would-be criminals. And tax compliance is no different.
HMRC’s published litigation and settlements strategy confirms that it will engage in loss-making enforcement activity if wider objectives, such as creating case law, are satisfied. Enforcement activity encourages taxpayers to behave compliantly, and this makes perfect sense.
But can we always measure the return on investment on compliance activity? Probably not, because it is impossible to measure and model the total impact of compliance activity on taxpayer behaviour. Should we obsess over whether every investigation makes money, by the commercial measures of what constitutes a profit? No, because HMRC’s job is not to make money but to collect revenue and enforce tax legislation, with deterrence being one of its tools to do this.
So, where does this leave the Chancellor in June, with the OTS’s final report and recommendations on IR35 alternatives? Well, you can bet the Treasury’s sums will include equations having measures of probability of the likely revenue-changing impact of IR35’s possible replacements.
But will its calculations contain ROI data from HMRC? No. Should we take HMRC to task over this? Probably not. Does HMRC generate more tax revenues overall than it costs, despite engaging in some loss-making compliance activity? Yes it does, by a whopping margin, and we should bear that in mind when considering IR35 enforcement and its alternatives.