I did not participate in the previous debate on incorporation because my comments are particularly relevant to clause 32. Some of the comments made by the hon. Members for Arundel and South Downs and for Fareham apply in spades to this clause.
The Government propose to cut the starting rate of corporation rate from 10 per cent. to 0 per cent., thereby increasing significantly the existing incentive for sole traders and self-employed people to incorporate. It is a huge increase in that incentive. I want to develop the argument and speak about the potential cost of the tax revenue lost. Calculations by the Institute for Fiscal Studies, and indeed a report in yesterday's Financial Times, suggest that the costs may be much larger than those estimated in the Red Book, so the debate is particularly important.
I shall begin by clarifying what is going on. At the moment, people have to choose between being self-employed and paying income tax on their profits and national insurance contributions at a reduced rate, or incorporating to create a company of which they are the only shareholder and employee, in which case they pay tax as normal on their salary and pay out profits to themselves in the form of dividends on which they may or may not pay corporation tax. [Interruption.] For the record, we can hear some interesting noises but I think that we are safe.
The measure will significantly change the tax question of whether to be self-employed or to incorporate. To illustrate that point with an example, by setting up a company a person would be able to pay themselves a personal allowance of £4,615 against income tax, and on top of that make profits of up to £10,000, which would be paid out in dividends, while facing no tax liability. As a result of the clause, a person who incorporates could earn £15,000 and pay no tax. Labour Members may want to reflect on the distributional issues raised by the measure.
The cost of the measure is relevant because the Committee is concerned with protecting the taxpayer. The Government have estimated the cost of the measure and, as I said in my brief intervention in the previous debate, that has been aggregated with the measure on the small companies tax rate in the figures that I read out previously. It is not clear, although I am sure that the Paymaster General will clarify this for us, what the Government estimate the cost of the specific measure to be. Assuming for the sake of argument that the cost of the measure is the whole of the figure in the Red Book—which is a heroic assumption, but let us make it—by 2004-05 the Government estimate that the cost would be £450 million. I should be interested to know how they arrived at that figure, or a lower figure of which the Paymaster General is about to inform the Committee.
I should particularly like to understand the assumptions about the number of corporations that will benefit. Have the Government assumed that that will consist of the current number of corporations because there will be no behavioural changes as a result of the measure? Have they made an assumption about an extra tranche of self-employed sole traders who will decide to incorporate? Have they assessed that in arriving at their estimates? If they have, how many sole traders do they estimate will incorporate?
As the Committee scrutinises the Government's policy, it is important to see whether they have got those estimates right. I want to dwell on that point
because of the work done by the Institute for Fiscal Studies. Through its analysis of the survey of personal incomes 1998-99, it says that 1.2 million self-employed people each stand to gain in excess of £500.
Sitting suspended for a Division in the House.
Before we broke, I was saying that I was concerned that the Government's estimate of the cost of the measure was an underestimate. I was using an analysis prepared by the Institute for Fiscal Studies to back up my case. The institute had established that 1.2 million self-employed people stood to gain in excess of £500 a year if they incorporated following this measure. One might ask why it chose that figure. My guess is that it decided that that was a large enough gain to act as an incentive, in conjunction with the other incentives in the system. I am told that it is possible to incorporate at around £100, although I am not suggesting that everyone can incorporate at that low figure. Many other considerations are involved in such a move, as we discussed in the previous debate, not least the hassle and time of going through the process, but they are one-off costs. The clause relates to a one-off gain—a permanent gain in the tax system. Therefore, if anything, the IFS was fairly conservative in its choice of 1.2 million self-employed who might be attracted by the measure.
The IFS tries to calculate the cost if 50 per cent. of the 1.2 million self-employed were to incorporate following the passing of the Bill. It estimates that the cost would be £1.2 billion, compared with the highest possible figure from the Government so far of £450 million. The institute also produces other costs estimates. If 75 per cent. of the 1.2 million self-employed who stand to gain more than £500 a year were to incorporate, the cost would be £1.9 billion; and if everyone in this community of 1.2 million self-employed were to incorporate, the cost would be £2.5 billion. That is the IFS estimate.
I am sure that the Paymaster General will agree that the Institute for Fiscal Studies is an independent and much esteemed body, which provides a great deal of useful research for our debates in this place. She may tell the Committee that its figures are incorrect and that it has got it completely wrong or that it has made a mistake in its methodology.
The hon. Gentleman seems to be developing an argument based on the idea that, if we implement a certain tax measure, everything else will stay the same, but one must not assume that what in this case is a gain for self-employed people is necessarily in the longer term a loss to the Exchequer. The point of the measure is to promote enterprise and business, which will in the longer term lead to greater revenues and lessen the loss to the Exchequer from the immediate impact of the measure. Surely the hon. Gentleman will accept that the tax might have dynamic effects as well as an immediate impact.
I cannot have explained myself fully enough. There will be no extra economic activity as a result of sole traders deciding to incorporate. It has no effect on the country's overall economic growth; it is simply the result of a tax change. Therefore, it is a net loss. There is no extra growth or economic activity to set aside, unless the Government are about to tell us that they have changed the laws of economics, but I doubt that the Paymaster General will tell the Committee that.
Therefore, I disagree with the hon. Member for Wimbledon (Roger Casale). As far as I can see, the result is simply a net loss, which is what the Government estimate. My quibble is that the Government have made an underestimate, and that the Committee is being asked to agree to a tax measure that will cost the Exchequer far more than they think. It is incumbent on us to think carefully about that and probe the Government in case they have got it wrong. There is time to change, and to avoid money for our public services being lost.
I take the point that sole traders may move in that direction, but people who operate in the black economy may also see the advantages of becoming legitimate and incorporated. Those people would benefit the Exchequer in a way that they have not done in the past.
That is a valid point, but not one against the thrust of my argument. I doubt that the Government's estimate took into account a reduction in the size of the black economy—the Paymaster General may prove me wrong.
I am going on the estimates of an independent body that is well renowned and well respected. It has considered dynamic changes, but not of the nature that the hon. Member for Dundee, East (Mr. Luke) suggested. The IFS considered the number of self-employed people available, the new incentive that could change their behaviour and move them towards incorporation, and what would happen if many of them took up that incentive. The IFS is describing not a static, but a dynamic picture. I want to probe the Government on whether they feel that their sums are wrong.
I will shortly conclude so that the Paymaster General can enlighten the Committee. If the Government are wrong, I would prefer it if they admitted it now. This is not about political point scoring but ensuring that the Exchequer gets the money it expects. If the IFS is right and the Government are wrong, we could see a questionable use of taxpayers' money—the hon. Lady would probably agree unless there is a policy objective that we have not heard about. Perhaps the Government want to give a lot of money to a certain group of people but have not got round to telling us. If that is so, we should debate whether that would be a sensible use of taxpayers' money.
Should the favoured group be in the business community or the community as a whole? Perhaps there is a policy objective for a group of businesses, but
does the clause address the best way in which to target money? Perhaps extra allowances should be given to the self-employed so that they do not have to tinker around with incorporation and can just receive money. However, perhaps the Government feel that incorporation has extra advantages for the wider economy, but will not tell us about them. Given the Paymaster General's response in the previous debate, I would not be surprised if she said that the Government were neutral on the issue. I do not believe that such declared neutrality is exhibited in the clause.
Distributional issues are related to the clause. When business people heard the Chancellor on Budget day, they must have thought, ''Great! Here's a pro-business measure.'' Labour Members should be aware that it could mean a huge tax cut for a particular group at a cost to the wider community, and that that could cause distributional issues. I shall remind them of the figures that compare a self-employed person with an employed person, each earning just under £15,000 under the regime. The self-employed person pays no tax, and the employed person pays—I am told by the Institute for Fiscal Studies—£3,827. That is a huge difference, which I am not convinced that Labour Members want.
The hon. Gentleman made some of the points that I wanted to make because he and I read the same briefing from the Institute for Fiscal Studies. Therefore, I will not go over the points again, but I am intrigued, as he was, by the reason for that. There is no indication in the explanatory notes as to what the economic result is supposed to be—whether the amount is a small expenditure, as witnessed by the Red Book, or the much larger numbers to which the hon. Gentleman has rightly drawn the Committee's attention. The example that the Government use in the explanatory notes shows a company saving £875, which is the equivalent of £74 a month. Anyone would rather have than not have an extra £74 a month, but what would they actually do with it? I do not intend to give a detailed exposition of that.
My first thought was that the measure was a sop to small and medium-sized companies for the extra burden that they will bear in national insurance charges. Obviously, for companies that are low on profitability but high on employability, it would be a drop in the ocean. I then wondered whether it had something to do with investment. The Paymaster General could have encouraged investment in the small and medium-sized sector in many different ways. It begs the question, why this way?
As the hon. Member for Kingston and Surbiton said, there is a friction between incorporation and unincorporation. He gave the example of a person on £15,000 who did not choose the incorporation rate having to pay £3,827. I noted the body language of the Paymaster General at that point. She was almost ready to explode with disagreement. If she disagrees with that calculation, I look forward to her demonstration of why the IFS figures are incorrect.
The Paymaster General used a very interesting term—''targeted help''—in her remarks on the previous clause. I wondered why she felt that the
companies at the lower end of profitability—the companies that would benefit from the measure—all needed help. One of the guiding principles of Government expenditure is to avoid a deadweight cost, if possible. I suspect that there is a lot of deadweight cost in the measure. Many companies might have been glad of some form of assistance, but through another route.
For example, in justifying their approach on oil taxation, the Government told us that they had enhanced first-year allowances for new North sea fields facing an additional 10 per cent. levy on corporation tax. The 100 per cent. write-off in year one was the key to inducing further investment and, by the magic of arithmetic, the Government tried to demonstrate to the Committee of the whole House that in some way companies would be better off. If that is a better way, why not visit that sum of money on enhanced allowances, for example? We do not have before us any form of compare-and-contrast analysis that would allow Parliament to decide whether the money is being used in the best way. The Government have decided on tinkering, to a certain extent. Someone with profit of £10,000 would get back £1,000 in monetary value.
What is the economic effect of using money in an across-the-board way as opposed to a more targeted relief, which the Paymaster General clearly favours? I should be grateful if she would give us some economic and business rationale and possibly agree to place in the Library the analysis—the Paymaster General looks pained.
The only reason that I look pained is that the right hon. Gentleman, who was a Financial Secretary in a previous Government, knows that certain elements of the modelling work that the Treasury undertakes cannot be disclosed. He implies that Ministers are withholding information that they could disclose. That is not the case, and he knows that he cannot plead for confidential Treasury information to be put in the Library. That is why I looked pained. I do my best to help him, but he stretches credulity.
If I had been asking for detailed company-by-company information, I would entirely accept what the Paymaster General says. However, the idea that the Treasury cannot provide some rational explanation—[Interruption.] I am sorry, but I do not accept that. There must have been a way in which the Treasury decided that that, rather than other alternatives, was a good use of public money to achieve an as yet unstated policy objective.
The Government are very happy when they believe that they have the justification to put on record gains such as economic growth or an increase in employment. The Paymaster General cannot have her cake and eat it. The Government are happy to put in the public domain, when things are going their way, the gains that they think can be made. It is different when I ask her in this Room to give a compare-and-contrast analysis of why this method has been chosen. If she simply said that the Government wanted to
reduce the level of tax on that company, that would be fine; I would respect that point of view, but if there are alternative reasons, Parliament should hear them.
I do not think it unreasonable to ask whether alternative ways of helping small and medium-sized enterprises were considered. Any reduction in taxation will leave more money with those companies but, using the arguments that I put forward on deadweight costs, there might have been a better, more targeted—to use the Paymaster General's own language—and therefore more appropriate way of using that money.
I am confused by this debate, which I think is very important, because the hon. Member for Kingston and Surbiton talked about amounts of up to £2.5 billion. He cited some figures, as did the hon. Member for Fareham. I confess that I was a solicitor before I entered this House in June, not an accountant. I get confused on this debate because I do not quite understand the figures and I have not had the benefit of the briefing from the Institute for Fiscal Studies. For some reason, it did not see fit to send me one.
Right, but I have not had the benefit of it, so perhaps those who have will explain it to me. Let us take a simple example. I shall talk in round figures, because that is how my mind is working, and I stand to be corrected, because I am not an accountant. Ted's Window Cleaning, as a sole trader, turns over £15,000. My understanding is that Ted will pay low national insurance, although I am leaving that out of the equation for now. On his £15,000 a year, in round terms, he gets a personal allowance of £5,000 and, as a sole trader, he pays 22 per cent. on the £10,000, which is £2,200.
If Ted decides to incorporate his window-cleaning company, that company has a revenue of £15,000 and employs Ted for £5,000 a year as an employee, with higher national insurance contributions. He gets that £5,000 in his pocket. He leaves the £10,000 in the company and because it is below the level, his company is not paying any corporation tax on it. The following month, after the year ends, his daughter announces that she is getting married. He says, ''I haven't got any money.'' She says, ''Yes you have, dad, you've got this company with £10,000 in the bank.'' He says, ''You're right.'' As the shareholder, he takes it out of the company. He has extended his income. Does he not pay 22 per cent. income tax on that? I shall give way, because I am standing to be corrected.
He takes it as a dividend after the company has suffered the appropriate corporation tax on it and, as such, if he is paying only standard rate tax, there should not be any further taxation on it.
I am grateful for that explanation. I am still not with it, and I stress that that may be my ignorance, but when Ted takes £10,000 out of his company, the company has not paid any corporation tax on it because it is below the threshold. He then has an income of £10,000 from the company—a dividend
income as the shareholder. [Interruption.] Is the hon. Gentleman telling me that he pays no income tax on that?
My understanding is—no doubt the Paymaster General can correct me—that because the company has paid whatever its corporation tax due is, the money paid out by way of dividend will qualify as a dividend that has suffered corporation tax. The recipient would pay further tax on such a dividend only if he were paying higher tax rates. This recipient would, therefore, not pay any further tax on that dividend.
I confess that I am getting more confused. My local brewery, the Wolverhampton and Dudley Breweries plc—the largest independent brewer in the country, which makes good beer—pays corporation tax on its profits. If I were to have shares in it, and I stress to the Committee that I do not, and it paid me a dividend as a shareholder, having paid corporation tax, is the hon. Gentleman saying that I then do not pay income tax at all on that dividend, or that I only pay it if I am a higher rate taxpayer?
Mr. Flight rose—
It clearly depends on one's tax rate. Personal taxation on dividends is complicated. The Government's 10 per cent. credit is soon to be abolished. In simple terms, unless the hon. Member for Wolverhampton, South-West pays higher rate tax, which he does, he would not have a further tax liability that was material.
Order. I am conscious that some extremely expensive advice is being offered free to hon. Members this afternoon, but I think that we had better come back to the matter in hand.
Thank you so much, Mr. Gale. I do not want to go down Ted's route at all, thank you.
The clause provides for the starting rate of corporation tax from 1 April 2002 to be zero. About 150,000 small companies, and other corporation tax payers that have taxable profits of less than £10,000, will therefore pay no corporation tax. When the starting rate first took effect two years ago it was set at 10 per cent.-- the lowest rate for small companies in the European Union, and indeed among all major industrialised countries. About 250,000 small businesses—around 60 per cent. of all corporation tax payers—benefited from the starting rate directly or indirectly through the marginal rate.
In his Budget statement, my right hon. Friend the Chancellor went further, saying that he wanted to send out the strongest signal about the importance that the Government attach to small businesses and the creation of wealth. The measure recognises that businesses growing beyond a certain size will often be companies. We believe that cutting corporation tax is an effective way of targeting support at small and growing businesses. It also encourages would-be entrepreneurs to set up new companies.
If we consider the Budget as a whole, in terms of where the Government are intervening to assist business, we see that there is a total package of measures assisting business worth about £1.6 billion. It goes from the research and development tax credit, to the cut in the small corporate tax rate from 10p to zero, to the reduction of administrative burdens on VAT and the introduction of the community investment tax credit. Each of those interventions will specifically help a part of the economy.
The hon. Member for Kingston and Surbiton asked about the figures in the Red Book. It is not possible to disaggregate the costs of the two cuts—I shall come on to the Institute for Fiscal Studies—because the 160,000 companies paying at the marginal rate will benefit from both the issues. The costings given in the ''Financial Statement and Budget Report'' take account of anticipated behavioural effects of some self-employed people converting their businesses into companies to take advantage of the zero and the 19 per cent. rates. That is in the calculations and explained in the FSBR.
The next set of issues concern the estimates. As a result of the zero rate, 150 companies will pay no corporate tax and a further 160 companies will pay less corporation tax. The estimated impact also takes into account likely significant or quantifiable effects on behaviour. The estimates have been made on the basis of the likely shift, but the economic rationale is clear. The measure is a targeted reduction in tax to help small and new companies thrive and grow. A great deal of activity has taken place to reform that area for entrepreneurs and growing companies.
Turning to briefing note No. 24 from the Institute for Fiscal Studies, I shall start by saying that it is an illustrious body, although why people should consider it to be more able than the full might of Her Majesty's Treasury has always puzzled me. It does a lot of very interesting work and puts out a lot of figures. Sometimes its figures are nearly right and sometimes they are spectacularly wrong. It puts out those figures in order to engender debates and tease out choices that are being made. When we introduced the working families tax credit, it published spectacularly large estimates of how much the child care tax element would cost. It was unbelievable how off beam those estimates were, and the Treasury was right.
An Opposition Member said that neither the IFS nor the Treasury always gets it right, which is true. We do our best to make forecasts on difficult issues. Let us examine how the IFS reached its £2.5 billion figure. It assumed that every single unincorporated business would move, given a theoretical gain of £500. That has
not happened, and we can question whether it will happen and whether we should expect it to happen. The IFS certainly has a different way of approaching behavioural impact analysis and, therefore, forecasting.
Some 78 per cent. of businesses—nearly 3 million of them—are unincorporated, despite the fact that there are already theoretical tax benefits for incorporating that would demonstrate to those companies that they could be better off. There is no shortage of tax advisers seeking to earn a fee from advising companies that that is the best way forward, but we have still not seen that change. The Government stand by their estimate in the Red Book of costs rising to £450 million.
Let me return to the point made by the right hon. Member for Fylde. The estimate is based on careful modelling of the impact of the measure that reflects the facts of real business behaviour, rather than dubious assumptions or sweeping decisions. As he knows, I cannot disclose the details of such modelling in the House of Commons. When he was a Minister the situation was the same, and analysis and calculations were not always revealed.
One reason why the hon. Member for Kingston and Surbiton is so frightened by the modelling from the Institute for Fiscal Studies, which raises the spectre of a £1.2 billion price tag on the measure, is because it would use up most, if not all, of the extra penny that the Liberal Democrats want to put on income tax. Back in the real world, we should think not only about what we are going to spend money on, but how we are going to raise it in the first place.
My hon. Friend made his point directly. The hon. Member for Kingston and Surbiton asked whether it would be justified to spend the money on something else. The Government have made the choice that the money should be spent to encourage the growth of smaller businesses and entrepreneurial activity. We note the estimates by the Institute for Fiscal Studies and also that they have been wrong in other estimates. We have checked our figures, and the costs in the Red Book are obviously the ones that we stand by. However, unless the hon. Member for Cities of London and Westminster does not want investment in the growth of companies, wealth and income for sustainable investment in public service over a long period--I do not believe that that is what Conservative Members are saying--the underlying issue is whether the Government have struck the right balance between incentives to incorporate and to remain unincorporated. If hon. Members are saying that we are perilously close to not striking that balance, we are not convinced. We are convinced that the balance is right, but we do not have a closed mind on that. Surely small businesses will not look a gift horse in the mouth. We want to create growth and economic activity, and to sustain entrepreneurial activity. That must be good for the British economy.
In view of the Paymaster General's profound statements about encouraging growth and targeting measures at entrepreneurs, will she tell us at what level of profits she wants businesses to incorporate. Presumptions have been made in the Red Book and we would be interested to have a broad view of the matter.
When I was in opposition, I heard Treasury Ministers say many times that it is unwise to go on the record with advice to businesses about decisions concerning their future. We set the rules to encourage growth and to ensure that the best choices are available, but the choices remain theirs.
I hope that the Paymaster General realises that I made my comments in a balanced way when I asked the Government about their view. I seek an assurance that, if the provision is exploited in the way described by the IFS--that is, in a way that does not add to economic growth, but encourages a change in status to exploit the tax incentive--will the Government take action to stem the loss of tax revenue?
I did not say that the hon. Gentleman was unbalanced and I am not implying that--yet. I responded to him in a balanced way. If he is raising another point, he knows me well enough to know that the Government continue to cast an eagle eye on the way in which the tax system is used. We shall discuss later in the Bill measures to deal with unintended ways in which the tax system is being used and for which taxpayers should not sustain the cost. If the hon. Gentleman is asking me to be as vigilant in the future as I have been in the past, I can give him that undertaking.
I am grateful for the Minister's helpful reply. I hope that she is right--
I am glad that the Paymaster General is so keen to ensure that the measure is not exploited. She should understand the effect that it would have if, in a year's time the IFS turns out to be even half-right and the Government decided to take action, because accountants would have spent a great deal of valuable time persuading companies to incorporate. If the Government then change, those companies would be free to try to unincorporate, but that would be an extra deadweight cost.
While the Paymaster General is right to assure the Committee that she will be vigilant, she must be careful when she makes what the right hon. Member for Fylde called ''tinkering changes'' that she is not creating accountants' activity that serves no good, economic purpose.
Question put and agreed to.
Clause 32 ordered to stand part of the Bill.