The first thing we do, let’s tax all the lawyers.

The UK taxes high-earning lawyers less than bankers. That’s irrational – and illustrates a wider problem with the tax system. It’s hard to change, but we’d all benefit if we taxed all income in the same way.

Here’s the problem:

• A City law firm has £100m of profits to share between 100 partners.¹Some people unfamiliar with City law firms may be shocked at how large these figures are; some people who work in City law firms may regard this as a poor level of profitability, and possibly a failing firm. The tax consequence: each partner has gross income of £1m on which they pay £435k income tax²i.e. tending towards the 45% top marginal rate, plus £35k national insurance³Tending towards the 2% marginal rate. So the lucky partners take home £530k⁴It will usually be less than this, because law firms – like most businesses – have non-deductible expenditure… in practice that will raise the effective tax rate by a couple of %, and lucky HMRC collects £47m.
• A bank has £100 million of profits to share between 100 traders. The tax consequence: the bank pays employer’s 13.8%⁵There’s a good argument I should add the 0.5% apprenticeship levy, because it does behave just like another 0.5% employer’s NI. But, given it’s semi-hypothecated, I decided to leave it out. If you disagree with me on this, then that means my bigger argument has 0.5% more force. national insurance, leaving £87.9m for the bankers.⁶I made a bad mistake here, and added the 13.8% employer’s NI to the £100m. That makes no sense, because the bonus pool was stated to be £100m – the bank is going to have to use that to pay the bonuses and the employer’s NI. Now corrected! So each banker has a gross income of £879k, on which they pay £380 income tax and £21k national insurance. So the poor bankers take home £477k, and even more lucky HMRC collects £52.3m.

The lawyers have an overall effective tax rate of 47%; the bankers’ rate is 52.3%. That is an odd and irrational result.

Why does it happen? The simple reason is that partners in a law firm are not employees, and so there’s no 13.8% employer’s national insurance.⁷Some people will complain at this point that the bankers aren’t paying employer’s national insurance – so why include that in their effective tax rate? The answer is that the economic evidence suggests that, in the long run, the economic incidence of employer’s national insurance largely falls on wages. In my example it’s particularly clear – the bank has a bonus pool, and the employers are going to get what’s left after employer’s national insurance is paid – so it is directly reducing their income. This isn’t tax avoidance, or even tax planning⁸Except when it is – see the smart comment from ‘Tigs’ below regarding salaried “partners” – it’s an inevitable consequence of the fact that our tax system puts so much weight on whether a person is an employee.

The question is whether we should change the law and tax partners in law firms and other large professional firms the same way as employees.

How much tax could we raise?

The Lawyer has crunched the numbers on large law firms, and reckon that the top 50 UK law firms and top 50 US law firms have a combined UK profit of £6.3bn, implying that if they were subject to employer’s national insurance, that would yield an additional £870m of tax.

The top 75 UK accounting firms have a profit of around £3bn, implying an extension of employer’s national insurance would yield an additional £400m of tax.

Add in management consultants, investment managers, and other large professional partnerships (whether in partnership or corporate form) and it’s realistic to think we’d be looking at between £1.5bn and £2bn of revenue.⁹There would certainly be difficult edge cases; this post is about the principle rather than the practicality. Similarly, lots of points to think about re. non-deductible expenditure, which for some large partnerships already takes the effective rate over 50%.

Should we do it?

Given the economic mess we currently find ourselves in, it’s hard to defend £1m lawyers paying less tax than other comparable professionals.

As Catrin Griffiths, editor of The Lawyer, says:

All the data points to the fact that commercial law is a highly successful UK sector that relies on an infrastructure of education, training and technology. In a climate of rising taxes for all, law firms will be increasingly challenged to consider their own financial contribution to the public finances.

Politicians may find the prospect of an easy £2bn of additional revenue tempting. 

And yet I pause at the idea of creating a headline tax rate of over 50%. On the one hand, that’s already what happens – the bankers in my example above have an effective rate of 53.5%. But – and this is important – they probably don’t feel like they do.

Wider implications – and solutions

It’s not just lawyers. The same distortions and difficulties arise throughout the economy.

We tax employment income much more than other types of income, and that creates distortion, uncertainty, and tax avoidance. I’ve no doubt that employer’s national insurance is a Bad Tax and we should end it.

But if we immediately abolished national insurance, and rolled it into income tax, then I fear many people would be aghast at how much tax they were paying (even if employers passed-on the benefit of the employer national insurance cut, which is distinctly optimistic). Tax psychology is a thing, and (on the basis of no evidence) I worry about the overall economic and fiscal effects of people feeling like they’re paying more in tax than they take home. That’s not a reason not to act, but it’s a reason to be very cautious.

This is a hard problem.

There are two things that might make it easier:

• First, make the change mostly revenue-neutral. We’d be greatly expanding the base of people paying the 13.8% tax. So we don’t need the rate to be as high as 13.8% to collect the same amount. My feeling (and tax policy needs more than a feeling) is that nobody should be paying a marginal rate of over 50%.
• Second, mandate that employers pass on the savings. This would be a highly unusual thing to do, but in this circumstance, it might be realistically achievable¹⁰The usual problem is this: when the 5% “tampon tax” was abolished, we couldn’t legally require that prices were cut by 5%, because retail prices move all the time, and it’s not possible to disentangle the tax cut from other price changes. Wages are different. It might (and this would need a lot of thought) be possible to require employers pass on an employer’s national insurance cut. That wouldn’t be a perfect solution, because an employer could pass on the cut, but at the same time scrap a wage rise that otherwise would have been paid. But it could (particularly in a time of low inflation) ensure that most of the benefit went to employees in the short term, and there’s good reason to believe that it will go to employees in the long term regardless of what we do.

This would have two effects. People who aren’t employees would see a tax rise, but it would be less than the full 13.8%. Employees would see an actual tax cut. It’s just about possible this could make the whole proposal politically feasible. Maybe.

All we need is a suitably courageous politician.

Image by DALL-E: “a statue of lady justice, with a stack of dollar bills in her hand, digital art”

• 1
  Some people unfamiliar with City law firms may be shocked at how large these figures are; some people who work in City law firms may regard this as a poor level of profitability, and possibly a failing firm.
• 2
  i.e. tending towards the 45% top marginal rate
• 3
  Tending towards the 2% marginal rate
• 4
  It will usually be less than this, because law firms – like most businesses – have non-deductible expenditure… in practice that will raise the effective tax rate by a couple of %
• 5
  There’s a good argument I should add the 0.5% apprenticeship levy, because it does behave just like another 0.5% employer’s NI. But, given it’s semi-hypothecated, I decided to leave it out. If you disagree with me on this, then that means my bigger argument has 0.5% more force.
• 6
  I made a bad mistake here, and added the 13.8% employer’s NI to the £100m. That makes no sense, because the bonus pool was stated to be £100m – the bank is going to have to use that to pay the bonuses and the employer’s NI. Now corrected!
• 7
  Some people will complain at this point that the bankers aren’t paying employer’s national insurance – so why include that in their effective tax rate? The answer is that the economic evidence suggests that, in the long run, the economic incidence of employer’s national insurance largely falls on wages. In my example it’s particularly clear – the bank has a bonus pool, and the employers are going to get what’s left after employer’s national insurance is paid – so it is directly reducing their income.
• 8
  Except when it is – see the smart comment from ‘Tigs’ below regarding salaried “partners”
• 9
  There would certainly be difficult edge cases; this post is about the principle rather than the practicality. Similarly, lots of points to think about re. non-deductible expenditure, which for some large partnerships already takes the effective rate over 50%.
• 10
  The usual problem is this: when the 5% “tampon tax” was abolished, we couldn’t legally require that prices were cut by 5%, because retail prices move all the time, and it’s not possible to disentangle the tax cut from other price changes. Wages are different. It might (and this would need a lot of thought) be possible to require employers pass on an employer’s national insurance cut. That wouldn’t be a perfect solution, because an employer could pass on the cut, but at the same time scrap a wage rise that otherwise would have been paid. But it could (particularly in a time of low inflation) ensure that most of the benefit went to employees in the short term, and there’s good reason to believe that it will go to employees in the long term regardless of what we do.