The chancellor of the exchequer Rachel Reeves is being urged to review the anecdotal jump in public sector spending caused by the roll-out of the April 2017 IR35 reforms, as she sets about closing the £22bn gap in the public’s finances left by the previous government.
Reeves revealed details of the “projected overspend” the previous government’s actions had generated during a speech to the House of Commons on 29 July 2024, before setting out plans to start work immediately on closing this “£22bn hole in the public finances”.
“I will today set out the urgent work I have already done to reduce that pressure on the public finances by £5.5bn this year and over £8bn next year,” she said.
One area that she has earmarked for possible savings to be made is by putting a stop to all “non-essential spending” by government departments, with consultancy costs flagged as an area where departmental savings could be made.
“The first difficult choice I am making is to ask all departments to find savings … totalling at least £3bn,” she said.
“To support departments as they do this, I will work with them to find savings ahead of the Autumn budget … including through measures to stop all non-essential spending, such as consultancy and government communications.”
Reeves’ decision to focus on reducing the public sector’s reliance on external consultants is being hailed as a step in the right direction by Dave Chaplin, CEO of contractor compliance authority IR35Shield.
Speaking to Computer Weekly, he said Reeves should kick things off with a review of the detrimental impact the April 2017 public sector rollout of the IR35 reforms had on the levels of “non-essential spend” generated by government departments.
“The IR35 reforms overreached, resulting in government departments forcing out limited company contractors, leading to a talent exodus and significantly increased costs to attract highly skilled workers,” he said.
Revisiting the reforms
The 2017 reforms saw contractors cede control for determining how they should be taxed to the public sector end-hirers who engaged them, as part of a disguised employment clampdown by HM Revenue & Customs (HMRC).
In the view of the government tax collection agency, the system of allowing contractors to decide for themselves if the work they do means they should be taxed in the same way as a permanent employee (inside IR35) or an off-payroll worker (outside IR35) had resulted in wide-scale non-compliance with the IR35 legislation.
As alleged by HMRC at the time, this system of self-declaration had paved the way for some contractors to deliberately misclassify themselves as working outside IR35 to artificially minimise the amount of employment taxes and national insurance they had to pay.
According to HMRC’s own figures, making public sector bodies responsible for deciding how contractors should be taxed generated an additional £550m in income tax and National Insurance contributions in the 12 months to April 2018.
However, shifting responsibility for determining how each individual contractor they engage should be taxed placed a sizeable additional administrative burden on government departments. To deal with this, some departments introduced hiring bans on limited company and personal service company (PSC) contractors, and said they would only engage individuals who provided their services via umbrella companies. This is because the IR35 rules do not apply to umbrella company contractors.
Other departments carried out “blanket assessments” that resulted in every member of their contractor workforce being classified as working “inside IR35” as a means of effectively achieving fast-tracked compliance with the IR35 rules. This is despite HMRC advising organisations in-scope of the rules to apply reasonable care when individually assessing the employment statues of the contractors they work with.
“It’s no secret that upon the introduction of the off-payroll rules in the public sector, government departments became quite hesitant to engage contractors outside IR35,” Seb Maley, CEO of contractor insurance provider Qdos Contractor, told Computer Weekly. “Time and time again, the annual accounts of government departments show that contractors are rarely engaged outside IR35.”
It’s no secret that upon the introduction of the off-payroll rules in the public sector, government departments became quite hesitant to engage contractors outside IR35 Seb Maley, Qdos Contractor
And this is an incredibly short-sighted, needless and expensive approach to managing the off-payroll rules, said Maley.
Because what these hiring bans and blanket determinations may have saved departments in terms of administrative burden has cost them in monetary terms because many are paying over the odds for the contractors they need, said Chaplin, adding: “Inflated rates now compensate for blanket bans on contractors or those only hired on [an] inside IR35 [basis].”
The increase in day rates requested by inside IR35 contractors is to compensate for the fact they will be paying additional tax on their earnings, and will need to increase the amount they charge to maintain the levels of take-home pay they are accustomed to receiving.
Also hiring a contractor via an umbrella company means adding more links to labour supply chain that connects the worker to the end-hirer or the employment agency they provide their services through.
“Adding those extra layers adds costs, because everyone adds their margin,” added Chaplin.
Therefore, Maley is of the view that Reeves should start now to “right the wrongs that happened on the previous government’s watch” and push departments to start engaging outside IR35 contractors again.
“If the government cuts ties with many consultancies while [still] refusing to engage contractors outside IR35, they will lose access to the skills, flexibility and fresh perspectives brought to the table by these parties,” he added.
Rising day rates in the wake of the reforms
A report by IFF Research in February 2022, commissioned by HMRC, looked into the long-term impacts of the April 2017 IR35 reforms and found the changes had led to an uplift in the day rates some central governments departments pay for contractor expertise.
According to IFF Research’s findings, 51% of central bodies said the reforms had no impact on the gross hourly rates paid to contractors working through own limited companies both before and after the 2017 reforms came into force.
“However, 38% [of central bodies] said that rates paid to these contractors had increased due to the impact of the reforms,” the report stated.
“Findings were similar for contractors that worked through personal service companies before the reform, but through a different structure after the reform … with 48% of central bodies reporting no effect on rates … [while] around one in four central bodies [28%] reported rates paid to this group had increased.”
Andy Chamberlain, policy director of The Association of Independent Professionals and the Self-Employed (IPSE), told Computer Weekly that the 2017 IR35 reforms had led to a “huge increase” in the number of umbrella company contractors. And this trend has contributed to “pushing up the costs for hirers” in the public sector.
“If the chancellor is serious about cutting costs across departments, she should focus first on the impact of IR35,” he said.
Departmental approach to IR35
The day after Reeves gave her speech, four central government departments – including the Home Office, HMRC, the Department for Transport (DFT) and the Ministry of Housing, Communities and Local Government (MoHCLG) – published their annual reports, covering the 12 months to 31 March 2024.
And while each of these departments has a very different remit and set of responsibilities, something they all have in common is that – as confirmed by their accounts – very few engage contractors on an outside IR35 basis.
HMRC’s report states that it engaged a total of 766 off-payroll workers during the 12 months to 31 March 2024, of which 727 were not subject to the IR35 rules and were – consequently – most likely to be umbrella company contractors. The remaining 39 contractors were classified as inside IR35, and the organisation engaged no contractors during this timeframe on an outside IR35 basis.
The remaining departments did engage a small number of outside IR35 contractors relative to the total number of off-payroll workers they used during the 12 months to 31 March 2024.
The DfT engaged a total of 1,934 off-payroll workers across its constituent agencies and public bodies, and 48 of these (2%) were engaged on an outside IR35. The vast majority (1,468) were engaged through umbrella companies, and the rest (420) were classified as working inside IR35.
Rather than seeking to reduce contractors and consultants, government should focus on reducing the costs of hiring them, starting with IR35 Andy Chamberlain, The Association of Independent Professionals and the Self-Employed
As stated in the DFT’s financial report most of the “core department’s” off-payroll engagements were via umbrella companies. And, in instances where contractor engagements were “deemed in-scope”, these individuals were recruited through the Public Sector Resourcing Framework and placed on the payroll of the department’s chosen commercial framework supplier.
This kind of setup represents another way that additional costs can creep into engagements where departments are trying to keep their exposure to the IR35 rules as low as possible, said IR35Shield’s Chaplin.
In cases like this “projects now go to large consultancies”, according to Chaplin. “They then subcontract to the same talent pool, but at significantly increased cost.”
The MoHCLG 2023-24 accounts confirm that across the main department, its agencies and arm’s-length bodies that a total of 378 off-payroll workers were engaged, with 8% of them on an outside IR35 basis. Meanwhile, 64% were engaged via an umbrella company and 27% were classified as being inside IR35.
Its report said the department had seen an increase in the number of off-payroll workers on its books because of its requirement for “specialist skills not readily available” within the civil service.
“These skills include building standards expertise and knowledge, expertise of SAP finance systems, as well as digital architect, software and developer skills,” the accounts stated. “There has been difficulty recruiting long-enduring roles permanently, due to the limited supply and high demand for these skillsets within the current labour market.”
This section of the report highlights the benefits of using contractors, with IPSE’s Chamberlain making the point that Reeves should not be looking to reduce the number of them engaged by departments.
“Contractors and consultants are an essential part of the skills mix in government departments, providing expertise on a flexible basis,” he said. “Rather than seeking to reduce their numbers, government should focus on reducing the costs of hiring them, starting with IR35.”
Departmental IR35 compliance issues
The legislation has also hit the pockets of central government departments in other ways too, with HMRC previously pursuing the likes of the Department for Work and Pensions (DWP) and the Home Office for multimillion-pound sums in unpaid tax for IR35 compliance failures, added Chamberlain.
As reported by Computer Weekly at the time, the Home Office received a demand for £33.5m in unpaid tax and penalties over its “careless application of the IR35 rules back in 2021”, while DWP was told it needed to pay £87.9m to HMRC for “historic IR35 compliance failures” that same year.
“HMRC has levied huge charges against departments for supposed non-compliance, which hasn’t been challenged,” he added.
These unpaid tax demands could be one of the reasons why the Home Office 2023-2024 accounts show that 0.2% (three) of the 1079 off-payroll workers engaged by the department were classified as working outside IR35, while 1,046 were determined to be working inside IR35.
Conversely, the department’s 2018-2019 accounts reveal that – across the core department and its arm’s length bodies – a total of 214 off-payroll engagements were in use and 77% (166) of these individuals were classified as working outside IR35.
And when you follow the trail the money these departments pay to HMRC, the enforcement action it has taken against the likes of DWP and the Home Office looks pretty pointless, added Chaplin.
“The whole thing is rather silly really, where public bodies are involved, because we now have rates being paid in excess of market rates, because extra layers are added,” said Chaplin. “Much of the extra cost is due to the added tax. HMRC get their figures up, which then funds the Treasury, which goes back to the department to fund the extra costs.”
He added: “Having off-payroll working in the public sector does seem all rather pointless – [all it does] is circulate tax and increases prices. The entire measure means the government loses money.”