The incentive that became a tax dodge

Profit-related pay has become a way of getting the taxman to fund pay rises. Perhaps not for long ...
Profit-related pay is, in many ways, a great success story of the Conservative government. Indeed, given that it is enjoyed by an estimated 4.5 million private-sector employees, and is believed to cost the Treasury pounds 1.5bn a year, it could be said to have been too successful.

On the other hand, there is little evidence that it achieves its true objective of linking employees' pay to profitability. Instead, many companies have realised that it is an effective way of using the Inland Revenue to give employees pay rises. This is because PRP involves employees giving up a proportion of their salary to receive it back as PRP; the tax advantages of that payment amount to an increase in income.

All of which convinces many that the scheme cannot continue as it is for long. In a paper issued last week, the accountancy firm Ernst & Young argue for a wholesale reform.

They point out that abolition in the Budget later this month is unlikely, because it would lead to a surge of wage claims by employees wishing to make up for the loss of pay. Therefore, the Chancellor may trim the benefit, much as has been done with mortgage tax relief, so that instead of PPP being tax-free up to a maximum of 20 per cent of gross pay or pounds 4,000, the tax relief would be limited to the basic or lower rate. Alternatively, the overall amount of PPP available for tax relief could be cut from up to pounds 4,000 per employee to something like pounds 3,000.

But the firm - which in their report, Heaven Can Wait - But Taxpayers Can't, also look at reform of benefits in kind and the treatment of foreign executives working in Britain - believes both reforms would be wrong. Although they would save money, they would not tackle the core of the problem.

It argues that the Chancellor need do only two things. First, he could state that, with effect from the next profit period, the capping mechanism is to be outlawed, but the pounds 4,000 tax-free maximum will remain in place. Secondly, he could outlaw some of the more blatant artificial arrangements.

The first solution is the important one, though. Lifting the cap could have a dramatic effect because it would mean that those on higher rates of pay would generally have to put some pay at risk, if they were to join the scheme. This is because their PRP would have two elements - a tax- free part and a taxable part.

"The good news about this approach would mean that only the relatively higher paid employees would be at risk. Lower-paid employees by and large would still be protected," says the report. "More important, however, the higher paid employees might put pressure on employers not to put too much of their pay at risk. If so, scheme designers would have to reduce the overall levels of PRP paid under the scheme for everybody"