Deadweight Loss from Payroll Non-Compliance

Payroll Errors as a Hidden Efficiency Cost of Wage Misclassification

While payroll errors are seldom framed by economists as a welfare problem, deadweight loss due to payroll errors is both quantifiable and significant. Employer classification errors, underpayment of National Insurance Contributions, and improper PAYE administration create distortions that are not merely administrative. They represent a misallocation of resources that will continue to shrink “the economic pie” before a single cut is made.

HM Revenue & Customs estimated in its 2022–23* tax gap report that £5 billion of the tax gap was due to incorrect reporting by employers of employment taxes (unpaid Income Tax / National Insurance due to PAYE errors alone). Similarly, the IRS estimates that the annual employment tax gap in the United States exceeds $40 billion. These estimates represent an ongoing wedge between labour market results that would occur absent compliance and labour market results that occur as a result of compliance with payroll law(s).

The Economic Mechanics Behind the Distortion

The deadweight loss resulting from payroll errors is derived from a common but underappreciated economic mechanism. Employers who incorrectly classify employees as "independent contractors" for tax purposes reduce the effective cost of labour for those employees; however, this benefit to the employer is not due to an increase in productivity, but rather represents an example of regulatory arbitrage. The employer gains financially from an unexpected reduction in costs, while the employee loses entitlement to statutory protections as well as employer contributions to pension funds. Additionally, the government receives less revenue than it should.

The difference between the employer's windfall and the employee's lost entitlements creates a wedge that acts as an implicit subsidy for employers that do not comply with statutory requirements. This wedge allows non-compliant employers to compete by undercutting compliant employers on price while incentivising employers to allocate more capital toward labour-intensive models through suppressed compliance costs. The Harberger triangle or the triangle of lost welfare exists wherever a marketplace is distorted by taxes; therefore, employees are misallocated with respect to who should be employed at what price and how many employees will ultimately be employed.

Several underlying structural forces are driving the continued existence of non-compliance in payroll. The increasing complexities of payroll—in addition to the UK's various payroll statutory requirements—create a demand for payroll expertise that many small employers do not have. For instance, as noted in a 2023 survey conducted by the Chartered Institute of Payroll Professionals, 42% of payroll professionals indicated that their current workload has increased due to changes in legislation; at that time, there were still upcoming more changes related to the National Living Wage threshold and holiday pay calculation.

Employers with fewer employees are less likely to be able to maintain in-house payroll expertise and thus represent the majority of payroll compliance errors. The asymmetrical compliance cost structure represents a well-established body of research. The fixed costs of understanding the various payroll legislative requirements fall more heavily upon employers with fewer employees than on employers with more employees to spread these fixed costs across. Therefore, in a rational, albeit socially detrimental, manner, small employers are incentivised to misclassify employees or take other shortcuts to reduce their payroll compliance burden.

Technological advancements are altering the dynamics of this asymmetry in favour of smaller employers in that the development of artificial intelligence (AI) payroll management tools will facilitate the automation of identifying employee classification errors, identifying changes to legislation in real time and lower the marginal cost of compliance associated with employing small numbers of employees. Increasing adoption of AI-powered payroll tools may therefore reduce compliance costs, improve reporting accuracy, and lessen the deadweight loss associated with payroll non-compliance.

There are both fiscal and distributional impacts that must be acknowledged when evaluating the issue of worker misclassification. The distributional impacts were documented in the UK's Taylor Review of Modern Working Practices (2017) wherein the review identified multiple violations resulting from worker classification errors that are typically associated with low-income, unstable workforces. Worker misclassification occurred most frequently in industries that were characterised by low-margin and high labour-intensity sectors (logistics, social care, hospitality).

As the economy continues to evolve, competitors operating within thin-margin, high-labour-intensity industries increasingly experience competitive pressure and thus experience an increasing temptation to exploit ambiguities in employee classification. In situations where non-compliance becomes a normative practice across an entire industry, the level of welfare loss suffered by compliant firms increases significantly. Regulatory bodies are then forced to allocate additional resources toward regulatory compliance simply to maintain a level of fairness between compliant and non-compliant employers.