.png)
.png)
KEY POINTS
- Differences between tax and National Insurance.
- Maintaining the contributory principle.
- Effect on taxpayers with little or no employment income.
- Treatment of benefits in kind.
- Wholesale change is unlikely.
Have you heard the sensational news? National Insurance contributions are to disappear at the next Budget. This was the message that many people might have taken from press coverage just before the 2011 Budget.
In reality, it seems unlikely that this will happen. For a Chancellor, such a measure would not so much be biting the bullet as firing it into his own mouth from point blank range.
There was considerable excitement when the redoubtable John Whiting and the Office of Tax Simplification delivered its first suggestions as to ways in which our complicated tax system could be made a little more user-friendly.
Many of the ideas might be seen as having limited value, since they would do little more than abolish pieces of legislation that were already obsolete or, at best, little used.
Few people will mourn the passing of their 15-pence-a-day luncheon vouchers, and this was by no means the most obscure of the 43 pieces of legislation that the Chancellor has now committed to turn into history.
That prize might go to the National Insurance exemption for payments by credit card providers for recovering lost or stolen cards, though there were other equally worthy competitors.
As a little research swiftly demonstrates, the idea of combining tax and National Insurance is a subject that is trotted out every few years without anything significant happening.
The main reason for this is that income tax and National Insurance operate under completely different principles, as well as each raising a lot of money for the Exchequer.
The differences
Readers of Taxation will be well aware of the rates and thresholds for income tax and National Insurance, so they will not be repeated here.
There are, however, some other major differences that would have to be overcome before a full marriage could take place:
- National Insurance applies only to employment income;
- it is paid in two parts, by employers and employees;
- contributions are still connected to benefits receivable;
- the legislation is not the same, so some items of income are charged to tax but not National Insurance and vice versa.
History and statistics
In 1946, Clement Attlee’s Labour government passed the National Insurance Act that underpinned the concept of a welfare state. This was the source from 1948 of the National Health Service and so much more.
The Act provided for compulsory contributions for unemployment, sickness, maternity and widows’ benefits, and old age pensions from employers and employees, with the government funding the balance.
With the notable exception of married women, people in work paid 4s 11d (just under 25 pence) a week in National Insurance contributions. This amounted to just under 5% of the average worker’s income.
James Griffiths, the minister of National Insurance at the time, extolled the scheme’s virtues claiming that it was ‘the best and cheapest insurance policy offered to the British people, or any people anywhere’.
By 2009/10, the ‘tax’ raised an estimated £95.5 billion, making it the second largest source of government revenues at close to 20% of the total. This compares with estimated Exchequer receipts from income tax of £144.9 billion, from VAT of £70.1 billion and from corporation tax of £35.8 billion.
Gordon Brown was the first man to connect the words ‘National Insurance contributions’ and ‘tax’ in a Budget speech.
Until that verbal slip, all of his predecessors had maintained the pretence that there were two completely different systems, and National Insurance should not be mistaken for a tax, since it was paid for a separate purpose, i.e. to qualify for future benefits.
Further, the general public still does not really regard National Insurance as a tax. As such, it is often the preferred way for any Chancellor to raise revenue by stealth.
The contributory principle
The current Chancellor has made much of the need to maintain the contributory principle. This works on the basis that certain benefits are only allowed to those who have made qualifying contributions.
The most widely known of these is the entitlement to claim a full state retirement pension. Individuals must have made sufficient National Insurance contributions in at least 30 years to be entitled to claim this.
Much of the data in the rest of this article has been drawn from a very helpful parliamentary briefing paper, National Insurance contributions: an introduction by Anthony Seely. This was published a month before George Osborne stood up to deliver his speech, in which he committed to the contributory principle.
The view 25 years ago
In March 1986, the Conservative government published a green paper on personal taxation, which led to the introduction of independent taxation for husband and wife.
The green paper also looked at the benefits and costs of integrating National Insurance contributions with income tax. It concluded that there were good grounds for a merger to cut the administration costs of both charges, but that the problems that would have to be overcome were too great:
‘In the case of people solely or mainly dependent on investment income, they would be paying for benefits, such as unemployment benefit, which would not be relevant to their circumstances. Taxpaying pensioners would in a sense be asked to pay twice: after a lifetime of paying National Insurance contributions, they would then have to pay contributions towards benefits which they thought they had earned as of right on the basis of their earlier contributions record. This kind of anomaly would tend to weaken the link between contributions and entitlement and thus undermine the contributory principle.’
Against these, the then Chancellor, Nigel Lawson, was able to set the considerable reduction in administrative costs both for the Inland Revenue (as it was then designated) and employers, who would have a much simpler system to operate.
This last point is now somewhat illusory to say the least, as a report by the Institute for Fiscal Studies on the declining connection between contributions and benefits over the past three decades makes all too clear:
‘An important distinction between different types of benefits is the extent to which they are non-contributory rather than contingent on having made National Insurance contributions… Less than half of benefit expenditure (41.2%) currently goes on contributory benefits. This fraction has been declining almost constantly since 1979/80 [when it was just over 63%]. In fact, these figures overestimate expenditure on benefits for which contributions have been made, since individuals can be credited with National Insurance contributions without having actually paid them. This can occur for several reasons: for example, periods spent in full-time education or as registered unemployed are credited with contributions having been made. Also, since April 2000, individuals earning between the lower earnings limit and the earnings threshold do not have to pay any National Insurance contributions, but are credited as if a contribution has been made.’
And in 2000
The topic was addressed again in June 2000, when the parliamentary Social Security Committee completed an enquiry on the principle. They noted that entitlement to any particular benefit depends on satisfying the contribution conditions (as well as other conditions of entitlement) for that benefit:
‘The contribution rules are complex, requiring the contributor not only to have paid contributions on a certain proportion of earnings, but also to have paid the contributions during a particular tax year, or, in the case of widows or retirement pensions, over a certain number of years of a working life.’
They then came to the damning conclusion for this principle that ‘there is very little direct financial relation between what an individual puts into the fund and what they get out’.
Most benefits are paid at a flat rate, whereas contributions are earnings-related. The Government Actuary said:
‘Over time, the link between the benefit and the contribution of the individual has been loosened so that now it is very clearly on a pay-as-you-go basis and contributions are set to meet the benefits in that year rather than the benefits of the individual in the future.’
If you add in the fact that, at more than £100 billion a year, the NHS budget is now greater than the total of all National Insurance contributions collected before considering any other benefits, it can be seen that attribution is at best fuzzy and not as Attlee intended.
What is clear is that while Chancellors of the Exchequer maintain an unshakeable faith in the contributory principle, a union between income tax and National Insurance contributions will never come about.
A radical solution
There are two significant obstacles to full integration: the redefinition of the contributory principle, and the implications for taxpayers whose earnings form a relatively small or insignificant part of their taxable income. These are primarily pensioners, but also individuals who enjoy income from interest, rents or dividends.
Following the 1997 general election, Gordon Brown set up a task force, chaired by Martin Taylor (then chief executive of Barclays Bank), which considered the clamour for a single tax:
‘Some employers and representative bodies have in the past argued that National Insurance contributions should be completely merged with income tax. This would save them the work of separately recording and accounting for two sorts of National Insurance contributions as well as tax. This is an understandable suggestion, particularly for small employers who face relatively high unit costs for operating PAYE and National Insurance. However, full integration of employee National Insurance contributions would require a substantially higher, basic rate of income tax. This could have very large redistributional effects, particularly if this higher rate were applied to other sources of income, such as pensions… Full integration would also mean a complete redefinition of the contributory principle for short term benefits and for pensions.’
Basic economics
There may be other good reasons why these two very different beasts will not be allowed to merge. Using the simplest mathematics, one comes to the tax rates that would be required if National Insurance was abolished overnight.
In 2009/10, income tax raised £144.9 billion and National Insurance £95.5 billion, around 66% of income tax.
Therefore, all that the Chancellor would need to do is increase income tax rates pro rata and he would fill the gap left by abolishing National Insurance overnight. Using this rough and ready approach, new income tax rates would be:
- Basic rate: 33%
- Higher rate: 66%
- Top rate: 83%
Can anyone see a problem?
To be fair, these rates could possibly be shaved a little, as some relatively significant administrative savings resulting from the merger/abolition could be offset, unless other uses were found for those by a hard-pressed government. In addition, if the new taxes were charged across the board, for example to pensioners and on investment income, the headline rates could be reduced.
It should also be noted that such a change is redistributive, both in relative and actual terms. While adding basic rate tax to National Insurance at below-average salary levels comes out at 32% next year, that is only if the personal allowance and National Insurance exemption is ignored.
Real rates are considerably lower. At the other end of the scale, top rate taxpayers only suffer a 52% rate at the margin and less overall.
Part of the problem is that National Insurance contributions come from two sources: employees and employers. Therefore, if the charge was ditched, employers would be celebrating a gigantic windfall.
It might be possible to keep the new income tax rates lower if employer’s National Insurance contributions were replaced by a new payroll tax and separate tax rates applied to earned and pension income.
Such a system, however, would hardly be simpler than the existing one.
The more likely solution
We are liable, therefore, to get a less radical solution. At the moment, there is to be a consultation paper on a prospective merger that is likely to be severely limited. In particular, the Chancellor has offered comfort to many by stating that there is no intention to charge National Insurance to pensioners or on non-employment income such as dividends.
The result will probably be a mere tinkering around the edges, which could reduce administration but is unlikely to be noticed by the majority of those currently in employment.
There is vast scope for making changes that would leave identical rules when it comes to applying income tax and National Insurance.
Some of these might not go down too well with the general public. For example, many benefits in kind are taxed and subject to employers’ National Insurance, but are not chargeable for the purposes of employees’ National Insurance. Similarly, an income tax exemption applies to termination payments of up to £30,000, but without limit for National Insurance.
There are many other examples where relatively simple changes would be welcome and, without any skulduggery, meet George Osborne’s goal of fiscal neutrality.
This might involve Treasury draftsmen poring over the two sets of legislation, spotting anomalies that could easily be eliminated, and making the necessary changes. In reality, this would chop out much tedious statute without having a noticeable impact on anyone other than those closely involved in tax, either in government or on the other side of the fence.
An outside bet
One other possibility that has not yet been aired could resolve many of the objections to getting rid of National Insurance. We could instead retain it with new, enhanced rates and lose income tax.
In that way, the contributory principle would be protected. Then again…
While the proposals from the Office of Tax Simplification and the Chancellor of the Exchequer sound superficially radical and exciting, in reality all that they are likely to herald are some minor, though welcome, legislative amendments.
Without wishing to denigrate the Chancellor, the likelihood of abolishing National Insurance is about the same as those of Ireland (or England) winning the next Cricket World Cup.
Philip Fisher heads the employment tax and rewards team at PKF(UK)LLP and can be contacted by email. The views in this article are his own and do not necessarily represent those of PKF(UK)LLP
