George Osborne is thinking about abolishing National Insurance (NI) as a separate tax and incorporating it into income tax. The implications of such a move would be very far reaching because the basic NI rules are complex and effect far more than just NI deductions and the practical IT difficulties it would create for both the government and employers, both public and private, are immense.
The most obvious and pressing reason why the idea should not go ahead is the fact that NI is one of the big earners for government. In the 2014/15 financial year it brought in £108 billion – see page 15. Only VAT (£113.9 billion) and income tax (£163 billion) provided more tax revenue to the Treasury. To make up for the loss of the NI contributions income tax would have to be increased massively if income tax has to raise the £108 billion currently raised by NI in addition to the £163 billion it currently collects. That could only be achieved by getting most of the extra money by raising the basic rate (currently 20%) massively, probably doubling it, because those paying the 40% and 45% income tax rate are not sufficient in number to be able to bear the brunt of the increase. Moreover, once tax rates go beyond 50% they become psychologically difficult and increase the likelihood of evasion. In addition, the present government is deeply unsympathetic to raising the higher income tax rates. The situation is further complicated by the government’s stated intention to keep on raising the personal allowance which at least in the short term is likely to reduce the income tax take.
The options for raising some of the £108 billion by raising other taxes are limited. VAT could be raised, but that would be regressive because it falls on everyone and would almost certainly suppress demand. The next two most productive sources of tax revenue in 2014/15 were corporation tax (£41.4 billion) and excise duties (£47.2 billion). The fact that both bring in so small an amount in relation to what needs to be raised means neither could supply more than a small part of the lost £108 billion even if their rates were raised substantially. Moreover, raising corporation tax would go directly against Tory policy of having a low tax burden on business and increased excise duties would again be regressive.
The next obstacle is the incompatibility of the income tax and NI systems. NI operates on a radically different basis to income tax. Income tax is simple in principle, the complications which arise come not from calculating the tax due but in deciding what is liable to income tax. There is the personal tax allowance which exempts a certain amount of earnings from tax and three rates of tax (20%,40%,45%) for three bands of earnings. The operation of NI is much more complex, involving both employees and employers, with a link to benefit entitlements and NI rates which do the exact opposite to income tax rates, namely, the NI rate decreases as income rises.
The NI system is too complex to give exhaustive detail here but I shall outline a few of the basic NI facts to give a flavour of its complexity. Currently NI is not paid by anyone earning less than £155 per week, although someone earning £112 per week (the Lower Earnings Limit) gets credit for benefits such as the state pension as if they were paying NI. Those earning £155 per week (the Primary Threshold) begin paying NI. When they reach £156 per week (the Secondary Threshold) the employer also begins paying NI. This employer’s contribution is in addition to the employees and is a payroll tax. When the employee earns £815 per week (the upper earnings limit) or above they pay a reduced rate of NI.
People who are employees pay 12% of their pay between £155 and £814 per week and 2% on their pay above £814 per week. The employer will pay 13.8% on all earnings above £156 per week. Benefits in kind, for example use of company car, attract employers but not employees’ NI at the rate of 13.8%. This is a big saving to an employee enjoying substantial benefits in kind. There are separate rules for the self-employed which the government has pledged to alter during the course of this Parliament. As can be seen the NI situation is very administratively messy.
If income tax and NI are amalgamated a problem arises with pensioners over the state retirement age. NI is not paid by those over retirement age, but income tax is. Hence, if NI is abolished and income tax is raised to compensate for the ta x revenue loss, many pensioners would be left paying far more tax unless the government exempted all or part of their income. But to do that would be incredibly messy, not least because large numbers of pensioners pay income tax. It is also worth noting that more and more pensioners are working past retirement age. If the income tax rise to compensate for the loss of NI revenue means a rate of income tax which makes those over the retirement age more expensive to employ, this will probably mean fewer OAPs working or having less income, either of which would create greater eligibility of benefits.
The payment of benefits generally would also create difficulty. At present NI contributions count towards entitlement for:
Basic State Pension
Additional State Pension
New State Pension
Contribution-based Jobseeker’s Allowance
Contribution-based Employment and Support Allowance
The position with the new state pension is complicated because , contrary to government suggestions that it would provide everyone with an enhanced pension, this appears not to be true with perhaps two thirds of pensioners not receiving the full pension.
Any consolidated system for tax and NI would have to either take into account the entitlement to benefits or the benefits would have to cease to have any connection with what the individual pays in tax. There would also be the complication of how to treat the entitlements built up prior to the abolition of NI. The present system of National Insurance numbers would have to be retained because they are tied in so firmly to the access to the British welfare state.
Creating an entirely new computer system to accommodate both the new amalgamated regime and the present stand-alone system for income tax and NI would be daunting at best and probably impossible. ( In this context it is worth bearing in mind the lamentable record of British governments of all colours with massive computer systems.) It is likely that both the old and new Government computer programs would need to keep running.
Then there is the IT problems and additional costs which would be faced by employers, the vast majority of which, together with many of the self-employed, use computerised accounting and payroll systems. All of those would have to be updated or new systems bought, installed and staff instructed how to use them. Many current systems would not be updated because they are either too old or the software company which created them has gone out of business. Public service employers are particularly vulnerable as they often use bespoke systems, that is systems developed for them alone, which are often very old in origin with many updates patched into them over the years.
Finally, there is the problem of ensuring that the additional income tax revenue is actually collected. There is also a very real general danger that a switch to a consolidated income tax/NI tax would not produce the same revenue even if the Treasury calculates that it would on paper. The Treasury might simply get their sums horribly wrong because of the complexity of the integration they are managing. Alternatively, smart accountants may simply find ways of minimising any additional income tax. The beauty of NI from a tax collection point of view is that it allows much less tax evading wriggle room compared with income tax.
National insurance is a far from perfect system, but it is difficult to see how it is radically unfair or its operation radically administratively inefficient. Its purpose is a sham in as much as there is no managed fund created to pay for specific services and benefits, and the link between NI and earned benefits is increasingly tenuous. But so what? It is a major revenue source which regardless of the fact that it goes into the general Treasury pot is major part of the funding source of the Welfare State. Moreover, any government could decide to make NI an hypothecated tax allocated to particular circumstances.
As for being administratively simpler, this seems wildly improbable when our past experience of large scale government IT systems is of consistent failure and there will be undeniable extra costs for employers.
At best the abolition of NI would be a tremendous gamble and at worst unreservedly reckless. Government policy should never be about gambling.