Merge national insurance and income tax if it can happen equitably

Nigel Williams, 3 July 2014

The idea of removing the distinction between income tax and national insurance is gaining momentum. Any tax has its detractors and most arguments in its favour usually depend on finding someone else to pay it. It comes as a surprise to learn that in the 1992 election, Labour shadow chancellor John Smith’s proposed reforms to national insurance involved a reduction at the bottom end. He received little credit from voters, whereas the 50 per cent top rate of income tax proposed in the shadow budget was lambasted as ‘Labour’s tax bombshell.’ If reform is to be part of the next election campaign as Conservative backbenchers are suggesting, then it is important that the public is fully aware of the issues.

National insurance is a tax on earnings, but it has several important differences from income tax.

Pensioners do not generally pay national insurance, which is in theory earmarked for funding two areas of government expenditure: benefits and parts of the NHS. In practice, funding can be diverted either way to reduce a shortfall or make use of a surplus, so it serves as a form of general taxation. Nevertheless, a person’s contribution record affects his or her entitlement to state benefits. On reaching state pension age, people are considered to have completed their contribution. Therefore any pooling of the burden between national insurance and income tax is likely to affect pensioners more than people of working age. Given that they have been spared some of the effects of austerity, enjoying a triple lock instead of a benefit cap, that may be equitable. Alternatively, that may be an example of wishing only for taxes on other people.

National insurance had an upper limit until recently. Unlike income tax, which applies to all declared income, national insurance did not normally apply to earnings above an upper threshold. Now the rate drops to 2 per cent on earnings above £805 per week. It was one of Gordon Brown’s achievements, although his usual urge was to complicate, to match the upper national insurance threshold to a starting point for a higher income tax rate, thereby keeping a progressive element in the tax system. Since national insurance falls more heavily on the poor than on the rich, it makes claims possible that a small percentage of top earners pay a high proportion of income tax. Such claims deliberately concentrate on the most progressive part of the tax system.

National insurance does not get the same reliefs as income tax. Gift aid attracts relief from income tax on charitable donations. So do pension contributions. An employee still has to pay national insurance on his or her own contributions, but the pension pot gets the income tax back. But salary sacrifice schemes allow the employer to pay pension contributions instead of salary, so that the Treasury does not get the national insurance contribution either. If the two systems get merged, there will be a lot of complicated negotiation to sort out where reliefs ought to lie.

Simplifying taxation always sounds appealing but does need to be weighed against fairness. Some complexities, like capital gains tax, exist to reduce the scope for avoidance. Neither should simplification be a euphemism for demanding reductions for particular interest groups. If national insurance is replaced, it is important not to substitute something worse, as happened with the council tax. Happily, the debate does not need to start from scratch. The Mirrlees review, done for the Institute of Fiscal Studies, has looked thoroughly at principles and details and does indeed recommend bringing the two earnings taxes together. That report provides good criteria for judging any proposals that may appear in election manifestos.