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 affect far more than just NI deductions. 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, which could only be achieved by raising the basic rate (currently 20%) hugely, probably doubling it, because those paying the 40% and 45% income tax rate are not sufficient in number 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 increasing 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) but even if their rates were raised substantially, together they could bring in only a small an amount of what needs to be raised. 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% and 45%) for three bands of earnings. The operation of NI is much more complex, involving both employees and employers, and the NI rate decreases as income rises.
In addition, 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 tax 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.
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, maternity allowance and bereavement benefits.
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.
Then there are 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 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 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 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 a hypothetical 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.