Tax and Fiscal Policy

National Insurance should be abolished

There are a myriad of reasons for merging National Insurance (NI) with income tax in a revenue neutral manner. It is an obvious and a much discussed way to simplifying the tax regime yet no Chancellor so far has had the bravery to tackle the apparently insurmountable task (although there has been plenty of consideration). A simpler tax code can boost economic productivity by cutting needless bureaucracy and axing a tax that distorts economic activity. In the UK, national insurance is part of an archaic patchwork of the tax code that made sense decades ago, but consecutive governments have failed to amend it along with other changes in the system that rendered it almost meaningless today. NI is now just another form of income tax, but because a part of it is nominally levied on employers, and due to its complexity, it is almost a stealth tax. It has wide economic repercussions as it deters employment. The common objections to abolishing NI as considered here (political and administrative problems) do not hold up. It is an ideal time for the government to contemplate abolishing NI to boost productivity and economic activity.

The principal problem is that NI no longer serves its original intentions. When William Beveridge helped create the British welfare state after the Second World War, his plan was that only people who made NI contributions should receive benefits. The idea was simple: anyone paying the same, flat-rate, premium would receive the same, flat-rate benefits if they became ill, unemployed or old. Thus NI was born. Nonetheless over time, governments of the red and blue shade began to transmute it into something else entirely. Successive adjustments meant that the rich pay a greater proportion for the same level of benefits while the very poor pay almost nothing. New benefits have further been introduced, such as means-tested income support for the very poor, which do not take NI contributions into account. Other amendments made to the system over the decades have further weakened the link between contributions made and benefit received. The link between paying NI and receiving certain state benefits has been so severely curtailed that the original rationale for NI no longer seriously applies anymore. It is now just a second income tax.

National Insurance is now essentially a more complex, stealth income tax. The name may fool you, but NI is nothing like an insurance policy – for a start, it is not based on a risk profile like typical insurance premiums as it has always been calculated like an income tax. But while NI is economically indistinguishable from income tax, it still abides by an entirely different set of rules to income tax, thus duplicating bureaucracy. Businesses have to hire tax accountants, employ extra staff or devote some of their employees’ time to complying with the tax and regulation. According to an analysis by KPMG, which only focused on a narrow spectrum of the cost, the cost of administering NI for businesses was put at £146 million. The abolition of employers national insurance contributions itself should mean that employers pass on some if not all of these tax savings to employees in the form of higher salary. It would mean a much simpler, easier to calculate payslip where employees recognise and appreciate the true salary being paid by the employer and the true amount of income tax they are paying. The current lack of transparency of the tax code further spawns tax avoidance and evasion through manipulation of loopholes and exemptions. A good, simple system with a single income tax would be far harder to game.

National Insurance further deters and defers economic activity, especially employment. The 2020 Tax Commission published a report in 2012 that estimated that a single income tax along with other changes in the tax system could lead to 9.3% higher economic growth by 2030. The tax code for income tax and NI is riddled with incentives and disincentives affecting different markets, capital and consumption goods. At its margins, the additional tax deters productivity and employment by imposing a direct cost on hiring new employees – it not only leads to lower net income but also underemployment and unemployment. This effect is amplified due to the fact that NI, unlike income tax, is payable only on ‘income derived from employment’ and is not paid by pensioners. A single income tax would spread the tax cost to income from dividends, rental, savings and pensions reducing the burden for those in employment. A series of studies have shown that indirect taxes and social contributions can be the most detrimental to growth – a study by Policy Exchange showed that a two percentage point rise in employers’ NI potentially reduces GDP after three years by two per cent. All this show that NI as an additional income tax is not fit for purpose.

The prospect of abolishing national insurance may seem to present significant political problems. NI raises tax revenue to the tune of £113 billion (17% of all tax revenue). As a fairly inconspicuous tax, it is a nifty tool to raise vast amounts of revenue for the Exchequer at little political cost. But from the taxpayers’ perspective, the increase in transparency that would result from an abolition of NI should be seen as a benefit, not as a cost. If we gain a more realistic idea of how much government actually costs us, that can only be a good thing.

The proposal is unsurprisingly popular with businesses as well – according to the Institute of Directors (IoD), 79 per cent agreed that NI and income tax should be merged with just 11 per cent disagreeing. Furthermore at a time when the government attempts to reign back on spending, the abolition of NI can reduce bureaucracy and administration costs by around £300 million, which is what the HMRC charge the National Insurance Fund for collecting contributions.

Another objection in abolishing national insurance is the perceived administrative problems of merging the two taxes. They exist, but they can be managed. The 2020 Tax Commission have come up with a practical, pragmatic proposal of how to deal with the merger. In the first phase the assessment period, assessment unit, exemptions, applicability etc. of two taxes are aligned, over a period of three years. The second phase in the fourth year would deal with the full abolition of NI and the merger into income tax. All welfare spending, including pensions, can move towards a fully means-tested system beyond this point as many benefits already have. As for those who have already paid contribution for part of their careers, it would be unfair to suddenly suggest their contribution will have no effect. The solution to this is to phase out the contribution element of eligible state benefits depending on the length of your career you paid NI; for example a worker who had paid NI for 15 out of 45 years before it was abolished would be able to receive an additional third of the difference in the contributory element on an eligible benefit/pension. Thus, entitlements already accrued through the payment of contributions would be honoured, but no further entitlements would be accrued. This is a credible, fair and pragmatic administrative plan for abolishing NI.

There is therefore a strong case for abolishing national insurance tax. NI is not an insurance policy, as its name misleadingly suggests. It is merely another income tax that creates additional costs for employers. The relationship between NI and benefits or pensions is now only marginal and likely to be further curtailed by the government in the future. It helps create an extraordinarily complex and counterproductive tax system in the UK. It is a tax burden on employment that leads to lower productivity, unemployment and underemployment. As a near-stealth tax on income, politicians would be wary of losing a covert tool to raising a large amount of tax revenue for the Treasury. Yet the short term political cost of abolishing NI will likely be compensated for by the long term gain in political credibility. Moreover, the administrative problems of merging NI with income tax are not insurmountable – there already are credible proposals for how to do this. George Osborne should thus pluck up the courage to abolish NI if he wants to be remembered as a bold and a reformative Chancellor.