CPS Research Fellow David Martin outlines why the Treasury's "Call for Evidence" on simplifying income tax and National Insurance contributions should consider the abolition of NICs altogether, a position he first adopted in the CPS publication "Abolish NICs: Towards a more honest, fairer and simpler system".
HM Treasury are today to close their public consultation on merging the operation of income tax and NICs. “Merging the operation” means for example levying income tax and NICs in the same way on income and benefits, and for the same charging periods, and on the same basis for separate employments, and so on.
However HM Treasury have said they do not want to abolish NICs entirely, because they want to retain the contributory principle, which they summarise as follows:
Individuals should pay NICs while in work in order to receive financial support while out of work, whether through illness or unemployment or in retirement.
Let’s examine this contributory principle in more detail.
As a preliminary point it is often hard to decide which individuals are “in work” and what is their “earned income” on which NICs are due. For example an owner of a company can pay himself dividends or salary. It is hard to decide how much is due to him in his capacity as “worker” or in his capacity as “investor”. Perhaps one portfolio investor is very passive, but another spends a long time actively researching and analysing alternatives so as to increase his return - is the second investor therefore “working” for his income? A partner in a business may be working hard, or working little, or hardly doing anything. Indeed a self-employed business man can invest in personnel or equipment so as to reduce (perhaps to nil) the work that he needs to do himself. At what point does his income become “unearned” in a substantive sense?
The attempt to define the boundary between “earnings” and other income and to charge NICs on “earnings” inevitably creates distortions and unfairness because no clear boundary exists.
Under the contributory principle those in work (assuming these can be identified) should pay NICs in order to get financial support while out of work. But there is a long and complicated list of categories of people who do not pay at all but nevertheless receive NIC credits: For example, this includes people on Jobseeker's Allowance, people on maternity or paternity leave, students, and people aged 60-65. There are many further limited categories e.g. for people on jury service , or people wrongly imprisoned.
Anyone in a job with earnings above the Lower Earnings Limit but below the Primary Threshold is also given NIC credits, even though their actual liability to pay is nil.
Further, for those who actually pay NICs, there is no real connection between the amount paid and the amount of benefit received, e.g. A earns £100,000 p.w and pays NICs accordingly but is entitled to the same contributory benefits as B, earning £200 p.w. People who already have thirty qualifying years’ earnings are entitled to receive a full pension, and so if they continue to work and pay NICs it does nothing for their pension entitlement. Such examples clearly demonstrate that the system has ceased to operate as an insurance scheme but as a tax, particularly since NICs became earnings related in the 1960’s. Indeed NICs are treated in practice by the Treasury simply as a tax.
The next point is that there is no logical connection between the aggregate amounts of NICs paid and the aggregate amounts of benefits paid out:
• Approximately £20bn of NICs collected (which is approx. 20% of the total) are paid direct to the National Health Service without being paid into the National Insurance Fund. This is distortionary, because everyone can benefit from the Health Service, whether they have paid NICs or not.
• The balance is paid into the National Insurance Fund, but amounts are not accumulated in any individual’s account. There is no actuarially-based calculation (as would be done in the case of a normal insurance policy). Broadly speaking aggregate amounts paid in equate to aggregate amounts paid out of the Fund, although in fact the Fund retains more money than official guidelines advise. Most people now retired will have begun paying NICs into the Fund at a time when the number of pensioners was half what it is now, i.e. those individuals have only paid approximately half the cost of the pension now being provided to them. This fact alone is sufficient to demonstrate that the system is unfair and distortionary.
• The Fund is at the mercy of arbitrary adjustments - for example employers’ NICs have been reduced (by about £13bn up to 2005/6 alone) to compensate them for paying green taxes. This reduction has clearly impacted on the amount available to pay contributory benefits, and yet there is no logic behind the adjustment. But perhaps the biggest problem of all with the contributory principle is that you don’t need to pay or even be credited with NICs in order to receive financial support while out of work. Indeed contributory benefits are typically less generous than their non-contributory counterpart;
• Income-based JSA is an automatic passport to health benefits, such as free prescriptions, and education benefits, such as free school meals, and maximum housing and council tax benefits. Contribution-based JSA carries no automatic right to any of these benefits, and is normally limited to 183 days;
• It is no wonder then that the amounts paid out in income-based JSA dwarf the amounts paid out in contribution based JSA (about 8 times as much) The contributory benefit is not worth claiming for those who qualify for the income based equivalent. Pension credit, which requires no contribution record, is (and will remain under proposals being considered by Government) greater than or equal to the state pension;
• less than 45% of expenditure by Government is now on contributory benefits - the biggest of which is, of course, the state pension. And this overstates the extent to which benefits are granted in return for NICs actually paid, because of the system for conferring National Insurance credits.
The NIC system is a mess. The basic problem, as can be seen from the above, is that there is no satisfactory relationship between the payment of NICs and the receipt of benefits. There are other key issues, such as what constitutes the earnings tax base for NICs. But fundamentally the problem is that too many people who need benefits have not paid sufficient NICs or been granted enough NIC credits. This problem was serious even in 1948, when it prevented many of Beveridge’s original recommendations being implemented - but now it is much worse.
Given the absence of a genuine relationship between NICs paid and benefits received it is not possible to reform the system satisfactorily with detailed changes. There is no clear rationale for deciding who should pay NICs and how much. Therefore it is not possible to determine where avoidance is taking place by reference to underlying principles.
The nettle needs to be grasped. For the most part benefits in future should either be means tested (such as the new universal credit) or universal (such as the Health Service, education, and, it is submitted, a universal pension). There is no space for a satisfactory and substantive state based National Insurance system in the middle.
There is actually a clear argument that we would then have a much better “contributory system” than before - one would make one’s contribution to qualify for benefits by paying due tax under an integrated system, in which all income is taxed in the same way. It is submitted that the current problems of distortion, complexity and unfairness can only be resolved on this basis.