How do we solve a problem like national insurance?by
The difficult member of the tax family has been suffering an identity crisis for over a century. The time has come to take national insurance in hand, says Rebecca Cave.
National insurance has always been a difficult member of the tax family. The name prompts confusion over its status as a tax, and the cost for employers has spawned numerous problems in the employment market.
National insurance (NI) has had issues with its identity since the scheme was conceived in 1911. That’s because national insurance was created as two twin schemes to provide workers with:
- health and pension benefits (run by unions and social organisations)
- unemployment benefits (run by the government).
These two schemes were merged into one in 1948 to support the welfare state and the NHS.
In the early days paying national insurance contributions (NIC) gave the payer entitlement to specific social security benefits. But now there is little connection between the amount of NICs paid and the level of benefits received, except for entitlement to the state pension and a few other contributory benefits.
At first, workers would buy stamps at a flat rate per week to attach to their NI card, although employers have always made a separate contribution per worker. In 1975 the flat rates of NIC for employees were replaced with a percentage of earnings collected via PAYE alongside income tax. The flat rate of class 2 NIC for the self-employed remains today as a curious fossil in the tax system.
Rising employer costs
The employer’s rate of NIC hovered around 10% of the employee’s earnings for many years, until 1999 when it jumped to 12.2%, with a slightly lower rate for contracted-out employees.
The late 1990s also saw a surge in workers who offered their services through their own personal service companies (PSCs) and thus allowed the engager to avoid paying employer’s NIC on the worker’s income.
The use of PSCs has been growing since 1994 when the audit exemption for small companies was introduced into the Companies Act 1985.
Incorporation of small businesses then exploded in 2000 when Chancellor Gordon Brown introduced the 10% starting rate of corporation tax, which was cut to a zero rate in 2002. This allowed a one-person business to incorporate and pay no tax at all on income of up to about £50,000 per year, if profits were extracted using a combination of small salary and dividends.
The combination of easy incorporation and cost savings encouraged employers to push skilled workers off their payrolls into PSCs, although many of those individual workers were happy to take control of their own businesses and pay their own tax.
To counter the massive loss of employer’s NIC, the government introduced the IR35 rules in April 2000, which as originally designed would have placed the NIC burden back on to the employers.
Oddly, after significant lobbying by large businesses, the responsibility for judging whether income from contracts should be treated as employment income (and subject to employer’s NIC), became the responsibility of the PSC. This responsibility has now been flipped back to the employer under the off-payroll working rules.
Now those large employers tend to push the responsibility for calculating payroll taxes for contractors down the supply chain to unregulated umbrella companies. The government has recognised that there is significant non-compliance in the umbrella company market, and it consulted on solutions to this problem in June 2023, but we are still waiting for its decision. Perhaps we will see an announcement of action in this area in the Chancellor’s Autumn Statement this month.
Call for change
The Institute of Chartered Accountants in England and Wales Tax Faculty has said that the problem of off-payroll working could be solved if the total amount of tax and NIC paid by individuals and engagers of workers was the same or very similar across all sources of income, and these charges didn’t vary between those who are categorised as employees and the self-employed.
The Tax Faculty has been pushing this message since March 2017 when it replied to the Taylor review of modern employment practices.
Why not merge NIC and income tax?
If a full merger of income tax and NIC was achieved, so that all income tax rates were increased by the NI payable on the same income, employees would see little difference in their take-home pay.
However, other taxpayers would be subject to comparatively lower rates of income tax on pensions, rents, dividends and interest. The fairness of having different income tax rates for different types of income would need to be addressed, as well as the primary NIC exemption that currently applies above state pension age.
The other big hurdle to a full merger with income tax is how to fill the £100bn hole created by abolishing employer’s (secondary) NIC.
Alignment not merger
If a merger is too difficult would closer alignment between income tax and NIC help employers and the employment market?
The Office of Tax Simplification (OTS) in 2016 examined this question twice in 2016. The OTS identified seven key steps towards alignment, but not one of those steps has been implemented by the government.
Perhaps it is time to think imaginatively about the NIC paid by both employers and individuals.
Could small employers be exempt from the NIC charge by implementing a high payroll value threshold such as for the apprenticeship levy? This would remove the need for the employment allowance.
Why not merge NIC and income tax for all individuals, so everyone pays the same rate of combined tax on all types of income, while retaining the contributory element for the state pension?