Thursday 03 November 2016 4:59 am

National insurance is a complicated relic: Axe it in three simple steps

If we were designing a new tax system from scratch, would anyone seriously suggest running three slightly different income tax systems at the same time? The fact that the government does precisely this is a relic of the past that has no place in a modern tax system.

The combination of charges – income tax, plus employer’s and employee’s national insurance contributions – conceals the truth from taxpayers who think their marginal rate is 20, 40 or 45 per cent. In fact the basic rate of tax on earnings is 40.2 per cent when you add it all up.

In politics, of course, it is never that simple.

The challenge of getting rid of national insurance is largely one of perception. Voters don’t mind it as much as income tax because they think it pays for an assortment of contributory benefits, state pensions and the NHS. It has therefore proven easier for politicians to increase than the better-understood income tax.

In reality, the contributory principle has been eroded over decades to such a degree that there is now next to no relation between what people pay in and receive. Even those receiving jobseeker’s allowance qualify for national insurance credits that build up their entitlement to the state pension.

The end of contracting out and the shift to a single-tier state pension should be the final nail in the coffin. Besides, if a future government wanted to make the welfare system more contributory, eligibility for benefits could easily be assessed through the income tax system.

And while a separate National Insurance Fund is maintained, it’s really just an exercise in accounting trickery. In years when national insurance contributions are less than benefits paid, it is topped up with revenues from other taxes. When the reverse is true, the fund uses the surplus to buy gilts. The government just borrows money from itself. The absurdity of this exercise is surpassed only by its pointlessness.

Then there’s the NHS issue. To their great shame, politicians of all parties have been calling for increases in national insurance to hike NHS spending in a repeat of Gordon Brown’s chicanery of the 2000s. This is nothing less than exploitation of voters’ ignorance of what is admittedly a complicated system with some intergenerational unfairness thrown in to boot.

Jim Murphy Asks Voters To Choose Between a Fair Economy Or Second Referendum
Gordon Brown engaged in fiscal chicanery through national insurance hikes (Source: Getty)

In practice the link between the National Insurance Fund and the NHS is no different to the link between VAT and the Ministry of Defence. It’s true that around £20bn of the NHS budget comes from the Fund, but so what? Budgets are not set according to how much a particular tax raises and tax revenues are perfectly fungible – a pound from national insurance can be substituted with a pound from any other tax.

So there is a clear case for abolishing national insurance and merging it into income tax. Even those who might lose out can be compensated.

For the majority of the population, their income is wholly made up of earnings from employment. But for those who have income from sources other than employment such as dividends and savings, a transitional rate should be available on income earned before the date of the announcement of the merger.

There’s no good reason why a merger would leave pensioners worse off either. Those over state pension age are currently exempt from employee national insurance, but to ensure they are not disadvantaged transitional arrangements could be put in place. A comprehensive information campaign would be required to reassure pensioners that they wouldn’t lose out.

There are three phases in which income tax and national insurance should be merged over the next five years.

First, transparency. The chancellor should mandate that the employer charge is printed on pay slips and should rename the employee and employer charges “earnings tax” and “wages tax.”

Then comes simplification. In a recent report, the Office for Tax Simplification identified 84 “misalignments” between national insurance and income tax. Allowances need to be aligned, some rates need to be nudged up, others down and some obscure charges abolished.

Then comes the final phase, abolition. We propose a flat rate of 30 per cent on all income along with the transitional arrangements mentioned earlier. That does not, however, make a merger incompatible with a progressive tax system if the government wishes to maintain one.

There is of course one potential headache for the chancellor: public revolt when they discover how much tax they have been paying all these years.