Technical
Peter Bartram 6 Jan 2017 03:25pm

Could merging National Insurance with income tax have worked?

The prospect of reforming income tax and National Insurance was on the table for a while. Peter Bartram takes a look at what might have happened if the alignment project had not been kicked into the long grass

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Caption: What might have happened if the alignment project had not been kicked into the long grass.

It would be as daunting as eating an elephant whole, but there has been talk for a while of Britain merging income tax and National Insurance.

Back in March [2016], the Office of Tax Simplification (OTS) published a report that, although not exactly gung-ho, was distinctly encouraging about the prospect. Bringing National Insurance contributions (NICs) and income tax closer together “would create a simpler and fairer system for businesses and taxpayers”, argued the OTS.

“We found near-universal support for reform to the NICs system with many seeing alignment as a simple and obvious step,” says John Whiting, OTS tax director. “The potential gains in easier administration, proper transparency and greater understanding are clear.”

Maybe. But, just like eating the elephant, one big problem would be knowing where to start. And that’s not the only poser. At the end of the day, any changes have to be approved by politicians constantly glancing over their shoulders to see what voters think.

Most plans to align NICs and income tax creates winners and losers – and any government will want to know how that will play out with its key supporters.

But although the task looked as indigestible as the elephant, the changing shape of the world of work makes many thoughtful people believe it’s time that something is done. Angela Knight, chairman at the OTS, points to trends such as the “gig economy” and the “sharing economy” as being stimuli for change.

“These different ways of working are with us, are expected to accelerate – and so the current system is simply out of date,” she says.

The OTS report, welcomed by the government, suggested seven steps to align NICs and income tax more closely.

But the OTS’s steps raise a whole raft of broader questions about the future of NICs in the longer term. ICAEW’s Tax Faculty started a debate on these options in 2015 with a paper entitled Income Tax and NIC – four options: a hard choice. It followed that up with a further paper, Hard Choices for Income Tax and National Insurance in autumn 2016.

The four options, says Peter Allen, research manager for tax policy and insight in the Tax Faculty, are to merge NIC and income tax in the search for administrative simplicity; to manage their future with a range of reforms designed to remove anomalies; to de-merge the two and return firmly to the insurance-based concept; or, simply, to make do with a system everyone knows and which raises big money. Allen, one of the authors of the report, points out that each option would have massive consequences.

The starting point for any debate about the future of NICs and income tax has to be recognition that both are big contributors to the UK’s annual £700bn government revenue. In 2015/16, income tax contributed £170bn and NICs £109bn. If these separate pots of money were both collected under the same principles, the two might have grown closer together years ago.

But while income tax has its roots in a tax levied to finance Britain’s fight in the Napoleonic Wars, National Insurance is, as its name suggests, an insurance-based fund that can trace its heritage to Lloyd George’s Health & Unemployment Insurance – and is designed to pay for specific benefits.

The National Insurance Fund (NIF) is independent of the Consolidated Fund, the pot that holds the bulk of cash the government collects. The NIF is audited independently. It finances current pension payments and makes a contribution towards NHS costs.

The significant differences between the history and nature of income tax and National Insurance could prove a key factor in decisions about the future of both, if ICAEW’s own focus group research is a reliable guide. It found that 55% of business professionals – including chartered accountants – prefer the “manage” option. Essentially, this is the route being charted in the OTS report.

However, when members of the public are asked to choose, a stunning 81% prefer the “de-merge” option. That figure compares with none from the professionals’ group. Allen explains: “Initially, there was a lot of confusion among members of the public about what NIC paid for. But when we explained that it was a separate fund to pay for pensions and some of the NHS, most people liked the idea.”

Allen explains the dichotomy between the two groups by the fact that accountants have “worked for a generation now within a process of converging evolution between NIC and income tax”. Because the tax features of both are at the forefront in tax professionals’ minds, it’s natural they think the two should be aligned from a practical and compliance point of view, he argues.

But Joe Public sees it another way. “For them, it’s the invisible deduction from salary which, when explained, is highly valued for its insurance qualities,” says Allen. “The universal contributions buy fixed non-means tested benefits – principally state pension – and are ring-fenced legislatively from other government spending.”

The technocrat’s arguments for merging the two may be strong, but the emotional arguments for keeping the fund independent of other government spending could weigh heavily with the public
when the time comes for politicians to take decisions. A full merger of the two – more than the OTS is proposing – could mean a higher joint income tax/NIC headline rate, which would be unpopular with taxpayers.

Even so, there are enough revenue-losing anomalies in the present system – such as the facts that NIC is not levied on most employee benefits-in-kind or dividends paid from close companies – to ensure that Philip Hammond and future chancellors will not completely sit on their hands. “The finer details of aligning contribution compliance would be welcome and not cause difficulties,” says Allen. “The extent to which the contribution aspects of NIC should be amended is a more open point.”

Looming over the debate is the long-term future of the state pension in an ageing society with a reducing proportion of working – and, therefore, contributing – people. In October, John Cridland, the state pension age reviewer, launched a consultation paper on the topic. Cridland’s final report could provide a clearer picture of the cost of state pensions towards the end of the next decade.

The danger is that any reform of income tax and National Insurance will be squeezed out by the government’s mounting problems over Brexit. In fact,

Brexit could prove to be the significant “unknown unknown” in this debate. Its impact on government revenues is still far from clear, says Allen. Although bolder reforms such as moving employer’s NICs – currently around 10% of all government revenue – closer towards a new-style payroll tax have already happened.

Reformers may gaze admiringly at other systems – such as Singapore’s Central Provident Fund, founded on the principles of self-provision and self-reliance, where separate taxpayer accounts finance a person’s lifetime needs including college education, medical care, house deposit, pension and other costs – but such a system is a far-off dream in the UK. Any change is likely to be slow and incremental. Eating an elephant takes time.

Seven steps from the Office for Tax Simplification

The seven key stages outlined by the OTS to closer alignment of income tax and National Insurance contributions are:

1. Move to an annual, cumulative and aggregated assessment period for employee NICs. This already happens with PAYE and income tax. But an annual period of NICs would create a patchwork with millions of winners and losers with some paying more and others paying less NICs.

2. Base employers’ NICs on whole payroll costs. This would be easier to understand and reduce distortions from fragmented hours, the OTS argues.

3. Align more closely the NIC position for the UK’s 4.7 million – and rising – self-employed with that of employees. This would remove complexity and could potentially deliver more benefits, claims the OTS.

4. Review critically the contributory principle. But, warns the OTS, first increase understanding of what the principle really does and doesn’t achieve. It’s worrying, says the OTS, that some people think their full contribution record of NICs qualifies them for treatment on the NHS.

5. Align the definition of earnings for income tax and NICs. In this way, the OTS says, the reliefs available for income tax and NICs will become more equal for employees. The move should also cut the burden of managing the differences for employers, the OTS claims.

6. Bring taxable benefits-in-kind fully into NICs. This will remove the distortions in the NICs treatment of non-cash pay, says the OTS.

7. Harmonise the rules governing the management of income tax and NICs. In this way, a reformed system should simplify administration for employers and HMRC, the OTS hopes. It wants to see a system in which changes operate automatically for both taxes.