Monday’s lead story in the Daily Telegraph claims that the Chancellor, Philip Hammond, is planning radical steps to promote ‘intergenerational fairness’ through the tax system in next month’s Budget speech. Whitehall sources promised a ‘bold’ attempt to ‘restack the deck for the next generation’ – ‘memorable stuff that changes thinking and changes people’s futures’. The leading option under consideration in Downing Street appears to involve a reduction in pensions tax relief for older workers, which would be used to fund a lower rate of National Insurance contributions for workers in their 20s and 30s.
The Conservatives’ new interest in intergenerational equity is a natural political response to the huge swings to Labour among younger voters in the June election – 10.5% among 18–24 year olds, 13% among 25–34 year olds, and 8% among 35–44 year olds – and is certainly welcome. However, it is far from clear that introducing new age-related complexities into the tax system is the best way of dealing with the problem. Although pensions tax relief is ripe for reform, it is risky to reduce tax incentives for those in their 50s and 60s when Department for Work and Pensions figures suggest that 45% of workers in this cohort are not saving enough to maintain a comfortable income in retirement
If Philip Hammond wants to leave a reforming legacy, he would be much better off tackling the complex interface between income tax and National Insurance contributions – the most serious anomaly in the personal tax system. For the vast majority of workers, Class 1 employees’ National Insurance contributions (ENICs) represent an additional 12p in the £ deduction from pay – the equivalent of 12p on income tax. Yet, ENICs start at a lower level than income tax (with a threshold of £157 a week or £8,160 a year), treat higher incomes more favourably (the rate falls to 2% above the £866 a week Upper Earnings Limit), and only apply to the earnings of those below state pension age. (Self-employed workers pay Class 2 and Class 4 contributions, which tend to be lower.) A working-age man or woman earning £30,000 a year would pay £3,698.20 in income tax and £2,620.32 in ENICs, but if the £30,000 came from investment income, a pension or the earnings of a pensioner, only the income tax would be payable. ENICs are thus both highly regressive and a major source of intergenerational unfairness. The weekly basis of assessment also disadvantages some low earners whose incomes fluctuate during the tax year, such as workers on short-term and zero-hours contracts.
Table 1. Impact of income tax and National Insurance contributions on specimen incomes
The original rationale for separate National Insurance contributions was to pay for the contributory benefits system. Both David Lloyd George (in 1911) and William Beveridge (in 1942) recognised the popularity of mutual aid and self-help schemes among working men and women, and built the principle of weekly contributions into the UK social security system. The Treasury liked National Insurance because it raised revenue from lower earners, whilst the trade unions welcomed the principle because it distinguished workers from the ‘undeserving’ poor and gave them a ‘right’ to benefit. In fact, as Sir Alan Peacock and George Peden have shown, the contributory image of the National Insurance system was always rather tenuous, since state pensions were heavily subsidised by the Exchequer and financed on a ‘pay-as-you-go’ basis.
Over the last 40 years, the justification for maintaining a separate system of ENICs has been further weakened in three respects. Firstly, the expansion of means-tested benefits and tax credits has dramatically reduced the importance of the contributory element in the working-age benefit system. When the Thatcher government took office in 1979, 39% of social security spending on working-age adults and children was based on National Insurance contributions; by 2014–15, this had fallen to less than 9%. National Insurance records have also become less important for pensioners, though the reforms which Steve Webb introduced during the coalition years – the single-tier state pension and the triple lock – have begun to reverse that trend.
Secondly, the rate of Class 1 ENICs has almost doubled – from 6.75% to 12% – since graduated contributions were introduced in the 1970s, as the chart below shows. Sir Geoffrey Howe raised ENICs sharply during the early Thatcher years to help make up the revenue lost from income tax cuts, and subsequent chancellors have followed his lead by turning to National Insurance contributions as a low-key way of paying for extra NHS spending (in Gordon Brown’s case) or plugging a Budget deficit (Kenneth Clarke and Alistair Darling). Whereas Beveridge envisaged that employer and employee contributions would cover two-thirds of the cost of unemployment benefit and five-sixths of the cost of other National Insurance benefits (such as pensions), they now raise 130% of the cost, providing a surplus which helps finance general government expenditure.
Thirdly, recent administrative changes have brought National Insurance contributions and income tax closer together and have made it difficult to regard ENICs as anything other than a tax. Gordon Brown transferred responsibility for National Insurance contributions to the Inland Revenue (now HMRC) after the 1997 general election, and the Blair, Brown, and Cameron governments all investigated the possibility of a closer alignment or full-scale merger. Indeed, influential outside groups such as the Institute for Fiscal Studies have repeatedly urged integration. As Sir James Mirrlees’ review Tax by Design put it in 2011,
National Insurance is not a true social insurance scheme; it is just another tax on earnings, and the current system invites politicians to play games with NICs without acknowledging that these are essentially part of the taxation of labour income. (p. 482)
Defenders of the status quo invariably point to the role of contributions in determining eligibility for benefits, but there are doubtless other ways of relating pension entitlement to work records. The real obstacle to integration is the political risk involved in shifting the tax burden from earned to unearned income. Given pensioners’ formidable voting power, it is hardly surprising that governments have put the idea in the ‘too difficult box’. Yet the Treasury and Office of Tax Simplification have remained interested in the possibility of closer alignment, and at a time when the median disposable income is higher among pensioners than the working population, the need for intergenerational equity could give a reforming Chancellor the perfect alibi for taking it out again.
What would a radical reform look like? The most drastic approach would be to abolish ENICs entirely and to make up the revenue lost – about £50 billion – by raising income tax. The Treasury’s ready reckoner suggests that 1p on income tax and 1% on ENICs yield roughly the same amount, so the new unified tax rates would need to be set at 32p, 42p, and 47p in the £. Although this seems like a technical change, the vast majority of working-age households would benefit, because the income tax threshold is so much higher than the ENIC threshold. Indeed, workers who pay income tax at the basic rate would generally be better off by about £400 a year. Nor would poorer pensioners lose out, since both Pension Credit and the new state pension (currently about £8,300 a year) are comfortably below the tax threshold. The sting, of course, is that middle-class pensioners and those with substantial unearned incomes would be hit so hard that even the strongest of Tory chancellors would struggle to contain the fallout. Many self-employed workers would also face higher tax bills. The storm over the ‘Dementia Tax’ during the 2017 election campaign would look like a gentle breeze in comparison.
Table 2. Distributional effects of radical reform
Yet this is not an all-or-nothing option for Treasury ministers. Instead of abolishing National Insurance for employees in one fell swoop, Philip Hammond could begin by taking 1% off ENIC rates this year and promise to make further steps down the ladder in due course. Alternatively, the Chancellor could levy National Insurance contributions on the earned income of those above state pension age – as a pamphlet by the Free Enterprise Group of Conservative MPs, including the new Chief Secretary to the Treasury, Liz Truss, suggested back in 2012. That would net the Treasury up to £2 billion – a useful addition to Hammond’s Budget war chest as he seeks to woo younger voters and ward off criticism from disgruntled Brexiteers.
Will the beleaguered Chancellor have the nerve to grasp the nettle on National Insurance reform? On 22 November we will find out.