The UK Budget: the end of National Insurance?

Budget day is always a classic piece of British political theatre. The magic of the ‘red box’ held by the Chancellor, the routines and rituals at the Palace of Westminster, the near-impossibility of actually taking in this myriad of policy details at the time, followed by the scramble to figure out what they really mean over the next few days.

The atmosphere was exciting last week, then, even though the actual announcements were not. The most newsworthy change was the more pessimistic projections for the British economy, showing that standards of living will fall even further and for longer than previously announced. But quietly in the background was an announcement that income tax and National Insurance (NI) could be merged – a long-term change which could have a dramatic (read: dramatically bad)  impact on the British welfare state.

What is National Insurance?

Even for benefits experts, a short recap of the system is necessary here (much of this discussion is taken from John Hills’ excellent discussion a few years ago). National Insurance was introduced by Beveridge after WW2 as a way of linking welfare state entitlements to people’s actual contributions, reflecting the popular feeling that you earn the right to welfare by paying-in to the system. People earning above a certain amount pay a % of their income in NI, and their employers also pay a % of the salary – although the exact calculation of the employer payments in particular is fiendishly complex.

According to popular belief, NI payments are hypothecated and primarily pay for the NHS – but this is a bit of a myth. NI is not hypothecated at all, and the surplus from the payments gets absorbed into general government revenues. And rather than paying for the NHS (which is primarily funded from general taxation), the overwhelming share of NI pays for state pensions.

‘Simplification’ was the reason given by the Chancellor George Osbourne for trying to merge tax and NI, and certainly the present system is headache-inducing. But from the left, a persistent criticism of the contribution-based system has been that it disadvantages those that don’t make contributions: primarily women, the disabled, and the low-paid. Labour reformed the system so that these people are credited-in to NI – yet this undermines the principle that this is a contributions-based system at all.

A final critique from the left – although not one I’ve often heard in practice – is that NI is less progressive than general taxation. The way that it’s calculated is that employees pay 11% of their earnings from £5-45k, and then only 1% on any earnings above that. This is still slightly redistributive – risks are pooled, and the rich pay more than lower earners – but only slightly, and certainly less so than income tax.

In defence of National Insurance

There are reasons aplenty for abolishing NI, then, and few people willing to fight passionately in its defence – but to me, this is a huge mistake. Firstly, NI is a successful ‘brand’.  That is, it conveys to people the idea that they pay money into the system in return for getting something out, which is a far more accurate description of the welfare state than seeing it as simply a flow from rich to poor. And this is much more popular than paying money in tax. As John Hills puts it:

“Given the imperfection of the system, this is close to saying that the system is a myth, but a useful myth for the population to believe in.”

New Labour – the masters of spin – understood this, and it’s noteworthy that when they wanted to get more money for the NHS, they explicitly did this by raising NI rather than the general tax rate.

Secondly, and even more importantly, people pay much more attention to tax rates than they do to NI payments. Obviously people can see that NI is deducted from their pay packet – but in public debate, it is the main tax rates that are bandied about as ‘crushing enterprise and undermining aspiration’. And employees do not even see the significant NI payments that are made by their employers, which for many employees are as much as 14% of their earnings.

If NI is merged into income tax by the current Government, then this would seem a prime opportunity to cut government revenues yet further without anyone noticing – particularly by reducing the employer contribution. John Hills is more optimistic here:

“Almost the only part of the tax system that registers publicly is the basic rate of income tax. It is hard to see a government of any persuasion agreeing to absorption of NI contributions into income tax, and a rise of 11 or 24 points in the basicrate. Some form of separately labelled tax mimicking NI contributions will survive any reform.”

Yet I’m still very worried by the proposed merger. It is not impossible for the Tories to avoid cutting taxes at the point that NI and tax are merged, and to keep an employer contribution in order to make the headline tax rate bearable.  But in the long-run this will lead to greater public pressure to cut taxes. Without the brand of National Insurance, the task of rebuilding the British welfare state in 5-10 years time can only become more difficult.