The Case for Alignment of Income Tax and National Insurance Contributions:
A Critical Assessment
Introduction
For a number of years there has been a considerable amount of proposals for simplifying the UK tax system, with one of the most proposed suggestions being the possibility for an alignment, or integration, of Income Tax and National Insurance Contributions (NICs). The Office of Tax Simplification (OTS) was set up in 2010, and in the Summer Budget of 2015 it was announced that the OTS would be reviewing the possible alignment of Income Tax and NICs. While many are in support of the alignment, it has not been free from criticism, with the Institute of Chartered Accountants in England and Wales (ICAEW) commenting that they would only “recommend some clear simplifications”, as opposed to an alignment. This essay will first discuss the current position of Income Tax and NICs operating through two different systems, and then the case for an alignment of systems will be assessed. The assessment of the case for alignment will evaluate the current problems which need reform, and whether the OTS’s recommendations would be an appropriate way of resolving these problems.
The Criteria of Assessment
This essay will use a range of opinions from different academics to assess the case for alignment of Income Tax and NICs. The opinions of the economist Adam Smith, in his work, “The Wealth of Nations” will also be used to assess the case for alignment. Smith considered there to be four principles which are required for a good tax system: the first principle relates to equity, the second to certainty, the third to convenience, and the fourth to efficiency. In order for the case of alignment to be credible, it could be said that the recommendations for change would follow Smiths principles.
The Separate Systems for Income Tax and NICs in the UK
There are currently two systems in place which deduct money from earnings: Income Tax and National Insurance. The two systems have different origins, with the money raised from them going to different government accounts to pay for different government expenditure. The two systems have evolved since their respective establishments and have become similar over time. While it is argued that these are only “superficial similarities”, there has been a case put forward for the alignment of Income Tax and NICs due to their likeness.
Income Tax
The revenue raised from Income Tax goes into the Consolidated Fund, and is used for government expenditure. In the present day Income Tax is payable on most income, including that from investments and pensions. Employees pay Income Tax through the Pay As You Earn (PAYE) system, and those that are self-employed pay through self-assessment tax returns. The amount of tax payable will depend on how much an individual has earned over the Personal Allowance (currently £11,000) in each tax year.
National Insurance Contributions
In contrast, the revenue raised from National Insurance Contributions pays for Social Security Benefits, and is paid into the National Insurance Fund. Currently, NICs are payable only on earned income, or profits if an individual is self-employed. The amount of NICs an employee must pay is not dependent on their annual income, instead it depends on how much they earn in each earnings period, whether that be weekly, or monthly.
The Case for Alignment of Income Tax and National Insurance Contributions
While the ICAEW does not believe the current system presents a “major problem that requires government action”, it is clear that this view is disputed. The OTS published the review “Alignment of income tax and national insurance”, in which they have set out their case for alignment. This essay will focus on three problem areas which were highlighted throughout the OTS review: a lack of understanding, a lack of transparency, and a lack of fairness. The case for alignment will be assessed through discussion of these problems, and evaluating whether proposals from the OTS would be able to resolve them.
Lack of Understanding
The lack of understanding of the differences between Income Tax and NICs could be said to be one of the major problems with the current system. This issue appears to be belittled by the ICAEW, who stated that although “they do not believe that the present structure is well understood by most taxpayers”, they also do not believe that this would be resolved through an alignment, and that making the system more understandable for taxpayer “would seem less than a worthy goal”. However, the ICAEW do believe that “employers…generally do not struggle with the differences between tax and NIC rules”. This opinion could be said to be an oversight, especially considering that other bodies disagree. The Association of Taxation Technicians have stated mistakes are caused “where employers are not aware or do not fully understand the rules of the two systems”, thus suggesting there is not a clear understanding from employees or employers. The confusion caused by this is contrary to the principle of certainty, established by Smith, who believed that taxes should be “certain, and not arbitrary”. This indicates that the lack of understanding is a problem which is causing the current tax system to be unfavourable; there would be a strong case for alignment if it could resolve this problem.
The OTS has proposed that the general lack of understanding of employees and employers could be rectified through simplifying the current system. In their review The closer alignment of income tax and national insurance, the “most common reform sought” by respondents to the OTS’s survey was that NICs should be assessed on an annual, cumulative and aggregated basis, and thus become aligned with Income Tax in that respect. The OTS believe this would provide a “greater understanding”. In addition to this, an alignment of the definition of “earnings” for Income Tax and NICs would help increase understanding. The OTS also believes this would increase understanding, and make future alignments simpler to introduce. Together these alignment would undoubtedly make the system easier to understand, and thus would conform to Smith’s principle of certainty.
Lack of Transparency
The lack of transparency is a further problem with the current system. The importance of transparency within a tax system has been highlighted in the Mirrlees Review: “transparency – a tax system that people can understand is preferable”. The lack of transparency concerning NICs is clearly evident, as their purpose as a tax is often not conveyed. For instance, as stressed in the Mirrlees Review it is uncommon for discussion to be made regarding the combined rate of Income Tax and NICs, instead individuals tend to discuss only the Income Tax rates which are much lower than the combined rate. This indicates that taxpayers do not view their NICs as a tax. This lack of transparency could be used to take advantage of taxpayers, and the Mirrlees Review even suggests that “governments may see the lack of transparency in the current system as a positive rather than a negative”. This is echoed by Loutzenhiser who believes that voters were “exploited” in the 2001 General election. Labour, after pledging they would not raise income tax, raised NICs once they were elected. If there was more transparency in the current system, it would be less likely that people could be manipulated in this way. Furthermore, there is also a lack of transparency concerning employer’s NICs. This is because they are usually not disclosed on payslips, and are thus not visible to many employees.
In order to resolve this issue, the OTS have recommended that online tax accounts should be used to provide taxpayers with information regarding their different tax payments. Furthermore, the OTS suggests that the systems are brought together “as close as possible short of merger.” These recommendations would improve transparency to some degree. However, there is a case for full integration as opposed to a mere alignment. Adam and Loz support this, stating integration would make people more “aware of the full tax wedge imposed on their earnings”. It could be suggested that the easiest way to resolve the lack of transparency concerning employee and employer NICs would be to abolish them, and impose a single tax on income. This would be supported by The Taxpayers’ Alliance, who are published the report “The Single Income Tax”. In this report they suggest that NICs should be abolished, and instead there should only be one tax on labour income. The level of transparency which would come from this would satisfy Smith’ principle of certainty and thus make a strong case for reform. However, there would barriers to overcome if such a drastic change were to be implemented. The main barrier is that of the contributory principle, which could be said to be central to the original idea of National Insurance.
Lack of Fairness
The lack of fairness, exemplified by the different treatment of employed and self-employed, is a further problem in the current system. It is clear that the self-employed are treated more favourably in terms of NICs than employees. Employees currently pay Class 1 NICs on earnings at the main rate of 12%, while the self-employed pay Class 4 NICs on profits at the main rate of 9%. However, employees are afforded better benefit entitlement. As suggested by Adam and Loutzenhiser, it can be argued that this disparity is fair because it is linked with “encouraging entrepreneurship”. However, in having this unfair system, it provides financial incentives for people to become self-employed. Loutzenhiser supports this idea by commenting that this system may lead individuals to choose a type of employment which is “not the most appropriate and efficient in their particular circumstances.” It could be said that this system is contrary to Smith’s principles of equity and efficiency.
In order to resolve this issue, it would not be a case of aligning Income Tax and NICs, but aligning employee NICs and self-employed NICs. The OTS found that the majority of respondents were in favour of aligning NICs for employees and the self-employed, as well as in return giving the self-employed equal benefits entitlements to resolve the “fairness issue” . However, there may be disadvantages in doing this. Adam and Loutzenhiser suggest “higher rates increase the incentive to evade tax”, and as the self-employed pay tax through self-assessment forms an increase in NIC may encourage more dishonesty. Regardless of this, an alignment of employee and self-employed NICs would increase fairness and conform to Smith’s principles of equity and efficiency, creating a strong case for alignment.
Is the Case for Alignment Feasible?
There are arguments that alignment of Income Tax and NICs would simply not work, including from the ICAEW that believe any considerable reform would “inevitably generate more errors than the current rules”. This opinion is arguable, because although there would be considerable transitions to be made, it would appear that overall alignment would improve the current system. In order to fully assess the case for alignment, the feasibility of the case must also be considered.
The Contributory Principle
The contributory principle could be said to be an obstacle to alignment. The contributory principle, as stated in the Mirlees review, is “the idea that NI is supposed to embody a form of social insurance in which contributions create rights to benefits” . While this is what was envisioned when National Insurance was introduced, there is an argument that the principle has been devalued over time, to the point where some now say it is “illusory”. The idea that a taxpayer is paying for their own future benefit is not true, and the Select Committee supports this by stating that “There is very little direct financial relation between what an individual puts into the Fund and what they get out.” Despite this the OTS have decided not to recommend to remove the contributory principle, although they have suggested it should be examined in the future. This may suggest that the contributory principle would create a barrier for full integration, however it would not in the case of an alignment.
Devolution of Income Tax and Welfare Powers to Devolved Assemblies
Scotland has been devolved powers to set income tax rates, however the UK government has reserved the right to set NIC rates.
Conclusion
In conclusion, it could be said that there is a strong case for aligning Income Tax and NICs. The current system is not favourable, and it does not adhere to the four principles which Adam Smith proposed for a good tax system. However, the case for alignment which includes resolving the problems of understanding, transparency and fairness does obey these principles. In addition to there being a good case for alignment, there is also a good case that alignment may not be enough, and that a full merger of the two systems needs to be implemented. However, it could be that alignment may be the first step into a full merger, and that one day there will be a fair, transparent, and understandable single tax on income.