Opinion: “The first £10,000 you earn tax-free”? Not unless we act on National Insurance

At Conference, Danny Alexander repeated his view that the personal allowance for income tax should be raised beyond £10,000, saying:

In the next Parliament, I want us to go further; our aspiration should be that someone working full time on the minimum wage should pay no income tax at all. An income tax threshold of £12,500 – think what that would do to work incentives, think what it would mean for basic fairness. Let’s put that on the front page of our next manifesto.

The idea certainly seems popular within the party. But remarkably absent from these discussions is any mention of National Insurance. The very first point in our 2010 manifesto was “the first £10,000 you earn tax-free” but, while it later clarified it meant income tax (IT), it’s hard to see why the parallel income tax that is National Insurance (NI) should be treated any differently.

To mitigate the rise in NI rates, the “primary threshold” for National Insurance contributions (NICs) rose from the equivalent of £5,720 per year to £7,228 this year. For 2011/12 that’s similar to the IT personal allowance of £7,475. But, like many benefits, the primary threshold will now rise only with CPI (presumably to £7,604 next year) while the IT personal allowance will rise to £8,105 in April and then by at least RPI subsequently to reach £10,000.

All this suggests that on May 7th 2015, income will still be taxed not from £10,000 but from around £8,000-£8,500 (an inflation-adjusted £7,228): with the 12% NI rate that would be a significant £180-£240 of tax paid on the first £10,000.

Some may think that NICs are – surely! – insurance contributions and not a tax but, to quote Stuart Adam of the Institute for Fiscal Studies, the link to benefits received is now “vanishingly weak”. It will be weakened yet further if Steve Webb succeeds in introducing the laudable single tier state pension. And the primary threshold is distinct from the lower earnings limit which determines, amongst other things, qualification for statutory maternity pay and state pensions. Certainly what one gets back from NICs — if anything — isn’t worth the lost income, and raising NI rates now seems to be established as a preferred (ie, opaque and deceptive) way of increasing taxation.

For these and other reasons, National Insurance should be scrapped entirely. Others on this blog have said the same, as have the Institute for Fiscal Studies and the Office of Tax Simplification [pdf]. This is something we should commit to as a medium-term goal in our next tax policy paper and manifesto. (Incidentally, I’m steering clear of employer NICs – and their threshold – in this article but if you see them as yet another opaque tax on wages and employment then total NI is more significant than income tax for the vast majority of taxpayers.)

The issues that merging NI and income tax rates would raise are at least surmountable – as with pension income and employee benefits – or at best are excellent opportunities for those who want a local income tax, changes to dividend and other non-wage income taxation, or a shift away from taxing income.

George Osborne, however, doesn’t seem up to the challenge. In the last budget, he revealed only that there will be a consultation by the end of this year on greater merging of the operation of the two taxes. This might include aligning the NI and IT earnings periods. As well as saving tens of millions [pdf] in administrative costs, an annual NI allowance would be fairer on many, such as those who are in and out of work.

And, returning to my main point, another consideration should be merging the lower thresholds (the NI “upper earnings limit” is already aligned with the higher rate IT threshold). The consultation’s focus will surely be on making life easier both for businesses and HMRC. Aligning the thresholds would do this, and pave the way for greater simplification in future, but Liberal Democrats must also emphasise the importance of the primary threshold to the least well-off, to the economy, and to the spirit of our manifesto.

One criticism of raising the personal allowance beyond £10,000 is that it wouldn’t mean any more cash for the millions of workers earning less than that.

As long as it is lower, raising the NI threshold is the more progressive move; helping people that a personal allowance raise would not. And if we get both thresholds to £10,000 and want to go further than inflation, it will be more progressive to raise both NI and IT thresholds at the same time, say to £11,560, than to raise only IT to £12,500. It would also have been better, politics aside, to have had a target lower than £10,000 but applied to both but that’s now politically impossible. For now, therefore, our priority for tax cuts should be also raising the NI threshold to £10,000.

Bridging next April’s expected £500 gap in thresholds would (only) cost around £1.8bn for that year, if there were no corresponding tax rises for those on higher incomes (which there should be). Shifting a fraction of the thresholds’ annual rises to later in this parliament could limit further costs of the alignment, but it would still surely require considerable persuasion by Danny Alexander. However, even more than most tax cuts, he would have on his side the argument that it would be good for the economy while further improving work incentives.

Repeating our income tax success with National Insurance may not be so politically glamorous, but this additional tax cut for the least well off is the right thing to do. We must push for this alignment in the earliest possible year (look out for that consultation). And, that done, we mustn’t forget about National Insurance in future tax and personal allowance policy development. I want us to truly be able to say we’ve taken millions out of income taxation.

* Adam Corlett is a party member and vice-chair of the Liberal Democrats for Drug Policy Reform.

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24 Comments

  • Nonconformistradical 1st Nov '11 - 12:35pm

    Agree totally that income tax and employee NI contributions should and could be merged.

  • David Boothroyd 1st Nov '11 - 2:52pm

    If the income tax and NI personal allowance is raised to £10,000 or £12,500, the biggest economic boost is received by everyone earning over the new threshold who all get the same amount taken off their tax bill. People who were already earning under the personal allowance do not benefit at all. People earning above the previous personal allowance but below the new level get a small benefit. While it is excellent spin to sell this policy on the basis of ‘taking people out of tax’ it is just spin, because this is a regressive policy that helps the better off and does nothing for people with really low incomes.

    There is in fact a considerable advantage in having the broadest possible tax base, so that everyone has a stake in the economy. Targeted dividend tax credits are a far better way of getting money to the in-work poor.

    Incidentally your Government is just about to hit the in-work poor very badly when it abolishes council tax benefit.

  • Adam Corlett 1st Nov '11 - 3:21pm

    @Caracatus, I’m not sure what you mean by “promoting a graduated flatter tax system”. Is that more gradated or more flat than the status quo? In either case, that debate would be helped immensely if the real tax rates on income (i.e. incorporating one or both main kinds of NI) were as apparent as the 20/40/50 ones.

    I think you’re right to say that not everyone on a low income is poor, e.g. when one partner provides a high enough income for the whole household. The differences between individual and household incomes also mean that even the best changes to income tax can have unwanted effects on some households, but I think it’s accepted that raising the allowance while lowering the higher rate threshold is broadly for the best.

    @David, Other tax rates and allowances can be altered to limit who gains from this kind of change. But you are right to say it doesn’t benefit those under the existing limit, which is why I wrote the same thing! That was also the basis for my main point, that raising the NI threshold is fairer than raising the IT allowance further.

    I fail to see how we shouldn’t help those earning 10k on the basis that it doesn’t help those earning 5k. The two don’t always need to be done through the same mechanism. As for how the Government is planning to have all children tortured abolish council tax, that’s neither true nor particularly relevant.

  • Adam Corlett 1st Nov '11 - 3:23pm

    Grr… In my last post that should obviously have read “council tax benefit” rather than “council tax”. Though, far more unfortunately, they also don’t seem to have any plans to abolish the latter.

  • Adam Corlett 1st Nov '11 - 6:10pm

    Thanks for your comment, William. I completely agree. I did briefly say that there should be corresponding tax rises for those on higher incomes but I really didn’t have room to write any more. However, one thing I did notice while writing this was that lowering the higher rate is now considerably more problematic as child benefit will soon be withdrawn at this limit, with no tapering. New wealth taxes – such as a replacement for council tax – will have a role to play too.

  • Stuart Mitchell 1st Nov '11 - 6:36pm

    “Repeating our income tax success with National Insurance may not be so politically glamorous, but this additional tax cut for the least well off is the right thing to do.”

    But as you allude to elsewhere in your piece, the “least well off” are already earning below the current limits. Tweaking with tax thresholds and NI limits is too blunt an instrument on its own if your goal is to help those at the very bottom. Raising tax thresholds may make good manifesto copy but there comes a point where I think the emphasis should be switched to other measures, such as wealth taxes and tax credits.

    If Osborne is not so keen on merging IT and NI this may be because he is well aware that increases in NI helped the last Tory government to reduce IT rates, which was instrumental in the Tory press so successfully hoodwinking just about the entire nation into believing that the Thatcher and Major administrations were low-tax governments.

  • Remember that merging IT and NI hits pensioners. You may want to do this, but there are a lot of losers here and you need to remember that. Note too that aligning thresholds is not as easy as it sounds, because IT is annual and NI is weekly, so if you don’t work every week apparently aligned thresholds are not in fact aligned. The same is true if you have additional IT allowances (because you give to charity) or if you have more than one job, are self employed, etc.

    I am in favour of raising the starting point for employers and employees NI, in order to make hiring relatively unskilled workers more attractive to firms, but don’t imagine for a moment that this sort of reform is easy to make add up, or does not create losers.

  • Andrew Suffield 1st Nov '11 - 7:29pm

    I did briefly say that there should be corresponding tax rises for those on higher incomes but I really didn’t have room to write any more.

    Or benefits cuts for those on higher incomes, and corresponding lack of tax rises.

    This is important: one of the sillier things about how things work in the UK is that people in the £20k-£40k income bracket – which is a huge chunk of the population – pay a substantial amount of tax, but also receive a substantial amount in various benefits. (Child benefit is one of the most well-known, but far from the only one)

    Now, I’m not saying those benefits are inappropriate in general, but it is hopefully clear to everybody how absurd it is for a person to be both paying taxes and receiving benefits at the same time. It even wastes money in administering the two systems!

    Rather than raising taxes further on these people, there is a lot to be said for reforming the tax and benefits systems further to reduce the amount of money spent on those who really don’t need it.

  • Daniel Henry 1st Nov '11 - 7:38pm

    Pretty much agreed on every point. Also appreciated the point that lowering the higher rate threshold could help fund raising of the IT and NI thresholds.

    Anyone working full time on minimum wage would see full benefits from both tax allowance rises.

    I don’t agree with the “stake in the tax system” argument. Why would we pay administrators more money to take taxes off people just to give it back to them in benefits?

  • Malcolm Todd 1st Nov '11 - 10:59pm

    “it is hopefully clear to everybody how absurd it is for a person to be both paying taxes and receiving benefits at the same time. It even wastes money in administering the two systems!” [Andrew Suffield]

    This is often said, but incorrect. The administrative costs of a universal benefit and an overwhelmingly employer-administered tax are massively lower than those for a means-tested benefit system. It may look silly – “Why are you giving me money and taking money away at the same time” – but that’s because as an individual you can’t help imagining that somebody somewhere is looking at your individual circumstances and calculating how much you owe and how much they owe you. They’re not. It’s all a lot more impersonal than that, which is why it’s cheaper.

  • Andrew Suffield 2nd Nov '11 - 6:22am

    The administrative costs of a universal benefit and an overwhelmingly employer-administered tax are massively lower than those for a means-tested benefit system.

    While I can see expensive ways to implement it – like repeating the current mess – I don’t see any reason why it should be expensive. It pretty much comes down to “look at tax bill when calculating benefits”, which can be done automatically for the majority of the population in the PAYE system.

  • Liberal Neil 2nd Nov '11 - 10:33am

    @David Boothroyd & Stuart Mitchell – Yes – this policy will not do anything for those on the lowest incomes because it is dealing with a tax they don’t pay. However this is only one proposal – about making the IT & NI system more progressive, it does not mean there can’t be other policies to make those on the lowest incomes better off.

    As well as making the system fairer it will also massively reduce administrative costs, cash that could otherwise be helping people who need it, and increases the incentive to work.

    I would also argue that the extra cash it puts back into the pocket of someone on an income below £10K, say, will have far more impact on that person than the same amount to someone earning twice as much.

    It is also worth noting that a very large proportion of the people who have a taxable income below the threshold will receive either benefits or other forms on non-taxable income already.

    @tim leunig You are right to point out that there is a downside to merging NI with IT, including on pensioners. My view is that this is fair overall but the details would need to be right. It certainly isn’t fair that a worker earning £8,000 currently pays a combined IT/NI marginal rate of 32% while a pensioner on £30,000 pays a marginal rate of 20%. There is an argument for pensioners to have a higher basic tax threshold, but not the level of disparity there is at present. If the basic threshold for all is raised to £10K or above that would seem a reasonable level for everyone (higher than the current pensioner threshold). The main losers, though, would be those on high incomes as combining the rates would flush out the fact that those on high incomes pay such a
    small NI rate at present.

  • Agreed and thanks for the citation!

  • Adam Corlett 2nd Nov '11 - 2:49pm

    Andrew, Malcolm and jedibeeftrix: Re. benefit rises vs tax cuts, I’d just add that, psychologically, most people would prefer not to feel reliant on benefits, whereas tax allowances are quite different. For the same reason, take-up of benefits where entitled is far from universal but take-up of tax cuts is! But I’m absolutely not arguing against, say, increasing the Universal Credit as well as these income tax allowances.

    Tim and Neil: I don’t think a merger has to hit [the majority of] pensioners. Surely it would be possible to have a separate rate for pensions (this would still mean a far simpler tax system than having IT & NI)? Or to raise the state pension further? As I said in the article, it is an issue but I think it’s certainly surmountable.
    Tim makes a good point about NI being weekly. But, as I wrote, making it annual seems like the one of the most likely outcomes of this consultation, and until that’s implemented the arguments for essentially aligning the thresholds still apply. As for the self-employed, I think the OTS document says quite a bit about how the current NI system distorts that area.
    There certainly are complications and potential losers from a full merger, but that’s why I said this should be a medium-term goal for the party; an assumption on which to base other policies in a joined-up manner. Aligning the periods and thresholds, and reforming the state pension would be a good start.

  • Adam Corlett 12th Nov '11 - 4:36pm

    Addendum: I’ve found the policy paper, ‘Fairer, Simpler, Greener’, which was debated at the September 2006 party conference (http://www.isitfair.co.uk/Downloads/75%20-%20Fairer%20Simpler%20Greener.pdf). Some of its proposals relate to what I discussed above and I hope the next tax working group will recall them:

    • “Raise the employee NICs threshold so that NICs begin to be paid at the same level of income as
    income tax, simplifying the system, and to seek to make employee NICs payable on annual rather
    than a weekly earnings.” – the latter will probably happen following this consultation, the former is what needs to happen as soon as possible
    • “harmonise the upper threshold for 11% NICs with the upper rate of income tax.” – this has since been done

    “In the longer term we aim to achieve much more radical change:”
    • “Raise the income tax threshold further – an intermediate objective would be to raise the threshold to around £10,000, the approximate annual equivalent of the National Minimum Wage.” – 10k is happening, but we’re far from catching up with the minimum wage. And NICs seem to have been forgotten about.
    • “Merge the system of employee and employer National Insurance Contributions as the contributory
    principle becomes obsolete.” i.e. merge with each other, not with income tax (unfortunately)

    @William: Yes, LVT was one of the things I had in mind when I suggested that merging NI and IT might be a great opportunity for those who want “a shift away from taxing income”.

  • I have just filed my self employed self assessment. out of my profit of £8860 I have the personal allowance of £6475 leaving £2385 to pay tax on at 20%, thats £477 plus class 4 NI contributions of £251.60, total £728.60. The removal of the 10% starting rate on the first £2230 was the first blow against the poor. And yes I do receive Tax credits but this a system fraught with difficulties, that can only get worse with the changes due in 2012. And most people I know that have had to attempt to claim income support or housing benefit have been shocked by an incredibly inefficient and obstructive system that seems designed to make people either give up and not bother or to feel like scum. So I would more than welcome a £10000 threshold.
    I feel that most modern day politicians have little or more likely no experience of living in poverty, whether in work or on benefits, so how can there be so much judgement about people that live hand to mouth when the reality is that when you are hungry or your children are hungry, people will do anything to get the necessary funds, even if it means breaking the law. And if anyone thinks that to say that people go hungry in this country is an exaggeration , I have to say that you are very wrong. There has to be more done to stop wealthy businesses and individuals from being able to pay little or no tax due to loopholes that only benefit the rich. And why not stop ALL benefits at £35000 earnings? Does anyone earning this much really need child benefit? We are also spending vast amounts of money on a never ending illegal war in Afghanistan, but that of course is another matter.
    I voted Liberal democrat at the last election, but after having formed a unholy alliance with the Thatcherite tories to be part of an unelected government, I have to say that I will never do so again.
    I really hope that the Liberal voice makes a difference in the present government but I think it is very unlikely.

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