Everything you need to know about National Insurance

Paul Johnson

Hello, and welcome to this edition of the IFS Zooms In with me Paul Johnson. And with me today is deputy director of the IFS Helen Miller, because today we’re going to be talking about National Insurance contributions and Helen is an expert on that and indeed most other parts of the tax system. And, of course, we’re talking about National Insurance Contributions because we are in for a pretty whacking big rise in them in April. But this episode we’ve actually asked our followers on social media to submit some questions which I will put to Helen as we talk about National Insurance Contributions or NICs or NI as we often call them for short.

Helen, let’s start with the basics, and we’ve actually got a question here from John Campbell.

John Campbell

Hello, I’m John Campbell, I’m BBC Northern Ireland economics and business editor, I have a very simple question, what exactly is National Insurance and what is it not?

Helen Miller

A good place to start. National Insurance Contributions are our second largest tax in the UK. They bring in about 20% of all of the government’s revenue, and in short, they are a tax on earnings. So, for most people, you’ll start to pay National Insurance Contributions once you earn around £9,500 a year, and they’ll come out of your pay packet just like income tax. But there are some differences compared to income tax. Notably there is also a large employer element; so, your employer pays some tax related to your wages. And that’s pretty important, it accounts for over half of the revenue the government raises; and even though employees aren’t paying in directly, you should probably still care because it may affect the wages that your firms are willing to pay you. So, without employer National Insurance Contributions, wages may be higher. The self-employed also pay National Insurance Contributions, it works a bit differently, rates are lower because there’s no equivalent of employer National Insurance, but there is a broadly similar system in place.

And importantly, National Insurance is not charged on all forms of income. So, it’s not charged on investment incomes like dividends and capital gains, it’s not charged on people who are working but happen to be above state pension age, and it’s not charged on pension income. We’ll come back to this I’m sure, but think about what National Insurance Contributions are not, they are not really a contribution-based system in the sense that there is barely any link now between how much you pay and the benefits you get. And the revenues of the government raises are not hypothecated, so they’re not earmarked for special causes, you think about them as all being put into the same pot. So, I would think of NICs really as being a second income tax, just one that isn’t levied on all forms of income.

Paul Johnson

So basically, just a tax on earnings and of course that means when National Insurance Contributions go up, it’s only workers who pay the additional National Insurance, people who get income from other sources don’t. One of the oddities of National Insurance, Helen, isn’t it, is that you’ve got this strange set of rates, it’s rather strange isn’t it that the rate falls from 12% once you were, as you were saying, earning £9,500 a year, to just 2% on earnings above £50,000 a year, I mean we normally expect with income tax that rates go up from 20%, to 40%, to 45%. Why have we got this strange higher rate and then much lower rate once you go above what we call the upper earnings limit?

Helen Miller

So, we have got this strange situation, I think it’s partly a hangover from a system where they’re used to be a bigger link between contributions and benefits. So, I guess it was kind of assumed that once you paid so much, you didn’t need to keep paying more and more. But as I say, now-a-days it’s just an income tax, and there is this weird system where the marginal rates, the rate you pay on the extra pay does fall for higher earners. And that often raises the debate about whether NICs are regressive, I think there’s some confusion about that.

So, what do we mean about regressive and progressive? So, we talk about a tax on income earnings as being progressive if the average tax rates - so that’s not the marginal rate but the rate where you take all of the tax you pay, divide it by how much income you have, if that rate is higher for those earnings more. And conversely, a tax is regressive if the average tax rate is falling. So actually, the National Insurance contributions are progressive for most of the earnings distributions. So, as you earn more, most people will pay more as a share of their earnings in National Insurance contributions. But at the very top, for the roughly top 10% of people, that’s not true, it becomes regressive, so you still pay more in cash terms, but you start to pay less as a share of your earnings. So, it’s a funny system with NICs, for most of the income distribution it is progressive, but because of this oddity of the 2% rate, it falls at the top and becomes regressive.

Paul Johnson

But it’s fair to say, isn’t it, that if you think of National Insurance as another tax on income or earnings, if you’re an earner then your overall marginal rate goes from 32%, that’s 20% income tax, plus 12% National Insurance, up to 42% once you hit the upper threshold of £50,000, that’s 40% income tax and 2% National Insurance, so whilst the National Insurance, a you say, is regressive at that point, the overall tax on your earnings remains progressive in the sense it goes up as your earnings go up?

Helen Miller

Yes. I think one of the problems with having the two systems of income tax effectively is that it’s really not very transparent. Most people will think that the marginal rates are, as you say, 20% and 40%, where really you should think of them as, for most people 32% and 42%, so the fact that we have these two systems sitting alongside each other makes it very hard, I think, for people to know what their marginal tax rate is.

Paul Johnson

To go off-piste slightly, it creates an interesting problems with the developed administrations in Scotland in particular, something I’ve been looking at recently where the Scots have income tax developed, but they don’t have National Insurance devolved and they’ve got this very odd situation which means that their National Insurance goes down to 2% when earnings hit £50,000, but they haven’t increased the point at which the 40% income tax rate comes in, in the same way that we have in England. And that means that they’ve actually got this overall income tax plus National Insurance schedule which goes up really to quite high levels, between about £45,000 and £50,000, because they’re paying 40% income tax and 12% National Insurance contributions above that level, so they’re paying at 52% on that level of earnings because they can’t change their National Insurance system at the same time as they’ve changed their income tax system, so sorry for that slight digression.

Helen Miller

I think another way to highlight that madness is to think that if you were starting from scratch, you might expect there to be one income tax schedule that you could look up your rate. In fact we’ve got a schedule overall that varies depending on how old you are, whether you’re self-employed, if your income comes from earnings or dividends, which part of the country you live in and so on and so on. So, actually, we have very many tax schedules rather than just one simple one.

Paul Johnson

Exactly, so one of the reasons that we have this, or one of the reasons that we have had this second tax on earnings, is that historically at least, there was a link between National Insurance contributions and benefits - and in particular the state pension. We’ve actually had a few questions on Twitter asking us about the relationship between National Insurance and the state pension. So, Helen is there still a relationship?

Helen Miller

The basic answer is no. So, you’re completely right obviously that there used to be, so our current system has its origins in a kind of, in an act in 1911 that set up a National Insurance system, where you know literally employers would go to the post office, buy stamps put them on the cards of employees and those stamps would get you some access to benefits. Our current system whereby National Insurance contributions are effectively a tax on earnings goes back to 1975, and at that point there was more of a link between, you pay more in you get more out. But that link has been eroded over the decades to the point where now there is basically no link.  

So, the biggest link of any type is the state pension as you mentioned, and people do need to have at least 35 years of contributions to get a full state pension. But lots of people can get those contributions even if they’re not paying tax, now there’s a whole bunch of ways to do that, but to give you a sense of that, you know we said earlier that you have you know you don’t start paying until you earn around £9,500 but once you’re earning around £6,000 you’ll be treated as if you contributed your National Insurance Contributions; and you’ll also be credited with contributions if you’re not working but if for example you are receiving child benefit for a young child; you’re unemployed, sick, disabled, receiving universal credit, and a bunch of other things as well. So, most people, even if they’re not earning enough to pay National Insurance, will still qualify and get the full 35 years of contributions. And if after all of that you still haven’t got your 35 years, you can make voluntary contributions; so, lots of people will get their state pensions regardless of how much tax they pay. And for those who make the minimum contribution every year, it doesn’t matter how much more you pay, you’re not going to get a different state pension, you’ll get the same flat rate pension. So really, I think you know the takeaway is that now-a-days, how much you pay in National Insurance Contributions, and how much you get through the government benefits, it just, it’s not linked at all, really. They’re just another tax.

Paul Johnson

So essentially you have to have lived in the UK for 35 years’ worth of your adult life and pretty much not have been idle rich. If you’ve lived here for thirty-five years, you’ve been working, if you’ve been unemployed, if you’ve been looking after children, if you’ve been disabled, then all of those things will count towards your pension.

Helen Miller

Yeah.

Paul Johnson

So not, no real relationship really between National Insurance and the state pension, and indeed not really any relationship between National Insurance and any other benefits you get. A very big difference from what was envisaged, certainly by Beveridge when he introduced this social insurance system after the last war. And as Helen said, one of the reasons we have this strange system where the rate goes down after £50,000 is that is what’s - all that’s left of what used to be a flat rate payment. National Insurance used to be flat rate payment for flat rate benefits, but it’s certainly not that now, so that’s a little bit of history. But something’s happening in April, Helen what’s happening in April?

Helen Miller

So, in April all of the main rates of National Insurance Contributions, for employees and the self-employed and employers are going up by 1.25 percentage points. So, to make that concrete, the main rate for employees will rise from 12% to 13.25%. There’ll also be an increase in the dividends tax rate, also by 1.25 percentage points, and then from next April, NICs rates will go back to normal, and they’ll be replaced by these new so-called Health and Social Care Levy. The only difference is being that at that point it will also be applied to the extra 1.25 percentage points to earnings above the state pension age. So basically, an increased in the rates of National Insurance from April.

Paul Johnson

So how much will that cost someone earning say £30,000 a year?

Helen Miller

So, if you’re earning £30,000, you’re roughly the average earner, then in April, had there been no change in the tax rates, you’d currently be paying about £2,400 in National Insurance Contributions each year, and you’ll be paying an additional roughly £250 because of the rate increase. But of course, how much more you pay depends on how much you earn. So, to give you some examples, if you’re earning about £10,000, your bill will go up from about £14 to about £16, and if at the other end of the spectrum you’re earning £80,000, then you would have expected to have been paying about £5,500 a year, and you’re now paying an extra £900 more. So, they’re, you know they’re fairly substantial increases for people.

Paul Johnson

And of course employers will also be paying a similar amount extra?

Helen Miller

Of course, and of course employees may then feel that through lower wages. So, you know initially, employers will pay that, but to the extent that wages are therefore lower than they otherwise would have been, employees may end up paying more than just the increase in their own rates.

Paul Johnson

So, quite a lot of additional tax being paid by people. We also had a question from a six-form student and here’s their question.

Tejal

My name’s Tejal and I’m an a-level student in southeast London. How much revenue is the government expecting to raise from the National Insurance increase and what will that be used for?

Helen Miller

So, the government thinks they’ll raise about £13 billion that they can go on to spend on health and social care. So, they said that initially they’ll spend most of it on the NHS, but over time they’ll spend more of it on social care system. And I think you know that’s a fairly chunky sum, and it will allow them to spend more. And I think in the short run there’s no reason to believe they won’t do what they’ve said and spend it on those additional services. But I think it’s worth sitting back and not falling into the trap of thinking, as many people do, that National Insurance Contributions more broadly are a hypothecated tax, an ear-marked tax.

So, there is this formal thing called the National Insurance Fund, which government accountants put the money in an insurance fund, there’s nothing real about that. So, there’s no sense in which if the government raises more or less in National Insurance in a given year, they’re going to spend more or less on healthcare or social care or benefits. Really, we should think about National Insurance in general as being, you know the government raises money, it all goes into a big pot and they decide what they want to spend it on. So, in the short run I think this additional £13 billion, we should think of as going on health and social care, but not think more broadly that NICs is special in that regard. They could have raised the money through another tax and also spent it on health and social care, it didn’t have to come through National Insurance if they didn’t want it to.

Paul Johnson

So that is unsurprisingly a question that another listener as posed.

Keith Gordon

My name is Keith Gordon, I’m a barrister at Temple Tax Chambers specialising in tax disputes. I have a two-part question if I may, could the tax raises have been more effectively imposed by an increase in income tax instead? And would that have been fairer, so as to catch individuals with unearned income, for example property profits?

Helen Miller

The short answer is yes, they definitely could have used income tax, there’s no reason why they couldn’t, and it would have been simpler in that we would have been increasing the rate of a current tax rather than introducing, you know a whole new health and social care levy that was basically trying to extend National Insurance Contributions to those above the state pension age. So yes they can do it and yes they could have done it and it would have been simpler in many ways.

Of course, as to fairness people will always have different views on what’s, on what’s fair, and ultimately you want to look at the whole system, look at who’s currently paying and think about who should pay more. Of course, the current context is that the government put up these tax rates, saying explicitly they wanted to fund more spending on health and social care, and arguably they’ve set up a mechanism, this new Health and Social Care Levy in which they may fund additional spending in future. So, they’ve set up a precedent in that sense. Of course, that’s spending that will benefit all of us including pensioners, which is at least why some people will argue it’s not fair to therefore only raise the tax on the younger generations. And of course, as we talked about with NICs, because they’ve chosen National Insurance Contributions, they’re choosing a tax that falls more heavily on low earners. So, it’s a lot less progressive than income tax, and therefore I think my personal view overall is that yes, there’s actually a very good case that they should have used income tax rather than National Insurance Contributions. And actually, more broadly, we should be thinking about the fact that we already tax different types of incomes on very different rates, including we tax business incomes at lower rates than earned income for example. So, I think ideally as we’re increasing spending over time, we should think about how we tax different people, whether we’re happy with that situation.

Paul Johnson

I think you’re quite mild there really Helen, it seems to be that other than the politics there’s no case at all, is there, for raising National Insurance as opposed to income tax for protecting people with unearned income and only taxing people with earned income, for protecting pensioners and only taxing workers, for doing something that’s clearly less progressive, and for doing something that distinguishes so much between the employed and the self-employed, as well as both of them and those living off pensions and so on. Is there any case for having done it this way?

Helen Miller

Well, you know tax have different effects and different incentive effects so you can you know if you put up income tax you might worry that you know, you’re taxing people who are older at higher rates, and maybe people who are older and more responsive to tax rates because they’re more likely to retire. So, I think you can, you can make some technical arguments about the difference between NICs and income tax. But look, big picture, right, I agree with you, I think the fact that they’re increasing taxes in order to increase sending that helps all of us, it is odd to exclude certain groups from that tax increase.

Paul Johnson

Odd indeed. It worth also saying that the Prime Minister’s continually claims that this is a tax to pay for the backlog in the health service as a result of COVID and to pay for social care, it’s pretty clear from our work that it’s nothing of the sort. It’s entirely a tax to pay for, if you want to hypothecate it at all, the inevitable and ongoing increases in the cost of health care. The amount that we spend on health has been rising forever, effectively, and is continuing to rise. And indeed our calculations suggest that if you were to continue to pay for the rising cost of health and social care, through to just the end of this decade, then you might well need to take the National Insurance levy, the Health and Social Care Levy up from 1.25 percentage points to possibly as much as 3 percentage points. So, if that’s what the government continues to do, that turns out to be a much bigger new tax than the ones that is currently being imposed.

Helen a couple more questions about National Insurance as a whole, you’ve sort of hinted at this, we’ve got income tax, we’ve got National Insurance, why don’t we just have a single tax on income?

Helen Miller

So, in my view, we should have. I think we should effectively merge income tax and National Insurance. I mean we mentioned that National Insurance was originally set up as a contribution-based system. And we could move back in that direction and make it more linked, so the more you pay the more you got out, we could have a debate on whether or not to do that, but that’s not the direction of travel that we have, it’s not an active debate. Therefore, I think given what we think currently, if that’s what we want to have, we should, you know, stop the pretence of having two tax and just have one tax. There’s not much benefit from this second tax, and as we said, the credits you get are very, very loosely linked, if at all, to how much tax you pay, so, we could just unlink them all together. And I think there really are big costs in terms of transparency, I mean we already mentioned this, most people don’t know their marginal tax rates, because they just don’t think about National Insurance Contributions. And that is a horrible starting point to thinking about a public debate about how high taxes should be and how different people should pay different rates of tax. So, I think we’d be much better off if we had one single rate of income tax per bracket, that everyone could see.

Now there would be some technical issues to iron out, because they are different taxes with different tax basis to some degree, and some people will argue that that makes it hard to do. My sort of glib view on that is if we can put a man on the moon, we can have one income tax, I don’t think it’s beyond us. So yes, it would be tricky in transition to sort it out, but given that we really only have, you know we have these two taxes that don’t make much sense along side each other, I think we should move towards one.

Paul Johnson

What would you do about employers contributions in that case? As you’ve said this is the tax not just on employees but on employers as well. Would you merge just employee National Insurance and income tax? Or would you shove the whole lot together, creating you know rather explicit marginal tax on people of something like 45%, I mean that would be pretty difficult wouldn’t it?

Helen Miller

I mean it would certainly be difficult politically because people don’t know the reality, so revealing the reality would be shocking for people, but arguably that’s one reason to do it. But no, I think that you’ve got a choice there basically, you could put it all together and just have it be one tax on individuals, you could also clearly just maintain a separate payroll tax. So, you could tax individuals that effectively merged income tax and the employee element of National Insurance Contributions, and you could maintain a separate payroll tax if you wanted and you could pick the thresholds of that, and there is an appeal to doing that.

I think whatever way you go, one issue that crops up very quickly, that we have currently, is how you treat the self-employed. So, at the moment self-employed people have a lower rate of National Insurance than employees but much more importantly, there is no equivalent of employer NICs on self-employed incomes, which I think actually is a really big problem. And I know listeners will be screaming at me for various reasons saying, well of course there should be a lower rate, but actually now-a-days the self-employed get the same government benefits as employees, basically, there is some tiny differences, but nothing like the differences that you can justify by differences in tax rates.

And people will say things like, well self-employed don’t get things like holiday pay and sick pay and those kinds of things, which is true, but they’re not government benefits they’re benefits that employers give their employees. So, for some degree at least, they will be reflected in lower wages for employees, so self-employed people can charge higher prices because they’re not getting those benefits. And rather than thinking of this sort of, the lack of National Insurance Contributions to self-employed people as helping the labour market, it may ways it’s hurting because there are employers out there who might like to offer employment positions, and there are people who would like to be employees but they’re not because employer NICs is stopping those employment positions being created in the first place, because it adds an extra tax. So basically, we have a tax penalty on employment that I think is a problem. So, whether we, you know merged it all together or kept a separate payroll tax, I think there’s a very strong case for doing something equivalent to the self-employed, which would you know also physically be difficult and unpopular, but I think currently the tax penalty on employment is difficult and should be unpopular.

Paul Johnson

Yeah, I think that’s an important way to look at it, this is a tax penalty on those of us that - the majority of working age people of course, who are employees and it is a tax penalty relative to pensioners and it’s a tax penalty relative to the self-employed. So, you’ve talked a bit about the self-employed there, Helen, I mean the other big difference of course, is that pension income is not subject to National Insurance Contributions. Very often, certainly in the past people have talked about occupational pension income in particular as the third pay, and as you’ve also said, seems particularly odd that the group who would most immediately benefit the most from additional spending on health and social care are the pensioner population. Would a useful half-way house at least be simply to say we’re going to impose National Insurance contributions or maybe call it a sur-charge on income tax, at the same level, on occupational pensions and payment?

Helen Miller

So, I think the tricky thing with pensions is about how contributions were initially treated. So, some people, many people, would have made their pension contributions, you know when they’re working. And they’d have paid no National Insurance Contributions at that point, and then they’ll come to take their pension income and they’ll pay no National Insurance Contributions at that point either. So that’s a form of earnings, deferred earnings if you like, that’s got no National Insurance Contributions at any point in time. And that seems to me to be very, very hard to justify why that doesn’t get any tax at all. And therefore, in that case, simply putting National Insurance Contributions or a sur-charge, however you want to label it, onto pension income makes a lot of sense.

I think where it gets tricky is for some people, and for some kinds of pensions contributions, they did pay National Insurance contributions on the way in. So, they paid a National Insurance Contributions before making, you know before putting the money into a pension, and so then if you tax them on the way out again, then you sort of double tax some people. So that’s an anomaly in the system, I think it’s a bit strange that we have these dual systems on the way in, but we do.

So, I think you know one way to solve that is to put National Insurance Contributions onto pension income, but maybe not at full rate, maybe start at lower rates and increase overtime, and we can obviously change how we treat contributions on the way in at the same time. So, we can for example, move to a system where like income tax, nobody pays any tax on the way in, and everybody pays tax on the way out. But I do think the fact that contributions are treated differently upfront makes it a bit of a, a bit less clear that we should obviously put just full rates on pension income. A broader point that as we’re spending more, having tax rises that don’t include pension income is a pretty important choice.

Paul Johnson

It is an important choice and I’d go so far as to say an incorrect choice, you’re being uncharacteristically holding back on this one Helen, it does seem extraordinary to be raising taxes on earnings and essentially leaving those that are dependent on other forms of income largely untouched.

So, on that controversial note, or perhaps not terribly controversial note, it’s probably time to bring this particular edition to an end. Thanks, in particular, to those of you that have asked us some questions, thank you for listening to this episode of the IFS Zooms In. Please hit subscribe and rate us and share this episode with anyone who might be interested. To see more of our work on tax and some accessible explainers, do visit www.ifs.org.uk/taxlab. And to further support our work, please do consider becoming a member of the IFS for as little as £5 a month.

Stay well and see you soon.