Taxes explained

National Insurance contributions explained

National Insurance contributions (NICs) are the UK’s second-biggest tax, expected to raise almost £150 billion in 2021–22 – about 20% of all tax revenue.

They are paid by employees and the self-employed on their earnings, and by employers on the earnings of those they employ. 

Up to a certain threshold, earnings are free of NICs. The main rates are payable on earnings above that level, but the employee and self-employed rates – though not the employer rate – are lower on earnings above a higher threshold (see chart and table below).

Unlike income tax, NICs are not charged on income from other sources such as savings, pensions or property. Payment of NICs qualifies individuals to receive certain social security benefits (most notably the state pension). In practice, however, the link between contributions paid and benefits received is vanishingly weak and NICs essentially act as a second income tax.

What incomes are subject to NICs?

NICs are levied on the earnings of individuals aged 16 or over. Individuals over the state pension age are not liable for employee or self-employed NICs, but employer NICs are still due on their earnings.

The earnings that are taxable are earnings from employment and earnings (profits) from self-employment (as a sole trader or member of a partnership – note that this does not include profits from a company, though a company might employ its owner and pay him/her a salary). In measuring earnings for NICs purposes:

  • Work-related expenses can be deducted; the rules on what can be deducted are much stricter for employees than for the self-employed.
  • The treatment of benefits in kind (payment to employees in the form of goods or services rather than money, such as company cars or health insurance) varies. Some are subject to NICs in full; others (generally those that cannot be sold or traded) are subject to employer but not employee NICs.

NICs are not levied on other income, such as income from savings and investments, rental income from property, private pensions, state pensions and other social security benefits.

Unlike for income tax, private pension contributions made by an employee or self-employed individual cannot be deducted from earnings for NICs purposes. This makes sense, since (unlike income tax) NICs are not levied on the future pension income they generate. However, pension contributions made by an employer on their employee’s behalf are not included in earnings for NICs purposes. This means that remuneration in the form of employer pension contributions escapes NICs altogether: there are no NICs when the money is paid into the pension, and no NICs when money is received from the pension either.

Employee and employer NICs rates, thresholds and reliefs

NICs are formally divided into classes. NICs on employment income are Class 1 NICs; employees pay primary Class 1 NICs, while employers pay secondary Class 1 NICs.

The table below shows the current rates and thresholds of employee and employer NICs. Class 1 NICs liabilities are assessed separately for each period for which an employee is paid; the table shows the thresholds in weekly terms, as is conventional, but they are adjusted pro rata for employees who are paid (say) monthly.

Class 1 (employee & employer) National Insurance contribution rates, 2021–22

Employer NICs have, in effect, a tax-free threshold per employer as well as a tax-free threshold per employee. The employment allowance reduces each employer’s aggregate NICs liability by up to £4,000 a year, provided that their liability in the previous year was less than £100,000 (and that a company director is not the sole employee earning above the secondary threshold). This takes many small employers out of paying employer NICs altogether, although much employer NICs revenue comes from big employers which are not eligible for the employment allowance.

Two groups of employees have their earnings taxed less heavily:

  • No employer NICs are payable on the earnings, up to the upper earnings limit (UEL), of employees aged under 21 or apprentices aged under 25.
  • A special married women’s reduced rate of employee NICs, 5.85%, is available on earnings between the primary threshold and the UEL (in exchange for lower benefit entitlements), but since May 1977 this option has been available only to married women paying it almost continuously since that date, which is now a very small number.

Employee NICs are taken out of earnings, whereas employer NICs are paid on top of earnings. The rates of the two are therefore not directly comparable, and when looking at the overall level of NICs on employment, the headline rates should not simply be added up and compared with the level of gross earnings (see the technical note below). A more informative calculation is to look at total NICs paid as a fraction of the total amount the employer pays out (i.e. their total labour cost – earnings plus employer NICs). On this basis, the combined main NICs rate – the marginal rateThe amount of additional tax due as a percentage of each additional £1 of a tax base (such as income).Read more applying between the primary threshold and the UEL – is not 25.8% (12% + 13.8%) but 22.7% ((12% + 13.8%) ÷ 113.8%).

The chart below shows the combined rates of employee and employer NICs. The marginal NICs rate is the proportion of each additional £1 of labour cost paid by the employer that is taken in NICs. The average NICs rate is the proportion of the total labour cost paid by the employer that is taken in NICs. The chart highlights that, while NICs are progressiveA tax is progressive if tax liability increases more than in proportion to the tax base, or to income.Read more across most of the earnings distribution – the average tax rateThe amount of tax paid as a percentage of the tax base (typically income).Read more is higher for those earning more – it is not progressiveA tax is progressive if tax liability increases more than in proportion to the tax base, or to income.Read more at the top. The average rate peaks at 18.9% at the UEL, the point at which the marginal rateThe amount of additional tax due as a percentage of each additional £1 of a tax base (such as income).Read more of employee NICs falls from 12% to 2% and the overall marginal NICs rate falls from 22.7% to 13.9%.

Self-employed NICs rates, thresholds and reliefs

The self-employed pay two classes of NICs:

  • Class 2 NICs are paid at a low, flat rate – currently £3.05 per week – by anyone whose self-employment income (profits) exceeds the small profits threshold of £6,515 per year.
  • Class 4 NICs are the main element of self-employed NICs, paid in relation to annual profits above the lower profits limit of £9,568 per year.

Current NICs rates for the self-employed are shown in the table below.

Self-employed National Insurance contribution rates, 2021–22

The main rate of self-employed NICs is lower than the main employee rate – 9% rather than 12% – and, more importantly in terms of the overall tax burden, there is no equivalent of employer NICs levied on the profits of the self-employed. The total NICs levied on self-employment income are therefore much lower than those on employment income, as shown in the chart below. The government estimates that having lower NICs for the self-employed cost it £5.9 billion in 2019–20. There is no good justification for the preferential NICs treatment of self-employment.

National Insurance contributions and benefits

National Insurance originated as a system of contributions in exchange for entitlement to specific (‘contributory’) social security benefits. However, the link between contributions and benefits has weakened over time, to the point where there is now barely any connection at all between the amount of NICs paid and the amount of benefits received. Throughout the many reforms to both contributions and benefits that have taken place over the years, minimal attention has been paid to closeness of the link between the two.

By far the biggest contributory benefit is the state pension. But it is now quite hard to live in the UK and not earn entitlement to a full state pension. The contributory system does serve to withhold certain benefit entitlements from some small groups. But its main practical function nowadays is to ensure that foreigners cannot retire to the UK and claim a full state pension. There may be a case for a genuine social insurance system, but it is not what we currently have.

NICs and income tax

The UK has two taxes on income – income tax and National Insurance contributions.

NICs are paid over to HMRCHer Majesty’s Revenue and Customs (HMRC) is the UK government body responsible for the collection and administration of most taxes.Read more along with income tax by employers and the self-employed.

The chart below shows the combined marginal rateThe amount of additional tax due as a percentage of each additional £1 of a tax base (such as income).Read more schedule for someone whose income is stable and comes entirely from earnings.

A striking feature is the number of thresholds at which the overall marginal tax rateThe amount of additional tax due as a percentage of each additional £1 of a tax base (such as income).Read more rises or falls. This is partly because of oddities in the income tax schedule, notably the withdrawal of the personal allowance once income exceeds £100,000But it also reflects a lack of alignment between income tax and NICs. At present, the upper earnings limit and the upper profits limit (UPL) are aligned with the higher-rate threshold (except in Scotland). But income tax, employee (and self-employed) NICs and employer NICs all start to be paid at different levels of income.

The schedule in Scotland looks even more complicated than that in the rest of the UK. This is because (a) Scotland has an unnecessarily complicated five-band income tax schedule (with separate 19%, 20% and 21% rates) and (b) Scotland has devolved power over income tax but not NICs, so when it chooses an income tax higher-rate threshold which is lower than in the rest of the UK it cannot align it with the UEL and UPL. This means that (for someone with stable earnings) there is a band of earnings between the Scottish higher-rate threshold of £43,662 and the UK UEL/UPL of £50,270 where Scottish residents pay both higher-rate income tax and the main rate of NICs.

Aligning thresholds within the current system matters less than it might seem for simplification, however. Since income tax and NICs are assessed over different periods (annual for income tax, pay period for Class 1 NICs) and on different measures of income, it is quite possible for someone to be above the income tax higher-rate threshold but below the UEL, or vice versa, anywhere in the UK.

Given the similarity of the two taxes, it would be simpler – both more transparent and less administratively burdensome – if they were merged into a single tax. Most of the remaining differences between the two taxes could be retained if that were considered desirable (for example, a combined tax could be charged at a lower rate on items that are currently subject to one tax but not the other); but integration would underline the illogicality of most of the current differences between the two taxes and provide an opportunity to remove them. Calls for such integration have been widespread for many years, but successive governments have rejected them. What we have seen instead is gradual moves towards greater alignment between the two taxes, making them ever more similar.

Progress towards further alignment has slowed. In 2016, the Office of Tax Simplification produced two reports proposing (relatively modest) NICs reforms to bring them closer to income tax; but the government rejected the main suggestions (for involving too much upheaval) and U-turned on its initial acceptance of two others, ultimately making only very minor technical adjustments.

The apprenticeship levy

The apprenticeship levy – a new tax introduced in 2017 – is not part of NICs, but it acts very much like additional employer NICs.

The levy is applied to employers with a total annual wage bill of more than £3 million. The levy is 0.5% of the total wage bill, with an allowance of up to £15,000 to set against the tax. In other words, it is a 0.5% levy on wages in excess of £3 million.

This is in effect a 0.5% supplement to employer NICs for large employers. The measure of earnings taxed is the same as for employer NICs, and the £15,000 allowance is analogous to the £4,000 employment allowance in NICs.

Despite its name, the levy has very little meaningful connection with apprenticeships (much like NICs have little link with benefits), determining only (in England) whether the government funds 100% (for levy-paying employers) or 95% (for non-levy-paying employers) of apprenticeship training costs up to certain limits.

Only about 2% of employers have a wage bill high enough for them to pay the levy, but they employ a majority of all employees. The tax is forecast to raise £2.9 billion in 2021–22.

 

Who pays NICs?

The majority of NICs revenue – an estimated 58% in 2021–22 – comes from employer contributions. Employee contributions provide a further 39%. Contributions made by the self-employed (comprising both Class 2 and Class 4 contributions) are a relatively small source of revenue, accounting for less than 2.5% of contributions. That reflects a combination of the much smaller numbers of self-employed people, their lower average earnings and the lower NICs charged on their earnings.

A key question is the economic incidenceThe economic incidence of a tax describes which people are ultimately made worse off by the tax (and can be different from those who are legally liable to pay the tax).Read more of NICs: who ultimately bears the burden, in the sense of having their living standards reduced by the tax.

The economic incidenceThe economic incidence of a tax describes which people are ultimately made worse off by the tax (and can be different from those who are legally liable to pay the tax).Read more of a tax must always ultimately be on real people. When a tax is paid by businesses, as with employer NICs, it could be felt by the firm’s owners/shareholders (via reduced profits from the business) or could be passed on to the firm’s workers (via lower wages), customers (via higher prices) or suppliers (via lower input prices). In practice, it will almost always be a combination of these.

Simple economic theory suggests that the incidenceThe economic incidence of a tax describes which people are ultimately made worse off by the tax (and can be different from those who are legally liable to pay the tax).Read more of employer NICs and employee NICs should be the same, at least in the long run. It is likely that the long-run incidenceThe economic incidence of a tax describes which people are ultimately made worse off by the tax (and can be different from those who are legally liable to pay the tax).Read more of both employer and employee NICs is predominantly on employees, but the empirical evidence is not clear-cut.

The chart below shows the distributional impact of NICs under the simple assumption that all NICs – employee, employer and self-employed – are fully incident on the worker whose earnings are taxed.

It shows the impact on overall household incomes, taking into account, for example: the extent to which high earners tend to live together; that the impact of NICs on many low-income households is cushioned as their reduced net earnings result in higher entitlements to means-tested benefits; and that if (as we assume) employers pay lower wages as a result of having to pay employer NICs, those lower wages reduce the amount of income tax employees must pay.

On average, NICs reduce household incomes in the UK by about £4,200, equivalent to over a tenth of their average income. The chart shows that higher-income households pay much more, not only in cash terms but as a percentage of their income – except that NICs reduce the incomes of the highest-income tenth of households by a smaller proportion than the 8th or 9th decile groups, because of the fall in marginal NICs rates above the UEL and UPL.