Background

The UK’s national insurance system was introduced at the beginning of the twentieth century at the time that the very first UK state pension was created. It was, however, transformed and expanded in the aftermath of the Second World War. The Labour government elected in 1945, promised the creation of a much-enhanced social safety net to those who had endured that war. The result was an improved state pension, unemployment and sick pay benefits and the creation of the National Health Service. These new commitments required that additional taxation be paid. The current form of contributory system of payment giving rise to an entitlement to benefits was created as a consequence.

This system of taxation was largely based upon payments made via a person’s employer through what became known as the pay-as-you-earn (PAYE) system, which also applied to income tax due on employment income. Post 1945 this was particularly suited to the structure of UK society. For example, in the 1940s and for some time thereafter, most employees were male, which fact was heavily reflected within this new taxation system, which was overall prejudicial to women, and especially married ones. In addition, most people were employed, with self-employment being surprisingly rare at the time, and the vast majority of those employees stayed with their employer for long periods whilst having no other sources of untaxed income of any note, meaning that the PAYE taxation system was highly likely to capture most income within it and tax it appropriately.

As it developed, national insurance became payable in several ways:

1. Class 1 national insurance was payable by employees, but in two parts. Part was due by the employee themselves and was therefore seen by them on their payslip. In addition, a second part, which currently exceeds in total tax collected that part paid by employees, was paid by employers. Employees did not recognise this as a taxation liability paid on their behalf, even though most economists agree that the impact of this payment was to reduce the level of net wages paid in the UK economy.
2. Class 2 national insurance was a basic contribution paid by those who were self-employed. It entitled them to credit for a few of the benefits that employees enjoyed, and in particular an old age pension. Unemployment and sickness benefits were generally excluded. This contribution was abolished in the autumn statement of 2023. Because in its early days those who are self-employed secured this benefit by purchasing stamps that were suck onto a contribution card that a self-employed person had to submit to tax authorities to prove their entitlement to benefits for a year this class of contribution was for a long time called “the stamp”.
3. Class 3 national insurance contributions were a voluntary contribution paid by person not in employment who wished to preserve their entitlement to an old age pension.
4. Class 4 contributions were additional contributions made by a self-employed person depending upon the level of income that they earned. These were originally considered the equivalent of an employer contribution but have never been paid at a rate that brought the contribution made by the self-employed to anything like the level paid by employees. This was a situation defended on the basis that self-employed people had significantly reduced entitlement to benefits payable as part of the social security safety net.

Over the years a number of variations on the above basic charges have risen, including the creation of Class 1A national insurance contributions, which are payable by employees and employers on the value of their benefits in kind provided by an employer.

The significance of national insurance in the UK tax system

In 2022/23 national insurance raised a total of £176.9 billion of taxation revenue[1]. This made it the second largest UK tax, behind income tax but ahead of VAT. Of this sum just over £100 billion was paid by employers and the balance by employees and the self-employed. The significance of national insurance as a source of government revenue is not, as a result, as apparent as it might be to most of those who pay it.

The rates at which national insurance is paid

Since the majority of national insurance contribution payments are made by those who are employed, or their employers, the rates for these people payable under what is called class one national insurance are summarised here:

The rates of tax payable are as follows:

In practice, what this combination of rates and thresholds means is that an employee starts paying national insurance when they earn more than £242 a week (£12,570 a year). The contribution due is payable at 12% on the excess over that sum.  However, the rate of national insurance rate due falls to 2% when weekly earnings exceed £967 per week (£50,270 a year).

These rates have, it should be noted, been co-ordinated with income tax rates for the first time in 2023-24. Income tax rates in that year are:

What is clear from comparing these tables is that:

1. When the income tax rate increases from 20% to 40% the national insurance rate on employees falls from 12% to 2%, mitigating that income tax increase for those in employment.
2. Whereas the income tax rate then increases again, albeit at significantly higher levels of income, the national insurance rate never does.

It is also worth noting that:

3. At no time is there a national insurance charge on anything but income from work. All other income is exempt from this change.

Problems with the UK’s national insurance system

The UK national insurance system might have had merits in the era post-1945. It is, however, anachronistic in 2023. in particular:

1. The system has failed over time to reflect the changing role of women in society, and there have been some significant problems that have risen as a result.
2. Self-employment is now substantially more commonplace than it was in 1945.
3. People change employment much more often now than they did when national insurance was first introduced, and many people also have multiple employments, which the national insurance system is ill-equipped to handle.
4. National insurance is not charged on anything, but income from work, meaning that the overall rate of tax paid on income of work is much higher than the overall rate of tax paid on any other source of earnings, most of which are derived from wealth. This contributes significantly to the growing inequality of incomes and wealth in the UK.
5. National insurance ceases to be paid by an employee or self-employed person (but not by their employer) when that person reaches the state retirement age (66, at present), which makes little sense when many people now work beyond that age. This creates a distortion in the employment market.
6. The scale of the employer’s national insurance contribution has encouraged many employers to treat their staff as self-employed, even when that is not the case, meaning that both the employer and the employee save national insurance cost as a result. This has seriously undermined the horizontal equity of the UK tax system. Much of this false representation of employment status has also been akin to tax evasion activity that undermines the integrity of the tax system as a whole.
7. Many people claiming be self-employed have during the course of the current century created limited liability companies to record their income. They have paid themselves a minimal salary out of the profits that company has recorded as a result of charges it has made for the supply of their labour. This means that they have kept their national insurance record intact for benefit purposes. They have then paid themselves dividends out of those profits, seeking to avoid both employer’s and employee’s national insurance liabilities on the sums they claim to have converted into what tax law recognises as investment income and therefore outside the scope of a national insurance charge. There have been many attempts by HM Revenue and Customs to address this issue, but they have still found no proper solution. As a result, horizontal tax equity has been seriously distorted in such cases. The cost of this abuse has never been estimated by HM Revenue and Customs, which is one of the many deficiencies in its tax gap estimate. So widespread has the abuse been that many government departments have been guilty of engaging consultants on this basis.
8. In the long term national insurance is a tax that clearly discourages the employment of people in the UK when the creation of full employment remains an objective for most governments. This tax creates wholly perverse economic disincentives that are implicit in its construction and design. When most benefits and pension payments to those in need are not now dependent upon having a complete contribution record this is particularly perverse.
9. The requirement that people have many decades of contribution record to automatically qualify for a state old age pension in the UK is deeply discriminatory in an era when the UK is already, and will increasingly become, dependent upon migrant workers to undertake significant roles within the UK economy.

Approach to tackling the issues that national insurance creates

The Taxing Wealth Report 2024 is not meant to be a programme for tackling every deficiency in the UK tax system. It is instead intended to suggest how taxation revenue might be increased from those with significant income and wealth who are resident in the UK. So significant are the immediate changes that are required for this purpose as noted in the Taxing Wealth Report 2024 that no attempt is being made to tackle more fundamental failures in some parts of the UK tax system. The weaknesses in the national insurance system fall into this second category. Whilst recognising many of the above note problems exist, the recommendations made in this section and others that are related to it are at best partial and a fuller consideration of the future of the national insurance system will have to await further consideration.

Recommendations made

The following recommendations are made in this and other sections of this report to address some of the failings that the national insurance system has created and to create additional tax revenues as a result:

1. To charge national insurance at a single rate across all levels of income earned, abolishing the reduced rate that now applies on income over £50,270 per annum as a consequence. It is estimated that this might raise £12.5 billion in tax a year.
2. To create an investment income surcharge on incomes from investment income (including capital gains) of more than £5,000 a year. This sum, which would be charged as income tax, would be broadly equivalent to national insurance and would raise £18 billion a year. It would end much of the incentive to tax avoid with regard to national insurance noted previously.

These two changes would end two of the most egregious tax abuses built into the UK tax system at present and might raise more than £30 billion in revenue in the process.

Detailed proposals

1. Reforming national insurance charges on higher levels of earned income in the UK, which might raise an additional £12.5 billion of tax revenue per annum.
2. Recreating an investment income surcharge in the UK tax system, which might raise up to £18 billion of extra tax revenue a year.

Footnotes

[1] https://obr.uk/efo/economic-and-fiscal-outlook-november-2023/