Confused by National Insurance? That’s not a bug: it’s a feature

First, let me make clear that Philip Hammond’s decision to compensate the Treasury for the abolition of flat rate Class 2 national insurance contributions (NICs) by increasing progressive Class 4 contributions is a sensible and moderate policy. The trouble is, for most people, that sentence doesn’t make much sense. What are Class 2 and Class 4 NICs? What happened to Classes 1 and 3? And did you know there is also a Class 1A? In any case, what is national insurance insuring against?

NICs are a mess, but an artful mess that exists for good reasons and because reform is not worth the candle. Fundamentally, the tax system is designed to extract cash from us with the minimum of fuss and without our understanding what is really going on. To achieve that, the machinery of tax collection is kept under the radar. For employees, that means we pay income tax and national insurance through the pay as you earn (PAYE) system. Under PAYE, our employers deduct the income tax and national insurance we owe from our pay packets. Effectively, the Treasury gets paid each month at the same time as we do. Better yet, we never possess the money that we pay in taxes and so never really miss it.

Employers also pay NICs on top of the tax that we see deducted from our wages. Make no mistake about employers’ national insurance. This is a tax on our salaries just as much as income tax. It is just that it is effectively invisible, which suits the taxman fine. In fact, if you earn £45,000 a year, you pay over 40% more in national insurance than you do income tax. Employees’ and employers’ national insurance taken together are Class 1 contributions. Class 1A NICs are paid on employee benefits like company cars.

As everyone now knows, Class 2 NICs are a flat rate tax of about £150 a year on the self-employed. George Osborne abolished these with effect from next year. All Philip Hammond has done is claw this money back by increasing Class 4 NICs on the self-employed, which are based on a percentage of profits rather than a flat rate. But, despite the recent fuss, the big difference between the employed and self-employed is those employers’ NICs, which the self-employed don’t pay. For example, a banker taking home £60,000 a year pays over £41,000 in income tax and NICs. A self-employed doctor, also getting £60,000, pays just £28,000. Given the fuss that Mr Hammond’s modest change has caused, we can be confident that the Government won’t be evening up the scales between the employed and self-employed any time soon. Instead, HMRC tries to reclassify people who are self-employed as being employed by someone else. This enables the taxman to extract more tax from them. Expect more action on this front involving Uber drivers and other workers in the gig economy.

There’s another reason that the self-employed tend to pay less tax. Because they don’t pay through PAYE, they have to write a cheque, or at least make a bank transfer, direct to HMRC. That means the self-employed know exactly how much tax they pay and resent it accordingly. Most employed people haven’t got a clue.

The complications don’t stop there. NICs are only paid by people in work. They don’t apply to savings income, which means that the leisured rich enjoy much lower effective tax rates than the working poor. You also don’t have to pay NICs once you get past the state retirement age, even if you are still in work. This means we tax the productive part of the economy far more heavily than we do the unproductive part. Sloth is tax efficient compared to toil, provided you have money in the bank.

The major benefit for taxpayers paying NICs is to ensure they get the full state pension. You need 35 years of contributions to be entitled to the full amount (Class 3 NICs can be paid if you miss a few years of the stipulated 35). Nonetheless, having to pay NICs to access the state pension is not a terribly good deal. It is currently worth about £8,000 a year, increasing each year by the higher of inflation, earnings growth or 2.5% (the so-called triple lock). Meanwhile, if a worker on the average wage could invest all their NICs in a private scheme, he or she could expect an index-linked pension of over £14,000 a year. Worse, pensioners are dependent on the largesse of future taxpayers to fund the state pension and keep the current triple-lock indexation going. There is no money invested by the Government to pay tomorrow’s pensioners.

The awful complications of national insurance make reform very difficult. As Philip Hammond has found, for every change you make, there are winners and losers. The winners are quietly satisfied while the losers are apoplectic. In the present case, these losers include a lot of self-employed columnists who can make their annoyance very public. Thus, even a tax change that has genuine public support (as the NIC changes do) can be portrayed in the media as a disaster.

Some have suggested that we should abolish national insurance completely and replace it with equivalent rates of income tax. This would be a transparent and rational reform. But politically, the change would be a disaster for the Chancellor foolish enough to implement it. Lots of people would suddenly realise that their income tax bills were much higher than they thought. Worse, the manifest unfairness of the employed and the self-employed paying very different rates of tax, not to mention the lower rates for rich pensioners and savers, would be out in the open.

Perhaps the events of the Spring Budget 2017 will serve as a lesson for future Chancellors who think that there is anything rational about reactions to tax reform.