Merging income tax and national insurance

I am relieved to hear that chancellor George Osborne is considering merging income tax and national insurance, even if the changes are likely to be slow in coming. The division between these two direct taxes on income tax once (just about) justifiable on the contributory principle – that payment of certain amounts of national insurance made you eligible for certain benefits. That justification no longer holds to any great extent, and if the state pension is changed as planned it will evaporate altogether. The only remaining reason to keep income tax and national insurance separate is for political, presentational reasons: to stop people from cottoning on to just how much tax they are paying.

Moreover, the various changes to income tax and national insurance rates and allowances over the last few years have left us with a dogs breakfast of a tax system, which makes no rational sense whatsoever. The table below summarizes how income will be taxed from the beginning of the new tax year in April, by combining income tax and national insurance.

The two 62 percent tax bands are caused by the withdrawal of the personal allowance for those earning between 100,000 and 150,000. The two very small bands at 12 percent and 22 percent are caused by national insurance thresholds not being aligned with income tax thresholds. Meanwhile, the the employers national insurance contribution (an extra tax paid on the income of employees) will be set at 13.8 percent on income over £7,072 – which adds a further complication.

Wouldn’t it be much simpler and more transparent (not to mention cheaper to administer) if we just said the following:

  • The first £7,475 of income is completely untaxed.
  • Income between £7,475 and £42,475 is taxed at 32 percent.
  • Income between £42,475 and £150,000 is taxed at 42 percent.
  • Income in excess of £150,000 is taxed at 52 percent.
  • Employers pay their additional 13.8 percent on everything in excess of £7,475 per person.

Naturally, that would be far from ideal. The employee rates are too high, will discourage enterprise, and will push businesses to relocate overseas. Similarly, the 13.8 percent employers tax is absurdly anti-job creation, and is likely to contribute to unnecessarily high unemployment. But at least this simplified tax structure would give us a rational place to start from.

I should add an additional caveat. Merging income tax and national insurance would be hard on pensioners, who currently pay the former on pension income but not the latter. Perhaps we should consider setting up a separate flat tax system for pensioners, like the ones in operation in Austria, Spain, Belgium and Cypress?

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