Glimmer of hope

KEY POINTS

• New call for evidence on tax and NIC ‘integration’.
• Contributory principle is not supported by the facts.
• Mirrlees Review explains how dividends could be limited to return on business assets.
• General questions suggest the door is not closed on real integration.

I wrote an article in our Budget issue on the failure by the government to catch the political hot potato of tax and NI integration. This arose from the Office of Tax Simplification (OTS) report on small business taxation.

The OTS came to an ‘overwhelming conclusion’ that ‘genuine and long-lasting simplification can only be brought about through major structural changes to the UK tax system’. Key among those changes was a need to integrate tax and national insurance.

Three little words in the budget speech were enough, it seemed, to neuter that proposal, while seeming to endorse it. Rather than saying that the government planned to consult on the integration of tax and national insurance, the Chancellor announced that they were to consult on the integration of ‘the operation of’ tax and national insurance.

He then added two firm commitments – that NICs were not going to be extended to those over state pension age, and were not going to be imposed on pensions, savings and dividends.

I concluded the article by writing:

‘As I read it, the Budget has failed to catch this political hot potato, and has blocked from the start any possibility of true integration of tax and NICs. I can only hope that I am wrong, and that once the first steps of integrating the operation of the two charges are underway, the government will be prepared to revisit the reform that we really need.’

Well, there is perhaps just a tiny glimmer of light at the end of that tunnel.

Contributory principle

In a rather strange exercise, the Treasury has issued a precursor to a consultation, a ‘call for evidence’ on integrating the operation of NI and tax. Initially this does not look promising, particularly because the foreword from Exchequer Secretary to the Treasury, David Gauke MP, repeats the promise:

‘As stated at Budget, the Government will maintain the contributory principle that underpins the National Insurance system, and ensure that this will be reflected in any proposed reforms. In addition, we will not extend NICs to individuals above State Pension Age or to pensions, savings and dividends.’

This assertion that the contributory principle will be ‘maintained’ deserves some attention, because the idea that we still have a contributory principle is more or less a myth.

In part it can be disproved from the call for evidence document itself. Paragraph 1.7 explains that the self-employed pay NICs based on the taxable profits of their business, but that ‘this alone does not give them entitlement to contributory benefits’.

Let’s try that again, shall we, and this time miss out the word ‘alone’. Class 4 NICs do not give entitlement to contributory benefits either alone or in conjunction with any other payment.

It is solely the payment of Class 2 contributions, at a couple of pounds a week, which gives access to supposedly ‘contributory’ benefits. Even though these are more limited than for employees, the idea that the relevant contributions are in any way enough to purchase the eventual benefits is ludicrous.

The contributory principle is further undermined by the fact, mentioned in the call for evidence, that a proportion of NICs goes to fund the NHS but that use of the NHS is not based on having paid sufficient NICs.

In fact, the NHS allocation is the way that funds can be siphoned out of NICs and into general government expenditure. The amount that the NHS can spend is set as part of overall governmental spending – if more money comes in from the NIC allocation that simply reduces the amount that has to be found from general taxes.

And finally, the contributory principle is undermined – though for very good reasons – by recent changes to the state pension. These now only require thirty ‘qualifying years’ for a full pension, and years spent looking after children under 12 (or which qualified for the previous ‘home responsibilities protection’) will count, even though no contributions were made during that time.

Exempting pensioners and savers

Taking the next of those promises, it would certainly be possible to ensure that those over pension age did not effectively pay NICs on their pensions and earnings, nor indeed on their savings and dividends.

If the intention is to maintain a broadly similar structure to the current one, that can be achieved in a combined tax and NIC structure by taxing pensioners at lower rates. Rather than, for example, the combined rate of 32% which those under retirement age would be expected to pay, they could be taxed at a reduced rate of 20%.

But this does seem to be a little unimaginative. It would surely be better to look at something which took more pensioners out of the tax net altogether and which rewarded them for making some additional retirement provision of their own.

What about exempting the basic state pension from tax entirely, allowing personal allowances to be set against any other pension income, but then taxing any excess at the full rate? I’m not sure if the figures would work, but that seems to me to be a better aspiration to work towards.

However, a reduced rate would allow the other promise to be met – that NIC, or an equivalent charge, should not be extended to savings income. Again, in a way which we have been used to in previous years, this income could simply be taxed at a different rate.

The logic for taxing savings income at a lower rate than earned income does rather escape me, just as the logic for taxing it at a higher rate escaped me when I started my tax career back in the days of investment income surcharge, but perhaps I am being a little over-ambitious in hoping for logic.

What are dividends?

The real problem is the promise that the charge will not be extended to dividends. If any progress is to be made on removing the tax advantage of operating through a company, as compared with being self-employed, then it is essential for dividends that really represent earnings generated by the shareholders’ effort to be subjected to a tax charge which represents the combined effect of tax and NIC.

The theoretical framework for this was examined in detail by the Mirrlees Review, but the difficulty is how to achieve this when the government is promising not to extend NIC to dividends.

The neatest way, if the government can be persuaded that it is a worthwhile objective, is probably to ask questions about what a ‘dividend’ really is.

Again, Mirrlees implicitly suggests an answer, by proposing that – assuming government wants to tax shareholder income at a lower rate - only an imputed rate of return on business assets should be taxable at that rate for owner-managed businesses, the rest should be charged at the full combined rate of tax and NIC which an employee would pay.

This would allow a distinction to be made between shares in an owner-managed business, and shares in a business where dividends do not make up a significant part of employee rewards, and therefore the dividends paid arise genuinely from profits and not from the work of the entrepreneurs.

That distinction might be enough to allow a system which protects investors from an NIC-equivalent charge on their dividends, whilst applying such a charge to those for whom it is really disguised remuneration.

Tiny light

But why, in the face of the seemingly obstinate tone of the latest Treasury document, do I persist in thinking that there might be a possibility of making any progress at all on genuine integration? Because of the questions that the document poses.

Remember that this is meant to be a call for evidence on how to integrate ‘the operation of’ tax and national insurance. Most of the document, and most of the questions, concentrate on exactly that.

They look at how the differences between tax and NICs cause problems for businesses, whether the differences are handled automatically through payroll software or need manual intervention, and at how time-consuming or expensive it is to deal with two different systems.

However, there is a further set of questions which you would not expect to see if the government really is committed to looking only at operational integration. They are actually the first three questions asked; see General interest questions.

The key issue here, it seems to me, is economic distortion. That was precisely what was being targeted initially by the OTS, but seemed to have been disregarded by HMRC. If the door on this is still open, then perhaps some concerted effort in the responses will mean that a more significant integration of tax and NIC can be achieved than at first seemed possible.

Issue: 4313 / Categories: Comment & Analysis , merger , Mirrlees , OTS , Admin , Income Tax