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No convergence

15 May 2012 / Robert Leach
Issue: 4353 / Categories: Comment & Analysis , Income Tax

ROBERT LEACH traces the evolution of National Insurance since its introduction 100 years ago


  • A national insurance scheme, not a tax.
  • Inexorable rise of contributions.
  • Link between National Insurance and benefits.
  • Additional classes of contribution.
  • Uniting tax and National Insurance.

In July 2012, National Insurance is 100 years old. Although this is not likely to feature significantly in the year’s national celebrations, it does provide an opportunity to see how it has evolved over a century from an insurance policy to an income tax that dare not speak its name.

One hundred years ago David Lloyd George was leading a Liberal government. They were concerned with recovering the nation’s finances, finding new ways to tax the rich, and reforming the House of Lords. Plus ça change.

First, some history

At that time, relief from poverty took the form of the workhouse or strictly regulated ‘outdoor relief’ to those not able to work.

This was frequently supplemented by private arrangements made through friendly societies and similar organisations. Many of these provided (as some still do) benefits as a mutual insurance society.

The first moves to a national scheme came in legislation such as Unemployed Workmen Act 1905 and Old Age Pensions Act 1908.

National insurance was introduced in the National Insurance Act 1911. Apart from some administrative sections, the bill had two parts. The larger part (85 of its 115 sections) was for health insurance. The smaller part was for unemployment insurance.

Most employees became ‘compulsory contributors’. Men paid 4d (four old pence), the employer paid 3d and the state 2d. Thus a man received 9d (just under 4p) worth of cover for a payment of 4d. Lloyd George campaigned with the slogan ‘ninepence for fourpence’. Women paid 3d and had 8d worth of cover.

To encourage employers to employ workmen during times of recession, three schemes of refunds or retrospective National Insurance holidays were introduced. None of them worked (sound familiar?). Two of the schemes were abandoned in 1920 and the third in 1924.

While some forms of health cover had already existed, unemployment insurance was a completely new idea. The first scheme provided seven shillings (35p) a week from the second week, for a maximum of 15 weeks, or one week for every five contributions.

It was restricted to certain occupations and to those earning less than £250 a year. Unemployment benefit was increased and widened in scope under the Unemployment Insurance Act 1920. There was a right for employers to contract out which was ended in 1927.

Not a tax

The government was keen to stress that National Insurance was not a tax and the related benefits were not hand-outs.

It was not legally a tax at all, but an insurance scheme run on a national basis: hence the name. A person paid an insurance premium in the form of contributions.

The money was held in a separate fund. The contributor could then claim on his or her ‘insurance policy’ in the form of benefits. All this is still true - at least in theory.

As post-war euphoria was replaced by 1920s depression, unemployment benefits for a man rose by 132% from seven shillings in 1913 to 16 shillings and three pence in 1931. The worker’s contributions rose by 300% from 2½d to 10d.

There was still an attempt to make contributions fund all benefits. In 1931, there were 2,726,000 people claiming unemployment benefit.

The first break from the contributory principle came in the Unemployment Assistance Act 1934 when unemployment assistance was provided beside unemployment benefit. Assistance was not based on contributions but was means-tested.

A state-funded pension scheme paid by weekly contributions was introduced in 1926 to replace the 1908 scheme.

The state pension age was reduced from 70 to 65. In 1940, it was further reduced to 60 for women as a temporary provision to reflect the fact that many of them had not had the opportunity to pay sufficient contributions. This temporary provision is now being reversed more than 70 years later.

There was a tidying-up of these laws in 1935 and 1936, and a new provision of allowing those not required to contribute to choose to do so. This provision remains as class 3 National Insurance.

Beveridge Report

The next landmark was the Beveridge Report of 1942. The report was written by the Liberal (later peer) William Beveridge, agreed by a Conservative prime minister and introduced by a Labour government on 5 July 1948.

This finally abolished the poor law and established a national scheme where benefits were paid as a right.

William Beveridge proposed a two-part scheme. National insurance would fund contributory benefits. Both the contribution and benefits were to be at a flat rate, regardless of income. National assistance was to be a safety net of non-contributory benefits funded by the Exchequer.

This included, for the first time, a form of child benefit known as family allowance payable for the second and subsequent child, but not for the first.

In 1968, it was considered inappropriate for wealthy families to receive national assistance in the form of family allowance, so a clawback arrangement was introduced in the income tax system. There is nothing new under the sun.

The social security system for the first time recognised industrial injuries as a separate category. These benefits were originally paid from a separate fund with its own contributions.

The report had proposed dividing the population into six classes, according to their economic activity. The original classes III (housewives), V (children) and VI (retired) were exempt from paying contributions. Their benefits would be funded by the Exchequer.

The other three classes were: I (employed), II (self-employed) and IV (others of working age not gainfully employed). This distinction remains as classes 1, 2 and 3 of National Insurance.

Each of these classes were entitled to a different range of benefits, and bought a weekly stamp to put on a card. Class I, as now, also had a contribution from the employer, and all three classes had a contribution from the Exchequer.

For example, in 1959, a male employee paid 7s 4½d (about 37p) a week. The employer paid 7s 0½d and the Exchequer 2s 5d, giving a total of 16s 10d (about 84p). Women paid at a lower rate from men and received a lower rate of benefits.

This flat rate scheme continued until 1973, within living memory of some readers, when an employee was paying just 96p a week, regardless of earnings.

Breaking the link

Almost every element of the Beveridge Report was abandoned during the 1960s and 1970s. The first break came with the Labour manifesto of 1964. This promised:

  • an earnings-related supplement to benefits; and
  • an income guarantee to provide a minimum level of benefit.

The former is the exact opposite of means-testing such as for tax credits. It means the better-off receive more social security on the grounds they have contributed more and have a higher standard of living to maintain.

This principle is still maintained in the state earnings-related pension scheme (SERPS) which subsequently became the state second pension, so our current social security system both rewards and penalises the wealthy.

The income guarantee never happened, at least not for more than 30 years.

With benefits now related to earnings, it was reasonable for National Insurance to be earnings-related also. This finally happened in 1975.

Once an employee had earned £11 a week, the employee paid 5.5% on all income (including the first £11) up to £69 a week. The employer paid 8.5% on the same figure. No National Insurance was payable on earnings above £69.

Earnings-related benefits were finally phased out in 1982, but earnings-related contributions remain.

The link between contributions and benefits was further weakened on both sides. On the social security side, new non-contributory benefits were introduced: pensions for over-80s (1970), attendance allowance (1971), invalidity benefit (1971), and invalid care allowance (1976).

On the National Insurance side, three new classes were added which earned no entitlement to any benefit, and are pure taxation. These are class 4 (1975), class 1A (1991) and class 1B (1999).

A secondary rate above the upper earnings limit for class 1 is also pure taxation (1985 for employers, 2003 for employees).

On all class 1 payments above the earnings threshold, the only extra benefit earned is additional state second pension. The rest is, again, pure taxation.

Why not unite the schemes?

From 1975 to now, rates of class 1 National Insurance have risen from a total of 14% to 25.8%. Over the same period, the basic rate of income tax has fallen from 35% to 20%. Total class 1 National Insurance first exceeded the basic income tax rate in 2000.

Also in 1975, National Insurance could easily be avoided by providing remuneration as benefit in kind.

As National Insurance rates rose, so did the realisation that it was ludicrous to have two different taxes on the same income. It was possible for a person to be regarded as employed for one and not the other, while benefits and expenses were subject to different rules.

In 1993, a working party was set up to harmonise the two regimes. This removed many of the discrepancies, although it was only in April 2012 that self-employed part-time lecturers escaped class 1 National Insurance. Even today, there are still some different rules.

For example, when reimbursing an employee for business use of their own car above 10,000 miles, the maximum tax-free rate is 45p for National Insurance but 25p for income tax.

Tax relief for occupational pension schemes is also given differently. Income tax relief is given by subtracting the contribution from gross pay and taxing the net figure. For National Insurance, tax is charged on gross pay but may be relieved by paying a lower rate.

We also have the anomaly that someone with two part-time jobs, each paying £100 a week, pays no National Insurance as each job falls below the earnings threshold, whereas a person earning £200 a week has to pay National Insurance.

The PAYE principle of cumulation is not applied to National Insurance, except for directors, for no good reason. National Insurance is also a regressive tax in that its rate for employees drops from 12% to 2% once the upper earnings limit has been reached.

Recent thoughts

The idea of merging tax and National Insurance goes back to 1978 when British Tax Review suggested removing disparities that were ‘unnecessary and unfair’. Since 1984, various reports have suggested how a merger could be effected.

A government green paper in 1986 included a detailed summary of the benefits of merger. In reality, the only two actual developments towards merger were independent taxation of husbands and wives in 1990, and linking the National Insurance earnings threshold to income tax thresholds, introduced in stages from 1999.

The Better Regulation Task Force noted in 2000 that ‘really big regulatory gains’ could be gained by merging the two taxes. At that time, the Inland Revenue listed the issues involved and then concluded:

‘The government is not persuaded that radical reform of the tax and National Insurance contributions systems is the best way of delivering worthwhile simplifications for employers.’

Employers have repeatedly said the opposite.

In 2011, the Chancellor of the Exchequer announced that he would merge the operation of income tax and National Insurance, but without extending it to pensioners or removing the contributory principle. Consultation documents have been produced.

This is like announcing the re-invention of the wheel, provided it is square, and has no axle, and consulting on what colour it should be.

In fact, the problems of a complete merger are not insuperable. Extending National Insurance to pensioners could be compensated by a generous age allowance, which would particularly help pensioners on lower incomes.

Extending National Insurance to investment income seems a reasonable move (and would end much tax avoidance). It could also allow tax rates to be reduced.

As for the contributory principle, the centenary of National Insurance is perhaps an appropriate time to acknowledge that it is no longer appropriate to deny benefits to those who were not able to pay contributions.

For pensions, the issue is admittedly less simple but not insoluble. The successive introduction of SERPS/state second pension, stakeholder pensions and now NEST (national employment savings trust) are all tacit admissions that National Insurance has failed to provide an adequate state pension scheme.

Sadly, the government seems more interested in rehearsing the issues rather than addressing them.

Robert Leach is an independent tax adviser who can be contacted on 020 8224 5695 and on email


Issue: 4353 / Categories: Comment & Analysis , Income Tax
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