Fiscal rules sound good to economists and are eagerly seized
on by politicians as a good way to appear responsible when it comes to matters
of public finance. Unfortunately, all too often they fall short of the
standards required of them. We all know about the Maastricht fiscal targets
which many EMU countries have found difficult to adhere to. Similarly, the UK
has experimented with a plethora of rules over the years, beginning with the
idea of a ‘golden rule’ designed to ensure that the government only borrows to
invest over the cycle with current spending matching current income. When that
did not work, the government adopted a policy of reducing the structural
deficit – a policy which relies heavily on estimates of the output gap, which
in turn is subject to a huge amount of judgement.
But one of the less clever ideas of recent years was the 2015 Conservative manifesto commitment “to no increases in VAT, National Insurance contributions or Income Tax.” It is not a fiscal rule in the sense of those previously outlined but it represents a “promise” to the electorate upon which an election was fought. It is thus not hard to imagine why Chancellor Philip Hammond’s budget announcement that he planned to raise national insurance contributions (NICs) on the self-employed to bring them closer into line with those paid by employees created such a political furore.
The first point to note is that a commitment not to raise taxation is a foolish policy choice: Every government needs some policy flexibility. By closing off this fiscal option, monetary policy has to do more of the heavy lifting and it is thus ironic that the Bank of England has been criticised by politicians for its policy choices when the government has taken a deliberate stance on taxation. Technically, the Chancellor did break an election pledge – though he can justifiably argue that it was made neither by him nor the current prime minister, and that economic circumstances have changed.
There is also a strong economic case for doing so. The Chancellor’s argument is based on the problem that many people change their employment status to self-employed to benefit from lower taxes in order to sell their services back to their former employer which in turn results in a revenue loss for the Exchequer. Under the current system self-employed people pay NICs at 9% versus employee NICs at 12% and a supplementary rate of 2% on higher incomes. The Chancellor argued that “employees and self-employees use public services in the same way but do not pay for it in the same way.” As Paul Johnson of the Institute for Fiscal Studies argued “A tax system which charges thousands of pounds more in tax for employees doing the same job as someone else needs reform. It distorts decisions, creates complexity and is unfair. The incentives for companies to claim that people who work for them are self employed rather than employees are huge.”
Lest we forget, NICs are supposed to be a tax designed to fund the social welfare safety net. At a time when welfare budgets are under huge pressure the Chancellor is hardly likely to turn down the opportunity to claw back some extra revenue. But one problem, as Ed Conway pointed out in The Times yesterday, is that employee NICs are no longer a hypothecated tax – they are simply seen as a branch of income tax. So why not get rid of them altogether? As the system works at present, those paying the basic rate of income tax face a marginal rate of 32% (20% income tax and 12% NICS) which quickly rises to 42% (40% income tax and 2% NICs) at incomes above £46k per year. A quick set of calculations suggests that assuming tax bands remain as specified for fiscal 2017-18, but abolishing NICs and replacing them with a higher rate of income tax, it is possible to set tax rates which leave most people with a higher post-tax income.
Thus, instead of levying income tax of 20% on the first £33.5k of taxable income (i.e. over and above the £11.5k threshold) plus NICs at 12%, we could replace this with an income tax rate of 33%. The bulk of earners would thus actually receive a post-tax income boost despite the fact that they are actually paying more income tax than they do now. This purely because they are no longer paying NICs which are often viewed as a hidden tax. For upper and higher rate tax payers, it turns out that their incomes are very sensitive to the higher rate (currently 40%). Raising this rate to 41% gives them a bigger income boost (blue line in the chart) than those earning the median wage but increasing it still further, to just 42% means that they suffer modest declines of no more than 0.3% (red line).
But one of the less clever ideas of recent years was the 2015 Conservative manifesto commitment “to no increases in VAT, National Insurance contributions or Income Tax.” It is not a fiscal rule in the sense of those previously outlined but it represents a “promise” to the electorate upon which an election was fought. It is thus not hard to imagine why Chancellor Philip Hammond’s budget announcement that he planned to raise national insurance contributions (NICs) on the self-employed to bring them closer into line with those paid by employees created such a political furore.
The first point to note is that a commitment not to raise taxation is a foolish policy choice: Every government needs some policy flexibility. By closing off this fiscal option, monetary policy has to do more of the heavy lifting and it is thus ironic that the Bank of England has been criticised by politicians for its policy choices when the government has taken a deliberate stance on taxation. Technically, the Chancellor did break an election pledge – though he can justifiably argue that it was made neither by him nor the current prime minister, and that economic circumstances have changed.
There is also a strong economic case for doing so. The Chancellor’s argument is based on the problem that many people change their employment status to self-employed to benefit from lower taxes in order to sell their services back to their former employer which in turn results in a revenue loss for the Exchequer. Under the current system self-employed people pay NICs at 9% versus employee NICs at 12% and a supplementary rate of 2% on higher incomes. The Chancellor argued that “employees and self-employees use public services in the same way but do not pay for it in the same way.” As Paul Johnson of the Institute for Fiscal Studies argued “A tax system which charges thousands of pounds more in tax for employees doing the same job as someone else needs reform. It distorts decisions, creates complexity and is unfair. The incentives for companies to claim that people who work for them are self employed rather than employees are huge.”
Lest we forget, NICs are supposed to be a tax designed to fund the social welfare safety net. At a time when welfare budgets are under huge pressure the Chancellor is hardly likely to turn down the opportunity to claw back some extra revenue. But one problem, as Ed Conway pointed out in The Times yesterday, is that employee NICs are no longer a hypothecated tax – they are simply seen as a branch of income tax. So why not get rid of them altogether? As the system works at present, those paying the basic rate of income tax face a marginal rate of 32% (20% income tax and 12% NICS) which quickly rises to 42% (40% income tax and 2% NICs) at incomes above £46k per year. A quick set of calculations suggests that assuming tax bands remain as specified for fiscal 2017-18, but abolishing NICs and replacing them with a higher rate of income tax, it is possible to set tax rates which leave most people with a higher post-tax income.
Thus, instead of levying income tax of 20% on the first £33.5k of taxable income (i.e. over and above the £11.5k threshold) plus NICs at 12%, we could replace this with an income tax rate of 33%. The bulk of earners would thus actually receive a post-tax income boost despite the fact that they are actually paying more income tax than they do now. This purely because they are no longer paying NICs which are often viewed as a hidden tax. For upper and higher rate tax payers, it turns out that their incomes are very sensitive to the higher rate (currently 40%). Raising this rate to 41% gives them a bigger income boost (blue line in the chart) than those earning the median wage but increasing it still further, to just 42% means that they suffer modest declines of no more than 0.3% (red line).
These are little more than back-of-the-envelope calculations
but they demonstrate how easy it is to play with various tax options to benefit
particular income groups. It tells us, too, that much of the current furore
over what level to set NICs for different groups is misplaced. Tax simplicity is
a critical element of any tax system. And as the influential Meade Committee
Report noted in 1978 “the very fact that over
recent years there have been so many changes in the tax system suggests that an
essential need is to put a stop to this bewildering process of altering each
element of the tax system as soon as the taxpayer gets used to it and arranges
his affairs appropriately.” What was true almost 40 years ago is still true
today.
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