A complete overhaul of the national insurance system could create a fairer system for all workers but it would be a brave move for the government.
The UK has seen a rapid growth in self-employment in recent years. The number of self-employed people increased from 3.3 million (12 per cent of the labour force) in 2001 to 4.8 million (15.1 per cent) in 2017.
This shift has been reflected in advisers’ business plans, with a greater focus on entrepreneurs as clients. But the change has also
been personal, as many larger advice firms turn to a self-employment model.
The Treasury is struggling to adapt the tax and National Insurance environment for this new world. Over the past 18 months, the government has twice performed a U-turn on changes to National Insurance Contributions for the self-employed.
In March last year, the chancellor rapidly back-pedalled from a proposed increase to Class 4 NICs for the self-employed, when this was met with outrage. The Treasury also recently announced it was not going ahead with a plan to abolish Class 2 NICs in April 2019.
Currently, the self-employed pay a flat-rate contribution of £2.95 a week if their profits are over £6,205. In addition, they pay Class 4 NICs of 9 per cent on profits between £8,424 and £46,350 (and 2 per cent on profits over £46,350).
Getting rid of Class 2 contributions was proposed to make life easier for the low-earning self-employed, saving three million people £153.40 each year. It would also have simplified the tax system for the self-employed. However, having delayed the abolition once already, the government has now announced it won’t go ahead at all. There are many rumours circulating as to why. One theory is it allows the government to hold on to what it has estimated to be £360m a year – a welcome inflow at a time when it is scrabbling down the back of the metaphorical sofa for every last penny.
The government maintains the change of plan is because of the unintended consequences for low-earning self-employed people.
The rub lies in how much it costs the self-employed to build up state pension entitlement. Paying Class 2 NICs means gaining access to contributory state benefits, whereas Class 4 NICs do not currently do this.
Even if their profits are below £6,205, the lower-earning self-employed can choose to voluntarily pay the Class 2 NICs to gain access to the state pension. They can build up a year’s NICs for the cost of £153.40.
If Class 2 NICs had been abolished, changes would have been made for Class 4 NICs to have counted for benefit entitlement. But this would have meant the lowest-earning self-employed would not have been able to build up state pension entitlement unless they opted to voluntarily pay Class 3 NICs. These cost £14.65 a week – meaning a year’s NICs to count towards the state pension would cost £761.80, nearly five times as much as the cost of paying through Class 2 NICs.
Whatever the government’s motivation for the U-turn was, we are left with a tax system for the self-employed which is not only complicated but also, some argue, unfair when compared with the rates the employed pay. Everyone who has built up enough years of NICs now receives the same state pension, whereas previously the self-employed would miss out on the additional state pension and only be entitled to the basic state pension. So the argument follows the NICs rates for self-employed and employed people should be more equal.
However, in July the Office of Tax Simplification stated: “The self-employed are paying only 37 per cent of the NICs that would be paid if they were employed. Differential benefit entitlements that remain may justify some difference in tax rates but not on anything like this scale.”
So where does this leave the government? It cannot cut state pension benefits for the self-employed. But equally after getting its fingers burnt last year – proposing a rise in Class 4 NICs and then having to backtrack – it will struggle to ask the self-employed to pay more.
It has restated its commitment to simplifying the tax system for the self-employed and has said it will keep this issue under review.
The answer may lie in a complete reform of NICs. The boundaries between employments are far less clear-cut today. Some people merge together employment and self-employment, others are on zero-hours contracts. There are also 2.8 million people who worked in the gig economy in the UK last year.
Redesigning the NICs system to reflect these changes may be the best option to create a fairer reflection of what people pay and what benefits they receive (aligning income tax and NI could be another – more radical – route).
But, unfortunately, taking this direction would create the most challenges and only a “brave” government may attempt it.
Rachel Vahey is product technical manager at Nucleus