TAX REFORM IN THE U.K.

Last week's Budget in the U.K. was a bit of a damp squib. Normally one of the set-piece events of Parliament, setting out the tax changes to the new fiscal year starting on 6 April, everything was constrained by the Coalition's emergency Budget of last summer, which set out the medium-term plan of tax rises and spending cuts designed to sort out the country's finances, and the pre-Budget report of last autumn, which detailed where those spending cuts would fall. Having made the strategic decision to stick to the plan, despite a poor economic performance in the fourth quarter of 2010, Chancellor Goerge Osborne was reduced to announcing a series of "lollipops", as they are known in the trade, eye-catching initatives that don't cost much and so can't do much harm.   

However, tucked away in the bowels of the Budget speech was one potentially major reform. The Chancellor will consult widely about the possibility of integrating the regimes for income tax and national insurance contributions (NICs). First introduced in 1911, NICs were originally, as their name suggests, insurance premiums designed to protect workers against illness and unemployment; they were then extended to cover pensions. This insurance aspect remains in one respect, since the right to a state pension and other benefits depends on one's having contributed (i.e. paid) NICs for a certain number of years; so, although I have not lived in the U.K. since 1992, I still have the right to a full basic state pension when I retire, since I have paid voluntary contributions each year from wherever I have been living. However, since pensions are paid by the Government on a pay-as-you-go basis, and since other welfare benefits have emerged to take account of illness and unemployment, NICs have gradually come to seem from a fiscal point of view more and more like any other tax. Calls to merge them with the general tax system have, therefore, been around for many years.

All of which seems both sensible and straightforward. There is however a big "but", which makes the whole thing fiendishly difficult; the bases for the two systems are different. As one famous House of Lords tax case put it, income tax is a tax on income, meaning all income; NICs, on the other hand, are a tax on the earnings of employees and the self-employed, but are not levied on other forms of income. For many people, earnings from employment are the whole or main source of their total income, so the distinction is not material. But for some groups, they are. When you look at those groups, you quickly realise that merging tax and NICs is not easy.

Who pays tax, but no NICs? One group of people here are those with no job, but lots of non-employment income such as dividends and interest; rich landowners and their ilk. Subjecting them to NICs would probably go down well in these straightened times. But there is another, much larger, group in this category, and that is pensioners. Not only are pensions not subject to NICs, but neither are pensioners' employment earnings, even though they would be NIC'able for anyone else. Tinkering with pensioners' rights is generally considered to be the third rail of Western politics; touch them and you die. This assumption is currently being reviewed (eg in Greece), as rich societies come to the realisation that the benefits they have promised pensioners are simply not sustainable in the long-run. Nevertheless, it remains the case both that pensioners represent a formidably united lobbying group and that they are the part of the electorate who are most likely to vote. For these reasons tax-reforming politicians tend to treat them with kid gloves.

Who pays NICs, but no tax? This consists mainly of low-paid workers. The personal tax allowance (the amount of income that is tax-free) is £7,475 from 6 April 2011, or £143,75 per week. The lower limit for NICs, on the other hand, will be £102 per week. In a previous move to combat this discrepancy, earnings up to £139 a week are NIC-able, thereby giving the working poor access to other benefits, but are not in fact paid (I told you this was not easy). However, £139 is still not the same as £143,75. Moroever, NICs are payable per job, so someone doing two part-time jobs paying £100 a week pays no NICs, whereas someone doing one job paying £200 a week does. Aligning the tax and NIC systems at the bottom end, and smoothing out all the wrinkles and interactions with the rest of the benefit system would undoubtedly make life easier all round. The problem with any changes at the bottom end is that they benefit everybody above it, and so are hugely expensive; every pound of change costs a lot. That is not easy in the current climate.

These are just a sprinkling of the problems that need to be ironed out. Which is why previous Governments have looked at this issue and backed away. When I worked in the Treasury at the end of the 1980's, a possible merger of the two systems was a hot topic, but it was "kicked into the long grass", along with reform of the residence rules, as simply too difficult. Since then, the system has become even more complicated and tangled, partly because of the deemed contribution change outlined above and partly because of Gordon Brown's new system of tax credits. And we haven't even begun to discuss the tax treatment of couples.

So, my prediction is that Mr. Osborne will consult widely, over a long period of time, and then not do very much.

Walter Blotscher