Will the Chancellor replace employer National Insurance with a payroll levy?

Published on Tax and Welfare

The Autumn Statement – the first fiscal statement not delivered by George Osborne since March 2010 – will be no small event. Given the replacement of the Prime Minister and Chancellor, the economic implications of the Brexit vote and the resetting of fiscal policy for the rest of the parliament, there will be plenty to watch out for. But despite the post-referendum turmoil, there are some unrelated areas of policy making that promised to be significant before the referendum and remain so. This includes the work of the Office of Tax Simplification (OTS) on aligning National Insurance (NI) with income tax. These wide-ranging proposals, expected to be complete before the Autumn Statement, ready for a government response, are potentially very significant.

The OTS will be making proposals on reforming the NI that is paid by employees and the self-employed. These include making this personal NI annual and per individual (like income tax) rather than weekly and per job as it is at the moment. These changes will have their own big implications both for individuals and the government’s tax take and deserve separate scrutiny.

But the focus of this blog is on potential proposals for employer NI. In a report in March the OTS recommended that the structure of employer NI should be reviewed and this work is now underway. We don’t yet know what the OTS will ultimately recommend. But the original document gave a preliminary outline of some of the approaches that could be considered, and these provide cause for concern. The reforms explored so far appear to pose a serious risk to the earnings or employment of low paid workers, and would do nothing to deal with the biggest distortions caused by employer NI – such as a bias against formal employment.

Employers pay employer NI at a rate of 13.8 per cent on each employee’s wages above £156 a week (around £8,100 a year). This threshold – a bit like the personal allowance for individuals’ income tax – is known as the secondary threshold. One of the alternative approaches the OTS floated in March was to scrap this secondary threshold entirely. Instead, there would be a flat rate of tax on all payroll costs. So instead of paying tax on any pay above £8,100, tax would be paid from the first pound. In isolation, this would raise around £28 billion a year for the Treasury (using 2015-16 figures), but the OTS report observed that this could be used to lower the rate from 13.8 to around 10 per cent. This would be a huge tax change.

The new system – which the OTS say could be renamed as the ‘payroll levy’ – would be simpler. Rather than calculate employer NI employee-by-employee, employers would only need to know their aggregate pay bill to calculate their tax liability. The OTS also noted that removing the secondary threshold could reduce any incentive to hire multiple employees on small numbers of hours rather than one employee full-time.

While the money raised from scrapping the threshold could be used to significantly lower the payroll tax rate, a second possibility explored in the OTS report would be to vastly increase the size of the per-employer Employment Allowance (currently £3,000). This would reduce the number of businesses that pay any employer NI or ‘payroll levy’ at all – perhaps to fewer than 1 per cent of employers. This too would be a simplification, and a large tax cut for SMEs (with obvious political appeal). But it would be a large tax increase for the rest and an overwhelming subsidy for smaller businesses over larger businesses, with very large distortionary effects and a big risk to the tax base if large employers were to restructure into (or be replaced by) smaller ones.

The payroll levy idea does have some attractions from the point of view of simplification. But these should be outweighed by the downsides. Below are the results of some simplistic modelling of what the revenue-neutral flat rate option (just under 10 per cent in these calculations) would mean. This includes abolishing the employer NI exemption for under 21s and apprentices under 25 (which don’t seem compatible with a payroll levy) and no changes to the Employment Allowance. In this case, almost two thirds of employees – those paid up to around £30,000 a year – would cost their employers more, with the top-paid third costing less. The cost of employing those with the lowest weekly pay – those earning below the employer NI threshold – would rise by almost 10 per cent.

Impact on labour costs of abolishing the threshold for employer NI and lowering its tax rate

Source: RF modelling using ONS, Annual Survey of Hours and Earnings 2015

Theory would suggest that “although employers and employees formally pay separate National Insurance contributions on the employees’ earnings, the eventual economic incidence of the contributions is likely to be the same”, as the IFS’s classic Tax by Design puts it. Put simply, it’s reasonable to assume that any increase in employer NI will ultimately lead to lower pay for employees. In this case, a 10 per cent rise in labour costs might eventually leave gross pay 10 per cent lower than it would have been for those employees. A small cut in labour costs for the highest paid could equally be expected to boost those employees’ pay in the long run.

While some employers could instead absorb the costs, higher labour costs might be expected in theory to reduce employment. While the same was said of the minimum wage and this turned out not to be accurate, a regressive increase in payroll taxes differs in that: a) it’s of no (direct) benefit to employees; b) it affects a much greater proportion of the workforce; and c) would come on top of welcome policies like the National Living Wage and apprenticeship levy and at a time of some economic uncertainty. Hiking up employer taxes by 10 per cent on low paid workers does not appear wise for the foreseeable future.

Of course, different people, sectors and regions would be affected to very different degrees. Such a regressive tax change as the one modelled here would be a transfer of £1.6 billion per year to London and the South East – regions where there are more high-paid workers – from the rest of the country. It would be a tax cut of over £600 million per year for the finance sector, and a tax rise for sectors like retail (£900 million) and care (£500 million). The eventual losers (either in terms of pay or employment) would be disproportionately women, part-time workers, the youngest and the old.

Cutting the tax rate to around 10 per cent, as modelled here, is just one of the possibilities the OTS may recommend to create a revenue-neutral package. Taking smaller employers out of tax would have different impacts. However, leaving aside the massive corporate distortion this would create, scrapping the secondary threshold for workers in larger firms (around half the workforce) would mean a flat payroll tax increase of over £1,100 per employee within big employers and a regressive payroll tax cut for employees of smaller firms.

There are certainly problems with employer NI. Chief among them is the distortion it creates against employment and in favour of self-employment (not to mention investment income and capital gains). The possibility that this tax difference unfairly favours corporate models like those of Uber, Hermes and Deliveroo, which use self-employed workers, does need fixing somehow (whatever the independent merits of those companies). The alternatives outlined so far by the OTS do nothing to help this – and indeed would worsen the bias by increasing taxes on low paid employment but not self-employment.

The government should give serious consideration this Autumn to many of the OTS’s NI proposals – such as on employee and self-employed NI – but, while their final recommendations may differ from the examples explored so far, any proposal for a £28 billion employer NI tax shift that would hurt low paid employees should be quickly dismissed by the new Chancellor.

Note: The tax modelling above is based on statistical data from the ONS which is Crown Copyright. The use of the ONS statistical data in this work does not imply the endorsement of the ONS in relation to the interpretation or analysis of the statistical data. This work uses research datasets which may not exactly reproduce National Statistics aggregates.