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What would be the impact of the Chancellor’s rumoured plans to merge income tax and national insurance?

22nd July 2015

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According to reports, the Chancellor George Osborne is considering merging Income Tax with National Insurance. Gary Smith, Financial Planner at Tilney Bestinvest looks at five potential implications…

1. Potential reduction in tax liability – the starting rates at which you pay income tax (£10,600) and national insurance (£8,060) are different. Logic would dictate that given the Conservative pledge to increase the personal allowance to £12,500 that this would also have to be the starting rate for any combined income tax / NI rate. This would mean that everyone could earn £4,500 more before paying any NI equivalent. It would also remove the anomaly for those who earn below the personal allowance, but above the lower earnings limit, having to pay NI but no income tax.

2. It would enable the government to increase the rate at which people pay higher rate tax to £50,000, whilst reducing the potential loss to the Exchequer. This is quite devious as, under the current system an individual pays 40% income tax and only 2% NI above the basic rate band. So, if they leave the system as it is, the exchequer will be giving up 20% income tax on circa £8,000 of income if they do increase the Basic rate band to say £50k (including personal allowance). However, if the government merge Income Tax and NI, the effective basic rate tax would be 32% and the higher rate 42%. Therefore, if they increase the basic rate band they are only giving up 10% on £8,000.”

3. The death of pension tax relief? The government has already announced a consultation on the pension tax relief system, and I believe that a merger of Income Tax and NI would likely result in the floated idea of a pension with ISA-like tax treatment. This is because at present, a basic rate taxpayer gets 20% tax relief on pension payments but surely this would increase to 32% under a combined system. It seems illogical to increase tax relief at a time when they are actually trying to reduce the cost to the Exchequer. An equal tax treatment of ISAs and pensions could be a prelude to merging the two, potentially drawing ISAs into some form of limetime allowance.

4. Would any new rate apply to dividends? We have already seen the introduction of tax on dividends for basic rate taxpayers of 7.5% from April 2016. At present, NI isn’t payable on dividends and one could suspect that the government will also seek to increase this rate to reflect the merged rate. Whilst probably below the 32% rate for people with earned income, the additional tax generated could cover the cost of increasing the basic rate band to £50k.”

5. Pensioners – I believe that this could be easily addressed by having a separate tax rate for pension income, similar to savings rate tax. So a 20% tax on the pension income in the basic rate band and 40% etc. thereafter.

Three scenarios:

In order to demonstrate the implications of combining Income Tax with National Insurance, here are three scenarios showing the tax differences should the Conservatives increase the personal allowance to £12,500 and increase the basic rate band to £50,000 (including the personal allowance) by the end of parliament. The current tax year rates and allowances for NI have been used for each scenario.

Individual earning £20k

Current tax rules:

No income tax on first £12.5k.

20% income tax on the remaining £7.5k = £1,500.

No NI on first £8,060

12% NI on remaining £11,940 = £1,432.8

Total tax and NI is £2,932.80

If the tax rates were combined the situation would be:

No tax on first £12,500

32% on next £7,500 = £2,400

This individual would pay £532.80 less tax

Individual earning £50,000

Current tax rules:

No income tax on first £12,500

20% income tax on next £37,500 = £7,500

No NI on first £8,060

12% NI on next £34,320 = £4,118.40

2% on remaining £7,620 = £152.40

Total tax is £11,770.80

If the tax rates were combined the situation would be:

No tax on first £12,500

32% on next £37,500 = £12,000

This individual would pay £230 more tax

So in example 2 the government would be able to increase the personal allowance and basic rate bands to £50,000 and the individual would still pay more tax by combining the rates. This, coupled with a reduction in pension tax relief, is how I suspect they will be able to afford to implement their proposals.

I also believe that, if they do press ahead with an ISA style pension offering with no initial tax relief and, merge tax and NI, they would have to ban salary sacrifice. This is because individuals would be better off (see following example).”

Individual earning £30,000 paying 4% of salary into pension (assuming no pension tax relief)

No income tax on first £12,500

32% tax on next £17,500 = £5,600

Pension contributions = £1,200

Net income = £23,200

Position with salary sacrifice of £1,200

If the tax rates were combined the situation would be:

No tax on first £12,500

32% on next £16,300 = £5,216

Net income = £23,584

This individual would be better off by £384 per year

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