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Merging income tax and NICs may be on Budget agenda

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The Chancellor may take the opportunity of the 2011 Budget to examine the possibility of merging income tax and national insurance contributions.

The case for doing so was set out in the recent review of small business tax published by the Office of Tax Simplification.

Since the publication of the review’s recommendations, Mr Osborne has signalled a receptivity to the idea.

He may outline plans for a merger when he makes his Budget statement on 23 March. The virtue would be a streamlining of the tax system and a reduction in the cost of collecting taxes.

When they were established at the beginning of the twentieth century, NICs were based on a contributory idea, but changes over the intervening decades has seen that principle softened. According to the OTS just six state benefits now rely on NIC contributions in order to qualify people for benefits. These include the basic state pension, maternity allowance and incapacity payments.

The decision to bring in a flat rate state pension of £140 a week determined by residence instead of by payments could add to the growing obsolescence of NICs.

Changes would also simplify current differences in taxation rates for the employed and the self-employed.

Backing its argument for a merger, the OTS pointed out that, although the employed and self-employed pay income tax at the same rate, NICs for employees is higher.

What’s more, income tax paid on dividends can be 15 per cent shy of the rates charged for those paid by salary and does not come with the NIC liabilities faced by those on salaries. This, the OTS said, provides a strong incentive for people to work through a limited company and reward themselves with dividends.

The savings for someone paid this way compared with an employee can be as high as £7,000 in tax on earnings of £50,000.

There are anomalies on benefits too. Some are free of income tax and NIC, whereas some are free of either income tax or national insurance.

The OTS report warned, however, that any move towards a merger would be complex.

There are perceptional risks too. Many taxpayers tend only to look at the income tax rate as their true rate of taxation rather than adding NICs. A merger would be seen, therefore, as an automatic rise in the marginal tax rate. Basic rate taxpayers could be looking at a new income tax rate of 32 per cent.

Were the two taxes to be merged, the Government would have to find the estimated loss in employers’ NICs of £60 billion from another source. Pushing the NIC threshold to that of income tax could also wipe out a further billion in tax take.

Changes, though, are likely to be some way off, with perhaps the Chancellor establishing a review of the detailed recommendations by the end of the year.

What will happen sooner on NICs is that employees will experience an increase come 6 April. For basic rate taxpayers, the NIC rate will climb from 11 per cent to 12 per cent; for higher earners, the NIC rate will go up by 2 per cent on earnings over £42,475.

The employers’ rate will also encounter a hike, up by 1 per cent to 13.8 per cent. This, however, will be tempered by a corresponding rise in the weekly pay threshold, so exempting any increase payable on employees earning less than £20,000.