Self's assessment: class 2 or not class 2?

On 6 September 2018, Exchequer Secretary Robert Jenrick announced that the government was not going to proceed with the abolition of class 2 national insurance contributions during this Parliament.

 

The headlines were predictable. ‘Philip Hammond has scrapped a planned £150-a-year tax cut for self-employed people’, said The Independent, describing it as ‘the latest government U-turn’. Labour’s shadow chancellor John McDonnell called the Treasury’s reversal a ‘betrayal of the self-employed’.

 

Those of us who remember the furore over the proposed ‘pasty tax’ in 2012, which led to the Budget being labelled an ‘omnishambles Budget’, are well aware that any tax rise – or, in this case, the reversal of a planned cut – will be met with howls of protest. But is the protest justified in this case, or is there more to the story?

 

First, let’s look at why the cut was scrapped.

 

The stated reason was that it would introduce more complexity and could have ‘negative impacts’ on some of the very low paid. This is due to the interaction between class 2 and state pension entitlement: class 2 is a flat rate of NICs, paid at a weekly rate of £2.95 on profits over £6,205. But if your profits are lower than this, you can pay voluntary class 2 in order to be credited with an extra year’s state pension entitlement. At a one-off cost of £150 to earn a potential extra £244 (a 35th of the full state pension) per annum, this is astonishing value – even though many of those on such low incomes will have little chance of affording it. However, abolishing class 2 would put that cost up to the class 3 rate of £14.65 per week, or £762 per annum – a very large jump for the lowest paid.

 

So the reasons given were true, but there is indeed more to the story.

 

Originally, George Osborne proposed the class 2 abolition in 2016. In his first Budget in 2017, Philip Hammond intended to go ahead with removing class 2, but would also have raised class 4 by 1% from April 2018 and a further 1% in April 2019. Instead of costing £360m for the abolition of class 2, the net revenue from the increases would have brought in £1.4bn a year by 2021/22. However, the chancellor was forced to scrap the increases, as they would have breached a manifesto promise, so he put the class 2 changes on hold as well.

 

The Institute for Fiscal Studies (IFS) spoke out strongly in favour of the original proposed increases, with IFS director Paul Johnson saying that it was a ‘modest but welcome change … taking a small step to correcting a big problem with the current tax system’. The big problem, as the IFS has pointed out in detailed research, is that the NICs system strongly favours the self-employed over the employed, with a net subsidy currently calculated to be around £4.1bn.

 

As HMRC points out in its factsheet, historically the differences reflected lower entitlements to benefits and statutory payments; over time, that gap has reduced however. In particular, the new state pension is available to both the employed and self-employed.

 

Many self-employed people will, quite naturally, object to the idea that they should pay more in tax or NICs. They will point to the uncertainty of their income, and the risks that they are taking – but a key point, made well by the IFS, is that the tax system is a poor tool to compensate for those risks.

 

Indeed, as pointed out by Ben Chu in an excellent article in The Independent on 9 September, the distortions are a powerful incentive to hire people as temporary contractors rather than full-time employees. As he puts it: ‘Plenty of people who are self-employed today, particularly in the gig economy, would prefer to be employed.’

 

In the current fiscal climate, reducing NICs for employees seems very unlikely – so if the gap is to be closed, it will have to be by increasing NICs for the self-employed, no matter how unpopular that will be.

 

There is also the thorny problem that the major gap is as a result of employer’s NICs – and how could you impose employer’s NICs on a self-employed person? Raising class 4 NICs to the combined class 1 employer and employee’s rates of 25.8% would be an eye-watering rise. 

 

Of course, it would be better to follow through on the Taylor review and take a thorough look at the whole system of employment and benefit rights, as well as taxation, but that would take even more political will to push through.

 

In my view, what may come to Philip Hammond’s rescue is the promise of an extra £20bn for the NHS. While paying more tax or NICs may be a bitter pill to swallow, the idea that it is helping to fund the NHS may make the medicine go down more easily.