National Insurance Contributions (NICs) and the self-employed

National Insurance contributions – NICs, for short – are paid by employees, employers and the self-employed. NI receipts are used to fund contributory benefits: the state pension, contributions-based jobseeker’s allowance, contributory employment and support allowance, maternity allowance, and bereavement benefits. In turn entitlement to contributory benefits is based on someone’s National Insurance payment record. Receipts from NICs go into the National Insurance Fund, which operates on a ‘pay as you go’ basis: broadly speaking, this year’s contributions pay for this year’s benefits, though a fixed proportion of NI receipts go to the National Health Service rather than into the Fund.[1]

NICs raised an estimated £132.5bn in 2017/18. This compares with estimated Exchequer receipts from income tax of £180.7bn, and £125.3bn from VAT.[2]

NICs are charged on income from employment and self-employed only, not income from other sources – such as savings, pensions or benefits. Someone is liable to pay NICs if they are aged 16 or over and under state pension age, though employers’ liability to pay NICs on earnings paid to employees is unaffected by employees reaching state pension age.

Employees pay income tax and primary Class 1 NICs on their earnings, deducted at source by their employer under PAYE. Their employer will be liable to pay secondary Class 1 NICs on the employee’s earnings. By contrast, self-employed persons providing their services to clients will receive any payments gross of tax, and be responsible for paying income tax and NICs on their annual profits. Individuals who are self-employed are liable to pay both Class 2 NICs, a weekly flat-rate charge, and Class 4 NICs, based on a percentage of their annual profits. There is a significant financial advantage to individuals working as self-employed rather than as employees. The rate of NICs that the self-employed pay is lower than the rate paid by employees (9% vs 12%), and the self-employed face no equivalent to employer NICs (charged at 13.8%). Employers also have incentives to engage self-employed workers, rather than take on employees: the absence of employer NICs on the payments they make, and the absence of employment rights which employees have.

Over the last decade there has been a significant growth in the numbers of self-employed persons, as well as the numbers of individuals providing their services through a limited liability company that they run as a company owner-manager. While these two groups are often considered together, there are important differences in their treatment by tax and legal systems. In the case of incorporated companies, the profits the company makes are liable to corporation tax, while its employees will be liable for income tax and NICs on their earnings. Company owner-managers may choose to pay themselves dividends to realise a further tax saving as dividend income is subject to income tax but not NICs.

The Institute for Fiscal Studies has published some analysis to illustrate the tax drivers to self-employment and incorporation.[3] For a person generating £40,000 of income per year, the total tax liability, taking into account both employer and employee NICs as well as the individual’s income tax, would be £12,146 if that person worked as an employee. The tax liability would be £8,713 if this income was earned through self-employment, and £7,358 someone provided their services through a company, and paid themselves dividends rather than wages. The IFS note that the figures will understate the potential tax advantages. The self-employed will have more scope to deduct work-related expenses from their income, and both self-employed persons and company owner-managers will have greater opportunities to (legally) avoid or (illegally) evade tax. In its Economic & Fiscal Fiscal Outlook in November 2016, the Office for Budget Responsibility looked at the impact that the current trend in incorporations could have on public finances if it continued, concluding that, “relative to a counterfactual that incorporations increased in line with employment, this takes around £3½ billion off total receipts in 2021/22.”[4]

Historically the self-employed have reduced entitlement to some contributory benefits. In paying Class 2 NICs, they could accrue rights to the basic state pension but not the state second pension, and were not entitled to claim contributory-based jobseeker’s allowance.[5] Payment of Class 4 NICs has not triggered any benefit entitlement. In April 2016 the new single-tier pension was introduced, replacing the basic state pension and state second pension for those now reaching state pension age, and it applies equally to employees and the self-employed.[6] Previously employees had the option to ‘contract out’ of the state second pension and pay a reduced rate of NICs on their earnings. As part of this reform, employees are now all liable to pay the same rate of Class 1 NICs on their earnings.

Although there has been a significant difference in access to contributory benefits between employees and the self-employed, overall the self-employed have paid relatively less into the NI Fund, given what they have been entitled to receive. In the past the size of this subsidy has been put at around £3 billion a year; taking into account the reforms to the state pension, HMRC have estimated that the revenue foregone by applying lower NICs rates to the self-employed exceeded the value of their reduced pension entitlements by £4.1 billion in 2017/18.[7] By comparison projected receipts from Class 2 and Class 4 NICs for 2017/18 is £3.4 billion.[8]

In his Spring 2015 Budget the then Chancellor George Osborne announced that “to support 5 million people who are self-employed and to make their tax affairs simpler, we will, in the next Parliament, abolish entirely Class 2 National Insurance contributions for the self-employed.”[9] In December 2015 the Government launched a consultation on the design of new contributory tests, so that the self-employed would continue to have access to contributory benefits when Class 2 NICs were abolished. In the Autumn Statement in November 2016 the Government confirmed it would proceed with its plans to abolish Class 2 NICs, with effect from April 2018.[10]

In the Spring 2017 Budget the Chancellor Philip Hammond confirmed that Class 2 NICs would be abolished from April 2018, and announced a two-stage increase in the rate of Class 4 NICs, from 9% to 10% in April 2018, and to 11% in April 2019. The Chancellor argued that it was fair to reduce the differential between the rates of NICs paid by employees and by the self-employed, following the introduction of the new state pension.[11] However, a few days later Mr Hammond reversed this decision to increase the rates of Class 4 NICs, on the grounds that it would have breached the ‘tax lock’ pledge made in the Conservative Party’s 2015 General Election manifesto not to increase the headline rates of income tax, VAT or NICs.[12] In his statement to the House, the Chancellor said that the Government would go ahead with the abolition of Class 2 NICs, as it was “an outdated and regressive tax, and it remains right that it should go.”[13]

In November 2017 the Government stated that it would defer the abolition of Class 2 NICs until April 2019, a one year delay to “allow time to engage with interested parties and Parliamentarians with concerns relating to the abolition of Class 2 NICs on self-employed individuals with low profits.”[14] There was relatively little comment on this delay, although the Low Incomes Tax Reform Group welcomed the announcement, “because of our concerns that the abolition of Class 2 was being rushed through without adequate further consultation, together with a lack of publicity and guidance for the people affected.”[15] However, on 6 September 2018 Treasury Minister Robert Jenrick announced that the Government would not proceed with the abolition of Class 2 NICs “during this Parliament … given the negative impacts it could have on some of the lowest earning in our society.”[16]

Notes :

[1] For more background on the National Insurance system see, National Insurance contributions: an introduction, Commons Briefing paper CBP4517, 9 June 2017.

[2] OBR, Economic & Fiscal Outlook, Cm 9713, October 2018 p104 (Table 4.6)

[3] Tax, legal form and the gig economy, Institute for Fiscal Studies, February 2017; and, Helen Miller, “Tax in a changing world of work”, Tax Journal, 21 April 2017. These estimates are for 2017/18.

[4] OBR, Economic and Fiscal Outlook, Cm 9346, November 2016 pp121-3 (Box 4.1)

[5] It is worth adding that unlike employees, the self-employed are not entitled to statutory maternity/paternity/adoption/shared parental pay.

[6] There are transitional arrangements to deal with past contribution records. For details see, The new ‘single-tier’ State Pension, Commons Briefing paper CBP6525, 30 August 2016.

[7] HMRC, Estimated costs of principal tax reliefs, January 2018. HMRC note this “represents the difference between Class 2 and 4 NICs paid by the self-employed on their profits and an estimate of the Class 1 NICs that would be paid at contracted out rates on an equivalent amount of employee earnings. The Class 1 estimate includes employer contributions due but assumes a corresponding reduction in earnings to hold staff costs broadly constant, and also takes account of the resulting reduction in income tax” (fn 49).

[8] Government Actuary’s Department, Report to Parliament on the 2018 re-rating and up-rating orders, January 2018 pp31-2 (Appendix D)

[9] HC Deb 18 March 2015 c777; Budget 2015, HC1093, March 2015 para 2.74

[10] Autumn Statement, Cm 9362, November 2016 para 4.8; HMRC, Abolition of Class 2 National Insurance contributions: tax information & impact note, December 2016

[11] HC Deb 8 March 2017 cc813-4. Taken together it was estimated these reforms would cost £80m in 2018/19, and then raise £215m in 2019/20: Spring Budget 2017, HC1025, March 2017 (Table 2.1 – item 15; Table 2.2 – item am).

[12] HM Treasury, Letter from the Chancellor to the Chair of the Treasury Select Committee, 15 March 2017

[13] HC Deb 15 March 2017 cc420-1

[14] Update on the National Insurance Contributions Bill: Written Statement HCWS220, 2 November 2017; Autumn Budget 2017, HC587, November 2017 para 3.10. These changes were estimated to cost £125m in 2018/19, rising to £645m in 2019/20: op.cit. Table 2.1 – item 66.

[15] LITRG press notice, NICs announcement good news for self-employed on low incomes, 2 November 2017. Prior to this the charity had published some advice for individuals in this position, following the Chancellor’s statement : Self-employed NIC reform – a trap for the lowest paid, 20 March 2017.

[16] National Insurance Contributions: Written statement HCWS944, 6 September 2018. Maintaining Class 2 NICs, while deferring certain other minor planned changes to NICs is estimated to raise £180m in 2019/20, rising to £395m in 2020/21: Budget 2018, HC 1629, October 2018 (Table 2.1 – item 75).