Budget implication: we need to talk about the state pension


The headline news in the Budget was a 2p cut in the main rate of National Insurance contributions for employed and self-employed people. This was the second such cut, the first being in the Autumn statement. And the Chancellor expressed an intention to go much further. He trailed the idea of abolishing personal National Insurance completely. 

These changes will have far-reaching implications for the state pension. 

The cuts to National Insurance together reduce the main rate for employees from 12 to 8 per cent, and for self-employed people, from 9 to 6 per cent of taxable profits. The self-employed also benefit from the forthcoming abolition of Class II National Insurance, a regular payment of currently £3.45 per week if profits are higher than the personal tax allowance of £12,570. Overall, therefore, this is a cut of about 4 per cent in personal tax rates for most workers. 

People who earn less than £1,048 per month don’t pay personal National Insurance, and therefore won’t benefit from this measure. And for workers on slightly higher incomes, the effect of the cut will be offset by freezing of the personal tax allowance and other tax rises. The Resolution Foundation estimates that overall, workers earning below £19,000 will suffer a net increase in tax. 

And there’s a much larger group that won’t benefit from the National Insurance rate cuts. State pensioners don’t pay National Insurance even if they are working. So, like low-income workers, they will suffer a net increase in tax: the state pension will rise by 8.5 per cent in April 2024, but because personal tax allowances are frozen, this will result in higher income tax payments for many. 

The people who most benefit from the National Insurance rate cuts are workers on middle to high incomes. This is understandable, since the Chancellor wants to attract Conservative votes.

However, cutting National Insurance rates rather than income tax rates may misfire, not least because it doesn’t benefit pensioners. The latest opinion polls show Labour extending its already enormous lead. 

The cuts to personal National Insurance rates will mean lower National Insurance receipts, though the Chancellor has offset this to some extent by freezing the thresholds for employers’ National Insurance. Many people might say “why does this matter”? Surely all taxes just go into the general pot, so it doesn’t really matter which one you cut.  

But National Insurance is not an ordinary tax. It is widely (though incorrectly) regarded as contributions to a personal state pension fund.

And it is designed to give this impression. There’s even a “National Insurance Fund” (NIF). This is not an investment fund, though it does receive some investment income. It acts more like a current account, receiving National Insurance contributions and paying the state pension and certain other welfare benefits. 

The fiction that people pay into a state pension fund which is invested on their behalf for their own future state pension has been preserved by successive governments since 1948. Originally, the purpose of this fiction was to create a link between “contributions” and “receipts”: only those who had contributed enough to the “fund” would be able to receive from it.

This is preserved today in the form of National Insurance “qualifying years”. These have no real financial value: the amount of National Insurance people pay during their working lives depends on their income, and since the abolition of the state second pension in 2016, now bears no relationship to the amount of state pension they will receive. But people nevertheless believe there is a direct relationship between the amount they “pay in” and the amount of state pension they will receive. ]

This belief is reinforced by the fact that people can pay for additional NI “years” if they find themselves short of the number needed to qualify for a full state pension. The system is, to put it mildly, a confusing mess. 

Abolishing personal National Insurance would break the link between National Insurance contributions and state pension entitlement. This might be welcome, but it is not something to be undertaken lightly. The state pension would have to be redesigned, either to eliminate the personal contributory principle – perhaps replacing it with a residence qualification – or to replicate it by some other means.

It is disturbing that the Chancellor has trailed this as a future objective without any consideration of the considerable implications for future state pensioners. 

Cutting the rates of National Insurance won’t immediately require a change in the design of the state pension. But it has such serious implications for its funding that redesign will become necessary in the longer term.

The NIF has for some years now run a surplus, which is lent to the government to fund public spending. At the end of March 2023, the surplus was some £72bn, up from £57bn in 2022. However, this is far from the healthy situation it appears to be. 

In his quinquennial review of the National Insurance Fund published in 2022, the Government Actuary said:

“The principal projection to 2085-2086 shows that the Fund balance is projected to rise to £104.9bn in 2032-2033 then to decrease and, in the absence of any additional financing, will be exhausted in 2043-2044. This projection does not allow for any Treasury Grants1 that may be paid in the future to support projected benefit expenditure.”

This assessment was based on the rates of National Insurance in force at that time. The Government Actuary has yet to evaluate the effect of the Chancellor’s rate cuts on the NIF’s balance, but it seems obvious that unless average wages rise significantly faster than the state pension – which is impossible while the triple lock remains in force – the NIF will be exhausted very much sooner than envisaged.

The government has in the past “topped up” the NIF when its reserves fall below the statutory minimum of one-sixth of expected outgoings. The last time it did this was in 2014-16, when it paid in £14.2bn from general taxation.

But once the NIF was exhausted, the state pension would become simply a welfare benefit funded from general taxation. And at this point, there would be no further reason to preserve the fiction of the “contributory principle”. Personal National Insurance could be abolished as a separate tax. 

Perhaps this is the future towards which the Chancellor is looking. But if so, he really should be open about it. Abolishing the contributory principle in state pensions would anger very many people, and abolishing a tax specifically intended to fund the state pension would frighten very many more.

Many of today’s young people already believe there will be no state pension by the time they become too old to work. These moves would seem to reinforce their view. 

We need to have a sensible debate about how best to make sure that elderly people are properly supported. This is not the right way to go about it. 

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