House of Commons - Social Security

Select Committee on Social Security Fifth Report

THE CONTRIBUTORY PRINCIPLE

National Insurance at a cross-roads: options for the future

121. The National Insurance system is at a cross-roads. At one end of the spectrum is a wholly means-tested system providing a safety net for the poor, with the majority having to make their own private provision. At the other, is a social insurance system capable of supporting people without resort to means-testing in which all have a stake.

122. In attempting to look into the future directions our social security system could go, we were hampered by the lack of data on the financial implications of the various proposals for change put before us. We therefore commissioned two pieces of research aimed at exploring in broad terms some of the potential options. One was from Ms Holly Sutherland of the Microsimulation Unit at the University of Cambridge and the other from Mr Andrew Young, Deputy Government Actuary. The questions put to Ms Sutherland and Mr Young did not represent firm ideas for reform held by the Committee. Rather, we were attempting to get a rough, and necessarily incomplete picture, of the financial implications of options for change. To recycle a quotation referred to by Ms Sutherland, "Models do not give answers, they give insights."[218]

123. Ms Sutherland of the Microsimulation Unit at the University of Cambridge was commissioned to model the financial consequences of moving towards a wholly means-tested social security system.[219] The key questions she was asked to answer were:

(a) Scenario A

What would be the cost of a social security system (and hence the savings) if contributory benefits and those non-contributory benefits that are intended for earnings replacement were abolished?

(b) Scenario B

As an alternative, what would be the cost of the above, if the basic pension were allowed to remain?

In Scenarios A and B, what would the cost (and reduced savings) of relaxing the rules for means-tested benefits by:

(ii) increasing the capital limits on all means-tested benefits to £20,000, and raising the threshold for tariff income from £3,000 to £10,000?

(iii) increasing all means-tested benefit personal allowances and premiums by 10 per cent save for the carer's premium, and raising the latter by 100 per cent?

(iv) a combination of (i), (ii) and (iii)?

Ms Sutherland was also asked to consider different methods of financing the above. These were: retaining the existing National Insurance contribution system as a revenue raising mechanism for the proposed benefits system; abolishing National Insurance contributions completely and raising income tax; using the existing National Insurance contribution structure as the basis for an earmarked social security tax; and creating a 'flat' tax on all earned and unearned income.

124. A second piece of research was commissioned from Mr Andrew Young, Deputy Government Actuary. He was asked to consider the financial implications of reforming the contributory system in various ways which had been suggested to us during the course of the inquiry.[220] He was asked, in particular, to consider the implications of proposals put to us by Mr Field for a new stakeholder pension. We also asked Mr Young to examine the cost implications of four further proposals:

(ii) as above, but increasing the level of benefit payment equal to the corresponding Income Suppport rates;

(iii) payment of a benefit to carers of disabled people at either the rate of Jobseeker's Allowance, or Incapacity Benefit;

(iv) reducing the Lower Earnings Limit for establishing entitlement to benefit to £30 a week.

Towards a wholly means-tested future

125. Ms Sutherland's research shows that the abolition of all contributory benefits[221] (scenario A) would result in enormous net savings - around £20 billion per year. Income tax could be cut by around seven percentage points if National Insurance contributions were retained as a means of raising revenue, and even the abolition of National Insurance contributions would not require a rise in income tax to pay for the rise in means-tested benefit claimants. If the basic state pension were retained (scenario B), the savings would be around £7 billion per year. Income tax could be cut by around two percentage points. But there would be dramatic increases in Income Support caseloads: around 40 per cent under scenario A (roughly an extra 1.5 million claimants and 13 per cent under scenario B (roughly half a million claimants). And there are significant losers. If all contributory benefits were abolished, a quarter of all families - 7.5 million family units[222]- would be worse off. If the state pension were retained, but other contributory benefits were abolished, 2.5 million family units would be worse off. Sizeable portions of losers would be in the poorest third of families, due to the effect of the household means-test (which could mean that the loss of a contributory benefit is not compensated by the award of a means-tested benefit due to the income of a partner); savings; or due to home-ownership (where people just above Income Support level do not qualify for housing benefit). Among the top half of the income scale, the proportion of losers is higher. Three quarters of family units previously entitled to contributory benefits would be losers under scenario A and just over four fifths (82 per cent) under Scenario B. Ms Sutherland concluded that cuts in tax or National Insurance contributions did not reduce the number of losers from the abolition of contributory benefits, because at any one time, the two groups - non means-tested benefit recipients and income tax payers are largely different.

126. Could relaxation of the means-tests help reduce the number of losers? If retirement pension were retained, the suggested 'enhancements' described in paragraph 123 above, would have only a small effect on the losers among the non-pensioner population, reducing the number by around one per cent. The enhancements appeared most effective for people of pension age. Thus if retirement pension were abolished, the number of losers would be reduced from 25 per cent of family households to 14 per cent - still around 4 million family units. The combined cost of the enhancements would be around £16 billion per year, and many of the beneficiaries would be people other than those who had lost contributory benefits.

127. There is no doubt that a wholly means-tested social security system would be considerably cheaper. The advantages emphasised to us in Australia were the flexibility of such a system - its ability to respond to change - and its low cost. In the absence of alternative benefits, there also appeared to be less of a benefit take-up problem. But, in a UK context, we are struck by the significant number of losers, if contributory benefits were to disappear, who were not compensated by receiving means-tested benefits instead. Many of the losers would be partners in couples, including many women, who would lose their right to an independent income based on working. Work incentives would be likely to be affected. Unless many billions of pounds were spent, people with savings and occupational or private pension provision, would also be among the biggest losers. As one witness put it, "if benefits are wholly means-tested instead, they cannot form the basis of a partnership between private and state provision encouraging people to save for foreseeable risks."[223] The flexibility of means-testing may be said to be a virtue, but it can also lead to massive complexity, with frequent changes of rules and complicated transitional arrangements. On a practical level, the vast increase in numbers of people who would be forced to claim Income Support would make the system almost unworkable, with soaring administrative costs and high risks of error and fraud.

128. There is also the question whether attitudes to paying for welfare would change. People might be less willing to pay for benefits for other people, which they were unlikely to be able to claim themselves. Ms Bennett said:

224

129. We conclude that a wholly means-tested benefits system would be cheaper, but would have an unacceptably large number of losers, would have severe consequences on work and savings incentives, and would be a bureaucratic nightmare leading to high error rates and fraud.

Towards a collective funded pension scheme

130. Mr Field outlined his proposals to us during oral evidence. He later submitted a summary of his proposals to us, which formed the basis of Mr Young's considerations.[225] Mr Field told us that he had focussed his attention on pension reform because "it is very difficult to make sense of welfare reform unless you get the pensions reform right, because not only is it the largest element in the budget, but if you get it right other reforms will follow from it."[226] In essence Mr Field's proposals are for a flat rate pension, the 'New Stakeholder Pension' (NSP), paid for by compulsory contributions from all earners. It would begin with a new generation of contributors and mature when they reached pensionable age. The pension would consist of two parts: the current basic state pension uprated in line with prices (which is therefore gradually declining), and a second, funded element which in the long term would take over as the main part of the pension. The NSP would offer a 'pension guarantee' so that people who retired after a lifetime's contributions would know that their stakeholder pension would take them above the means-tested benefit level.[227] Mr Field described the effect as follows:

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Mr Field's argument was that such a guarantee would create a pool of interest among both rich and poor: "any person can devise a pension scheme for the rich. The trouble is how to design one for the poor which is viable and the only way to do that is to have one in which the appeal is such that richer people are prepared to pay something more because they see it in their interests to be in that scheme...richer people would see advantages, particularly in something they cannot buy in the private market."[229]

131. Mr Young remarked in his paper, "pensions have a way of becoming complicated." In examining Mr Field's proposals, he made a number of key assumptions which affect his conclusions. These include methods of uprating the Minimum Income Guarantee in the future; the target level of New Stakeholder Pension at which to aim; future increases in earnings and prices; and assumed rates of return on investments. Mr Young's conclusions are therefore necessarily tentative, and we have no doubt that they will stimulate further discussion when published.

132. Mr Young chiefly examined the costs of a new pension which would allow a single person to retire in forty years time with an income which would more than bridge the 'gap' between the basic state pension (assumed to rise in line with prices) and the rate of Minimum Income Guarantee available at that time (assumed to have risen in line with earnings).[230] His target level for the New Stakeholder Pension (NSP) was £142.70 a week. He also assumed that the NSP would rise in line with earnings, in order to keep people off means-tested benefit. He estimated that, if people retired at 65, the contribution rate needed to meet the target level of income was 9 per cent. This would rise to 12 per cent, if the assumed rate of investment return fell from a figure of three per cent in excess of average earnings to two per cent. Significantly, these contribution rates were in addition to National Insurance contribution rates, which would still be needed to fund the basic state pension. Thus an employee's total contributions would rise from the current rate of 10 per cent to 19 or 22 per cent, depending on the return from investment. The rates would be lower (16 or 18 per cent) if the retirement age was raised to 70 years. The costs could be further reduced if contributions were levied on earnings above the current Upper Earnings Limit. This would reduce the rate by approximately 12 per cent. Could part of the cost be borne by employers? Mr Young suggested that this would create a disincentive to employ young people who were in the new pension scheme.

133. Mr Field wanted to create a scheme which allowed certain groups to have their contributions towards the NSP met. Initially the concession would be for people caring for a child under 5 and those with full-time care responsibilities. Mr Young estimated that contribution rates would have to rise by a further ten per cent to pay for this. Alternatively, the cost could be paid by the highest earners, by a levy on earnings above the Upper Earnings Limit. Mr Young estimated that a levy of about one half of the rate for earnings below the limit would cover the cost. He queried whether it would be feasible to similarly 'credit' unemployed and long-term sick people, on grounds of cost. Contribution rates would rise by a further 15 per cent.

134. There was considerable interest among us concerning Mr Field's proposals. Like him, we fully recognise the considerable value in enabling people to retire in old age with a pension which is sufficient to avoid having to claim means-tested benefits. But having studied Mr Young's findings, we think there are a series of almost insurmountable difficulties. The change from the present pay-as-you-go system to a funded system would be likely to involve complex transitional arrangements. Not least is the 'double funding' problem, which would require contributors to the New Stakeholder Pension to continue to contribute to the existing National Insurance Fund to support beneficiaries reliant on the old system. It is difficult to see how such double funding can be avoided. If members of the NSP were to pay lower contributions into the National Insurance Fund to compensate for their extra NSP contributions, there would be significant losses to the National Insurance at an early stage, which would grow substantially as more people were brought into NSP. These losses would have to be made up from elsewhere if pensioners under the old system were to be protected.

135. Like Mr Field, we want to maintain a system where collective provision means that everyone including the weakest members of society receive social protection. Therefore the extra costs of including such groups (notably parents with young children and full-time carers) must be considered an intrinsic part of the scheme. We are doubtful of the willingness of people at the present time to pay contributions at the level necessary to fund Mr Field's proposals for a New Stakeholder Pension.

Towards a non-contributory future

136. It became increasingly clear as the inquiry progressed that most supporters of the contributory principle favoured an even greater loosening of the link between individual contributions and National Insurance benefits, which is already pretty notional. Professor Alcock was one of the exponents of this view. He argued that it was time to explode the myth 'I have paid in so much a week and I am going to get my so much a week back' and replace it with the notion of National Insurance, not as an individual insurance contract, but as a form of earmarked taxation, a 'social security' tax:

"What you would have is a ...system of redistribution in order to provide social protection which was based upon a contribution from people in employment and the benefits to people outside of the labour market. And we can talk about the contingencies, you know, which people should benefit, and the conditions under which they might receive that entitlement - you know, do they have to be looking for work, do they have to be engaged in certain kinds of tasks - but the notion of payment on that basis does not seem to me to be problematic either in principle or in practice. It is a notion of, as I said before, a lifecycle horizontal redistribution which I would have thought would still be popular."[

231

137. In order to give ourselves a rough idea of the cost implications of a such a system, we asked Mr Young to estimate the cost of extending National Insurance benefits to everyone who satisfied the conditions of entitlement for those benefits, but did not meet the contribution conditions, firstly at current rates, and secondly, at levels of payment equal to the corresponding Income Support rates. The questions put to Mr Young were fairly crude; by limiting entitlement to people who met all the rules for National Insurance benefits apart from the contribution conditions, we excluded lone parents and the long-term unemployed whose circumstances are not covered by National Insurance. Therefore the answers are illustrative only.

138. Mr Young's answers were necessarily partial. He was able to estimate the extra expenditure needed from the National Insurance Fund, but he was not able to give estimates of the consequent reductions in means-tested benefits - which he considered would be "significant". He estimated that the extra cost to the National Insurance Fund of extending entitlement to Retirement Pension, Sickness and Incapacity benefit, Jobseeker's Allowance, Widow and Widow(er)s benefit, and Maternity Benefit would be £14 billion per year. If financed by additional National Insurance contributions paid by employees and self-employed people, an extra contribution rate of about 5 per cent would be required. The cost would be lower, if split with employers. Were National Insurance rates to be raised to the level of Income Support, the cost would rise to £22 billion per year. A contribution rate of 8 per cent would be required. Again the cost would be lower, if split with employers.

139. Again, there are considerable costs attached to these proposals, although there would undoubtedly be significant savings, not only through reductions in expenditure on means-tested benefits but also through abolishing the massive cost and complexity of collecting National Insurance contributions and maintaining life-time records. Another consideration is the political robustness of a system of non-contributory, non means-tested benefits, in the face of budgetary pressures. Ms Bennett argued that, in theory, such a system would be capable of being more inclusive than contributory benefits. However, she pointed out that there was a problem: "we will [shortly] have only one non-contributory income replacement benefit left, which is Invalid Care Allowance. The other one is due to be abolished, the Severe Disablement Allowance. There are huge attractions in that model of provision, but it does not seem to me that it has proved itself sufficiently robust yet to be the main framework of provision for non-means-tested benefit." We consider that these proposals merit further attention. We hope it may be possible for the Department of Social Security to consider whether it would be worthwhile to produce an analysis to show the impact on means-tested benefits of the above proposals, and the likely financial implications which would result from the abolition of contribution conditions for National Insurance benefits.

The way forward

140. We have concluded that social security has a wider role than simply providing a safety net for the poor. Tackling poverty is a key goal and means-tested assistance such as the Minimum Income Guarantee and Working Families Tax Credit are important in providing extra money. But tackling poverty can not be the only objective of a social security system in today's society; it must have a wider role in tackling inequality and underpinning individuals' steps towards independence and responsibility and, as social insurance, should help protect individuals against the adverse consequences, including a drift into poverty, as a result of unexpected life events such as illness or injury. The Government is committed to getting people into work as a key element in its strategy in combatting poverty. But in today's insecure world, working people who may not be poor still need help in ensuring that they are able to use periods in work in order to make proper provision for life's contingencies, in order to avoid poverty in the future. National Insurance provides a means of collectively providing social protection, whilst not undermining an individual's capacity to make additional self-provision.

Strategies for reform

141. The National Insurance system is in serious need of renovation and modernisation. In discussing options for reform, we have decided to reject the 'big bang' approach at this stage. We agree with Ms Joan Brown, respected independent researcher, who said, "what we have is far from perfect, but a sound reform based on current arrangements can produce positive results, while a leap in the dark to untried provisions carries the risk of serious disruption to some, perhaps many, people's lives."[232]

Funding

142. In discussing strategies for reform, the question of further funding is key. Some attention was given during the course of our inquiry to the growing surplus in the National Insurance Fund. There were differing views on its significance. The Secretary of State was dismissive. He said, "there is a surplus of about £5.9 billion at the moment, but you have to be careful about that...To give you an example, some people have said that if you increase the state pension by a little more this year, you will use that surplus and that is fine. However, that would take the surplus away in two years and you would then be left with a National Insurance Fund deficit. You cannot make long-term decisions on benefits based on what could be a temporary surplus."[233] In contrast, Mr Field told us that "there is going to be a very, very substantial surplus without cutting contributions," which he thought represented an important means of funding change.[234] When asked whether the surplus represented a "crock of gold," the Government Actuary and his staff were cautious but did not totally reject the idea: "there is some sensitivity analysis which gives an indication, but I like to think of the contribution rate being broadly stable in future rather than thinking that there is emerging here a certainty of a pot of gold. Maybe our best estimate is that there would be, but we have got to be careful not to assume that that will definitely happen."[235]

We have concluded that, unless there is a significant change of policy, there is likely to be a growing surplus in the National Insurance Fund as a result of benefits being linked to prices, and contribution income, based on earnings, rising at a faster rate. However, we agree with the Secretary of State that any use of the surplus must be sustainable in the long term.

143. We have also considered the question of whether National Insurance contributions should be raised to pay for improvements to benefits, to diminish reliance on means-tested benefits. The question arose, in particular, in connection with our views on the basic state pension. The Government Actuary's figures show that, in order to pay for earnings uprated benefits, the combined contribution rate for employers and employees would have to rise by 3.2 percentage points by 2020-21 and by 7.6 percentage points by 2060. In the context of real earnings growth, we recommend that the Government should consider this as one option for funding improvements to benefits.

144. The research we commissioned from Mr Young prompted consideration of much higher rises in contribution rates to pay for more radical reform. We have concluded that, before rises of the scale envisaged could be contemplated, considerably more work needs to be done to promote the National Insurance scheme and its advantages, and to give the public at large a greater sense of ownership of the National Insurance Fund and the benefits to which it gives rise. We recommend that the Department of Social Security should work with the Department for Education and Employment and the Qualifications and Curriculum Authority to develop appropriate guidance for schools to include an understanding of National Insurance in the citizenship curriculum.

Making National Insurance more inclusive

145. An urgent priority is to better adapt the National Insurance scheme to modern labour markets. We consider that more can be done, at relatively little expense, to bring low paid workers currently below the Lower Earnings Limit, the majority of them women, into the National Insurance system. Mr Young of the Government Actuary's Department estimated the extra annual cost to Jobseeker's Allowance and Incapacity Benefit, if the lower earnings limit were reduced to £30 a week, would be £150 million and £600 million. This compares with annual overall expenditure on these benefits of £525 million and £6,770 million respectively.[236] In the case of Retirement Pension, Mr Young was able to give only a rough figure for the extra cost of giving low earners earning at least £30 per week access to the basic pension. He estimated it would cost an additional £0.4 billion. Again, it seemed relatively low in relation to the annual expenditure on basic Retirement Pension of £33.8 billion. We recommend that eligibility for Incapacity Benefit, Jobseeker's Allowance and the basic state pension should be extended to people earning £30 or more a week.

146. The combined effect of the National Minimum Wage and the uprating of the Lower Earnings Limit in line with prices is already having the effect of bringing more workers into National Insurance. We support the Chancellor's creation of a 'zero rate band' for National Insurance contributions where low paid workers eligible for National Insurance are exempt from contributions. In order to assist low paid workers to enter the 'zero rate band' for National Insurance contributions, we recommend that the lower edge of the zero rate band be frozen in cash terms, thus allowing inflation gradually to raise the number and proportion of workers entitled to National Insurance Benefits.

147. One group currently outside the National Insurance system for whom there is considerable public sympathy are carers of sick and disabled people. Dr Stafford's research on public attitudes to the contributory principle found there was public support for including such carers within the scheme. Mr Young of the Government Actuary's Department was asked to estimate the cost of paying carers of disabled people (currently eligible for Invalid Care Allowance) a benefit from the National Insurance Fund at either the rate of Jobseeker's Allowance or Incapacity Benefit. The cost was estimated at £1,090 million (JSA rates) or £1,400 million (IB rates). The cost could be financed by an extra contribution rate of about 0.5 per cent. This does not take account of a concomitant saving to the Treasury of £850 million in the cost of Invalid Care Allowance. We recommend that the Government give serious consideration to using the surplus in the National Insurance Fund to pay for a non means-tested benefit for carers of disabled people paid at the rate of Incapacity Benefit.

218 Appendix 26 para 1.3, quoting the Performance and Innovation Unit, Adding It Up: Improving Analysis and Modelling in Central Government, 2000, TSO. Back

219 Ms Sutherland's report appears as Appendix 26. Back

220 Mr Young's report appears as Appendix 28. Back

221 And earnings-replacement non contributory, non means-tested benefits. Back

222 In this context, 'family' and 'family unit' and ' household unit' refers to an individual, plus any partner and any dependent children. Back

223 Fran Bennett, Ev p 117 para 7.1. Back

224 Fran Bennett, Ev p 114 para 5.5. See also Joan Brown, Appendix 23 section 2. Back

225 See Appendix 27. Back

226 Frank Field, Q. 225. Back

227 Mr Field did not include Housing Benefit here, on the assumption that it is abolished. Back

228 Q. 226. Back

229 Q. 237. Back