Select Committee on Social Security Minutes of Evidence



  1.  Summary

  2.  Introduction

  3.  The National Insurance Scheme

  4.  International Comparisons

  5.  Reform of National Insurance Contributory Benefits


  A.  Summary of key legislation and the major changes to social security

  B.  Tables and Charts showing Expenditure by Type of Benefit from 1949-50 and Real Growth in Social Security Benefit Expenditure since 1949-50

  C.  Tables showing total spending by category of benefit since 1949-50 and Charts showing percentages of different categories of benefit paid to different client groups since 1979-80

  D.  Table showing National Insurance Lower and Upper Earnings Limits compared with personal tax allowance and average earnings from 1979


  1.  The key features of the National Insurance scheme are:

    —  Contributions are paid by employees, employers and self-employed people.

    —  Entitlement to contributory benefits is linked to an individual's contribution record—the Memorandum sets out in detail how the link works for different benefits, in particular:

      —  credited contributions are available to help people supplement their contribution record to qualify for benefits in different ways;

      —  not all contributions provide the contributor with entitlement to (all) benefits;

      —  the award and payment of benefits can be subject to additional conditions (including taking some account of other income), as well as the existence of the relevant contingency and satisfaction of the contribution conditions;

      —  low earners can work significant hours and not qualify either to pay contributions or receive benefits; and

      —  higher earners need only work for a few weeks of the year to pay sufficient contributions to qualify for benefits.

    —  Contributory benefits are funded, to a greater or lesser extent, from general taxation as well as from contributions.

    —  The system provides a measure of protection for some of those who could not otherwise afford insurance, or who would otherwise be uninsurable as bad risks.

    —  The system tends to favour higher earners and those with full-time, regular work patterns, while lower earners and part-time workers with less regular work patterns may find it difficult to qualify for equivalent benefits.

    —  The system tends to be of least help to the poorest, whose contributory benefits usually have to be supplemented with income-related payments.

  2.  The mix of spending on contributory, non-contributory and income related benefits has varied over time and between client groups, with changes in economic conditions and changes to the structure of benefits and entitlement rules.

  3.  Across the world many different models of contributory and non-contributory systems have developed and are operated to cover the same contingencies as those covered by the National Insurance scheme.

  4.  For the future, the Government's plans to reform National Insurance and contributory benefits will:

    —  give low earners and carers improved access to a second state pension, and enable them to be less reliant on income related benefits;

    —  strengthen the link with recent work in the contribution test for Incapacity Benefit, and discourage its use as an early retirement benefit by taking some account of occupational pension payments;

    —  modernise support in bereavement by giving men equal access to contributory bereavement benefits;

    —  align the starting point for paying National Insurance with the single person's tax allowance;

    —  protect the benefit entitlement of those earning between the current Lower Earnings Limit and the new threshold; and

    —  simplify the system for employers by administering National Insurance contributions through the Inland Revenue and more closely aligning the rules for contributions and income tax.


  1.  This Memorandum has been prepared for the Social Security Select Committee for their inquiry into the future of the contributory principle. It provides the Committee with the information requested in their letter of 1 April 1999. The Memorandum also provides background information on the history of the development of social security benefits and the funding of contributory benefits.



  2.  Under the current system employees and self-employed people "earn" entitlement to National Insurance benefits and pensions by paying contributions on their weekly or monthly earnings. Access to benefit depends on a satisfactory record of contributions over a given period. People who earn below the Lower Earnings Limit—currently £66 a week—do not pay contributions, and therefore do not generally have access to contributory benefits. The Lower Earnings Limit is also currently used as an earnings threshold in tests for Statutory Maternity Pay and Statutory Sick Pay. By far the largest contributory benefit in terms of both coverage and costs is retirement pension, which accounted for over three-quarters of contributory benefit spending in 1996-97.

  3.  From 1948 arrangements were made in the National Insurance scheme to protect the entitlement of those who would normally be in the labour market and contributing but who were unable to work because of sickness, unemployment or in certain other situations. These arrangements have been expanded over the years, notably through the introduction of Home Responsibilities Protection for people with children, and credits for some carers. The extent to which people can use these means to help qualify varies from benefit to benefit. All entitlement tests for contributory benefits currently require an individual (or in some circumstances their late husband) to have actually paid contributions at some stage in their working lives.

  4.  Over 20 million employees each year pay some National Insurance contributions—though not necessarily sufficient to qualify for benefits—and employers contributions are paid by over 1 million employers. Around 2.3 million people pay National Insurance contributions in respect of self-employment (some 300,000 paid both in respect of self-employment and employment). About a quarter of a million people will pay Class 3 (voluntary) contributions for the current tax year. About 10.5 million people are credited with National Insurance contributions for various spells, by reason of incapacity, unemployment etc and about 12.9 million claimants are at any one time expected to receive benefits financed from the National Insurance Fund. About 4 million rebates will be paid to contributors who are in personal pension schemes.

  5.  The transfer of the Contributions Agency and National Insurance contribution policy to the Inland Revenue means that, from 1 April 1999, the Treasury and the Inland Revenue are responsible for policy and operations on contribution issues. The DSS and the Benefits Agency retain responsibility for policy and entitlement conditions for social security benefits.



  6.  National Insurance was introduced in 1911 to provide a source of non-means-tested basic income during interruptions in earning capacity caused by sickness and (to a lesser extent) unemployment. Throughout the period it was limited to workers below an earnings threshold, with a small area of voluntary participation for those with earnings just above it. Some occupations (mainly large public-sector employments) were excluded from insurance. Contributions were flat-rate, and paid and collected separately for different contingencies. Sickness benefits were insured (and the benefits paid) through Friendly Societies and it was possible for benefits to vary above a flat-rate minimum depending on the investment performance of the society. It was possible to be insured for different combinations of unemployment, sickness, pensions, and widows' benefits. There were also separate insurance schemes, with different benefit and contribution rates, for some types of occupation, such as agricultural workers.

  7.  Over the period, the scheme became more comprehensive, covering more groups of workers and a wider income range. The range of benefits provided expanded from the initial working-age protection against sickness, unemployment and maternity needs introduced in the National Insurance Act 1911 to include contributory retirement and survivors' benefits in 1925. However, there was no consistency in the rate of benefit or in the treatment of dependants.


  8.  Following the recommendations in Sir William Beveridge's 1942 report Social Insurance and Allied Services, the National Insurance system included all employed and self-employed earners and was accessible voluntarily to non-workers, though married women were not expected to participate. However, contributors were divided into different classes with access to different groups of benefits. From 1948, the introduction of the National Health Service meant that sickness insurance contributions purchased benefits alone, not—as previously—benefits and medical care.

  9.  Contributions were flat-rate within the class, but varied by age and sex. They were pitched at a level intended to be affordable by the lowest-paid worker. Benefits were paid at a common flat rate for all contingencies, though different benefit rates were payable for men and women and for young people.


  10.  Partially earnings-linked (graduated) contributions were introduced in 1961, bringing entitlement to units of extra retirement pension. From 1966 they also yielded earnings-related supplements payable for the first six months of entitlement to unemployment and sickness benefit, maternity allowance and widow's allowance. The graduated contribution scheme was superseded in 1975 by fully earnings-linked contributions, which from 1978 began to earn State Earnings-Related Pension (SERPS) entitlements. Earnings-related supplements with short-term benefits were discontinued in 1982.

  11.  The transition to an earnings-related contribution system led to a number of major changes in the structure of National Insurance between 1975 and 1978:

    —  the introduction of lower and upper earnings limits for contribution liability. A lower limit was required both for practical administrative reasons and to concentrate contributions and benefits on people who depended substantially on income from work. The lower limit was linked to the level of basic retirement pension. An upper limit was required to prevent excessive burdens (and the acquisition of very high benefit entitlements);

    —  the concept of a two-part benefit system for longer-term needs, consisting of a basic flat-rate benefit and an earnings-linked second pension;

    —  equalisation of contribution and benefit rates for men and women and young people;

    —  the abolition of the "married women's election" (the special lower-rate National Insurance contribution paid by married women) for marriages after April 1977;

    —  the introduction of Home Responsibilities Protection (HRP) for people prevented from working to the full by the care of children. HRP made it easier to achieve a full retirement pension by excluding years of very low earnings and child-care from the length of the working life over which retirement pension was calculated; and

    —  the calculation of earnings-related pension over the best 20 years of the earning lifetime, in order to minimise the effects of breaks in contribution history.


  12.  Although the National Insurance contribution and benefit system did not radically alter its basic structure during this period, a number of significant changes were made to its details so that the overall impact altered. Important themes of change were:

    —  the gradual conversion of Beveridge-type sickness and maternity benefits into statutory sickness and maternity pay from employers, the costs of which were to some extent supported from contributions;

    —  successive measures from the mid-1980s to reduce the levels of contribution paid by lower earners, and by employers in respect of them, whilst maintaining benefit entitlement. The purpose of these changes was primarily to encourage employers to take on lower-paid workers and to make work more attractive for employees themselves;

    —  in 1985, the lifting of the ceiling on National Insurance liability by employers;

    —  a redefinition of the respective roles of the contributor, employer and the taxpayer in meeting the costs of National Insurance benefits. From 1911, it had been recognised that all three had a role to play. In 1981, a policy of gradually reducing the taxpayer (Treasury) contribution was introduced, leading to the abolition of the Treasury Supplement in 1989. A Treasury grant was re-'introduced in a new form in 1993;

    —  the removal or reduction in value of a number of original features of the SERPS scheme, together with tighter controls over benefits for long-term incapacity;

    —  the removal of additions for dependants from most contributory benefits except retirement pension and widows' benefits; and

    —  greater diversification of second pensions with the introduction from 1988 of personal pensions.

  13.  In addition some changes were legislated for during this period but will not come into effect until later: for example, the equalisation of state pension age for men and women.

  14.  Another important theme in recent years has been greater alignment of the conditions for National Insurance contributions and income tax, which are collected together. This has led to the introduction of new contribution classes, which do not bring entitlement to benefit (for example, on company cars).

  15.  Throughout their development, contributory benefits have been conditional on satisfying certain criteria other than simply the contribution record. For example, widow's benefit is subject to not remarrying or cohabiting. Earnings were taken into account for widow's benefit until 1964 and for retirement pension up to 1989. In 1980 the decision was taken to restrict entitlement to unemployment benefit when a person received an occupational pension (later extended to cover personal pensions) above £35 a week.

  16.  In addition, the availability for work condition for those claiming unemployment benefit was strengthened in the 1980s to include the requirement to actively seek work and this and the occupational/personal pension rules were extended on the introduction of jobseeker's allowance in 1996. Unemployed claimants are expected to satisfy additional labour market conditions in order to receive benefit. The labour market tests are administered by the Employment Service, with an array of sanctions up to complete withdrawal of benefit if the claimant is judged to fail them.

  17.  Adult dependency increases for contributory benefit are now only payable—except for people over 60—where there is a dependent child in the family and where the adult dependant has earnings below the level of the dependency increase itself. Child dependency increases, which are paid in addition to child benefit, also depend on the partner's earnings.

  18.  The rules for receipt of contributory benefits have therefore changed considerably over the years, and non-contributory benefits have grown in importance. What an individual gets out of the system in terms of flat rate contributory benefits is not generally linked directly to what he or she pays in. The most "purely" contributory of benefits is State Earnings-Related Pension, which is directly linked to the level of a person's earnings on which contributions have been paid. For the remaining benefits the link is more tenuous. For example, about 4 million people (mainly with low earnings) who paid either standard rate Class 1 contributions, Class 2 (self-employed) or Class 3 (voluntary) for short periods at some point during 1995-96, do not attain a qualifying year for basic retirement pension, even with credits. Conversely, higher earners can build up entitlement by contributing for only a few weeks.


  19.  The National Insurance scheme is funded on a "pay as you go" basis by contributions from employees, the self-employed and employers. In practice around 94 per cent of National Insurance contributions (NICs) are collected under Class 1 PAYE and Class 4 arrangements alongside income tax. There are currently six classes of National Insurance, as follows.


  20.  Class 1 NICs are paid by both employees and employers. An employee is generally someone employed under a contract of service or in an office with emoluments chargeable to Schedule E Income Tax.

  21.  They are worked out as a percentage of an employee's gross pay each time a payment is made based on the shortest interval which the payment covers, eg generally a week or a month (known as the "earnings period").

  22.  Class 1 NICs are made up of two elements:

    —  primary contribution (employee's contribution), which is deducted by the employer from an employee's pay. All employees aged 16 or over and under State pension age (65 for men, 60 for women) who earn more than the lower earnings limit (presently £66 a week) must, from April 1999, pay employee's contributions on all their earnings over the lower earnings limit and up to the upper earnings limit (presently £500 a week); and

    —  secondary contribution (employer's contribution), which the employer is liable to pay on all earnings above the lower earnings limit (from April 1999, the lower earnings limit is £83 a week for employers), there is no upper earnings limit for employers' liability.

  23.  Employees' Class 1 NICs qualify them for flat rate contributory benefits such as contribution-based jobseeker's allowance, incapacity benefit as well as widows' and retirement pensions, including State Earnings Related Pension where they are not contracted-out. (Contracted-out means that the person is a member of their employer's pension scheme which is contracted-out of the State Earnings Related Pension Scheme.)


  24.  The Social Security (Contributions) Act 1991 introduced a new Class 1A contribution in 1991-92 payable by employers only. The charge is assessed at the main standard contribution rate on the cash equivalent of the benefit of cars and car fuel provided by employers to their employees for private use. The cash equivalent is the scale charge used by Inland Revenue to assess the employee's Schedule E tax.

  25.  Class 1A contributions do not count for benefit entitlement. They form part of employers' general contribution to the NI Fund.


  26.  Self-employed people have to pay a weekly flat rate Class 2 NIC (£6.55 in 1999-2000). They can do this either by a monthly direct debit or quarterly billing. However if a person expects their annual profits to be very low (under £3,700 in 1999-2000) they can apply for a small earnings exception from Class 2 liability.

  27.  The self-employed qualify for the same flat rate contributory benefits as employees except for jobseeker's allowance. They get sickness, incapacity and maternity benefits as well as widows' and retirement pensions. An important difference is that they do not qualify for State Earnings Related Pension even though they pay a profit related contribution in the form of Class 4 contributions (see below).


  28.  Class 3 NICs are paid voluntarily, at a flat rate, currently £6.45 a week (1999-2000 year). Although payment is voluntary, there are strict time limits in which they must be paid to count for benefit/pension entitlement. They can be paid by direct debit, quarterly bill or as a lump sum at or after the end of a year.

  29.  Class 3 NICs are paid to help people qualify for basic retirement pension and widows' benefits. They help someone where they are not liable to pay Class 1 NICs (eg students or those who work abroad), or where someone's NI record is not good enough to qualify for benefit or pension.


  30.  In addition to Class 2 the self-employed pay a separate Class 4 profits related contribution which is generally assessed and collected by the Inland Revenue at the same time as they make the self employed person's Schedule D tax assessment. Class 4 is currently 6 per cent of the profits falling between £7,530 and £26,000 a year (1999-2000 rates). Class 4 contributions do not count towards benefit entitlement.


  31.  Class 1B NICs were introduced from April 1999 and will be paid by employers only on small non-cash payments which are dealt with under a PAYE Settlement Arrangement, these will be first payable on 18 October 2000 and paid annually. Like Class 1A these will not count towards benefit entitlement.

  32.  The main differences between National Insurance contributions (NICs) and income tax are set out in Table 1.

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Prepared 13 December 1999