Public sector workers are about to lose their unfair tax advantage

Is Iain Duncan Smith’s universal pension of £140 a week a good idea? I think it is. £140 in 2016 (which is when it might start) won’t represent much of a real rise in payments to most people, but that isn’t really the point.

What a universal pension will do is to clear away our unbelievably complicated state pension system and replace it with something that is actually possible to understand. It will also junk the perverse incentive we currently offer people not to save: why bother if all your savings will do is disqualify you from getting means-tested benefits? And it will cut the costs of pension administration (employing people to do the means testing is expensive) and end the way in which women are penalised in retirement for their child-rearing years.

But it will do one more very important thing – something that I have seen mentioned absolutely nowhere: it will equalize the tax rates paid by private and public sector workers.

Right now public sector workers pay 9.4% in National Insurance (NI) while private sector workers pay 11%. So their effective income tax rate (let’s not forget that NI is just income tax in disguise) is a massive 1.4 percentage points lower.

How can this be? It is, says Ros Altman, all down to a historical anomaly “that has never been corrected.” Everyone is allowed to contract to opt out of the Second State Pension Scheme (S2P) so as to replace their future National Insurance S2P with a non-taxpayer-funded pension. You pay less NI but you forfeit the right to any taxpayer-funded S2P pension when you retire. At least, that’s how it works in the private sector.

However it is rather different in the public sector. Here workers pay the lower rate of NI but their pension scheme includes S2P payments anyway. They pay less tax but forfeit nothing. And even more irritatingly, they get their S2P pensions, not from state pension age but from their retirement age. So while the private sector workers are paying for S2P and won’t get it until they are 66, 68 or whatever the state pension ages end up being, those in the public sector get it from age 60 or below.

Altman calls this something that “defies all economic logic.” I call it outrageously unfair. However the absolute wrongness of it aside, we should also note that it costs the Treasury something in the region of £6.6bn a year in pointlessly forgone tax.

However a £140 universal pension will end this. It will get rid of S2P completely and mean that everyone will pay the same rate of National Insurance. That’s got to be a good thing. It might also do something deeply satisfying – make everyone realise that NI is just income tax. It used to be that you had to be paying or have paid your NI to get anything in the way of benefits. No more. Today you just get them.

The only thing that really relies on NI payments is your pension: you have to have paid it for a certain number of years to get one (which is why the system was considered to be unfair to women). But now, as Tim Worstall says, if we are to have a flat pension simply by “dint of being 67, then we can abandon the whole NI system and simply roll it into one single income tax.” Then everyone will begin to understand that their basic rate of income tax is not 20% but 32% and rising.

I’m not holding out hope for this (calling one third of the nation’s income tax NI is a great way of pretending income tax is low) but alongside the £6.6bn saving it would be a nice little side effect.