Taxation as Insurance, Welfare and Entitlements

 

A rather abstract discussion which leads to a very specific conclusion about the merger of income tax and employee national insurance contributions

Paul Krugman has described the Federal US government as a gigantic insurance company with an army. Can the same thing be said of public spending in most European countries, including the UK? Broadly yes, with one big caveat and some smaller caveats. Indeed, where countries have an army for defensive purposes alone (unlike the US at present) even the army can be regarded as a form of insurance. Spending on law and order can equally be regarded as a kind of collective insurance against being harmed or robbed by others.

The biggest item of departmental spending in the UK is on health. This is a classic form of insurance, where we pay taxes but receive health care that is by and large free when we need it. Much of welfare spending is a form of insurance. The biggest item of welfare spending in the UK is the state pension, which is a type of insurance policy where you receive an annuity on retirement, which in effect insures you against the financial cost of a long life. Disability benefit can be seen as insurance against becoming disabled, unemployment benefit as insurance against becoming unemployed, and universal credit as insurance against low earnings.

In some of these cases, and particularly the last, seeing spending as insurance only works for everyone if it is insurance you might take out behind a veil of ignorance before life begins. A medical consultant is unlikely to want to take out insurance against low pay, as would an unborn child who knew their parents were billionaires. For that reason I’m using insurance in a Rawlsian, social liberal sense. Perhaps, as a result, we could describe much of state spending as a form of social insurance.

The major caveat is that a significant part of public spending is on education. (Of course the same is true in the US: Krugman was referring to Federal spending, and education is funded at the state level.) If we add child benefit, we could say that a significant part of public spending is for types of child support [1]. The smaller caveats include spending on transport, housing, overseas aid etc.

Of course a lot of this insurance individual citizens could provide for themselves using the private sector. We could provide for our health by taking out private insurance, but since Arrow’s seminal work economists have recognised the problems with personal health insurance, and the United States is a good example of why a private health system can be very inefficient. We can also buy our own pensions, but one large advantage of a state pension is that it avoids the risk of stock markets or interest rates being low when your pension matures. [2]

Putting the caveats to one side, taxation can therefore be seen as a form of insurance payment. Indeed one of our main taxes has the word insurance in it. In particular, taxes are a significant part of insurance against old age. This is important, because it means that during the middle part of people’s lives, and much of their voting lives, they will be paying taxes that considerably exceed the benefit they receive in terms of public services. Indeed in this respect taxes and benefits are like individual income and consumption: we earn (pay tax) more than we consume (use public services) in middle life and vice versa in early and late life. (This is also why the claim that immigrants on average put a strain on public services is just wrong.)

The insurance provided by the state is a little different from insurance provided by a company in terms of both contributions and benefits. State insurance is unlike most private insurance because benefit entitlements can be changed at any time. In addition, in theory many of the benefits paid out by the government, including benefiting from the NHS, do not require any contributions whatsoever. In practice we all make a contribution by paying tax, and everyone beyond a certain age pays taxes the moment we buy anything that isn’t zero rated for VAT. The idea that those paying income tax should have a greater voice in spending decisions makes no sense for this reason alone, and because few would want to argue that billionaires should have the right to much more political influence than anyone else.

Some state benefits require a degree of contribution. The state pension, for example, requires a minimum period of contribution to receive it, and how much you receive depends on how long you have been either earning or receiving child benefit. But how much you receive does not depend on how much money you contributed. What is less often noted is that the same is true for unemployment benefits, where you need to have been paying contributions in previous years. These requirements sometimes lead people to think that their contributions fund their pension, but this is false. Pensions today are paid for by those paying tax today.

Periodically I come across people who think that state pensions should not be classed as a welfare payment by the government because it is something they are entitled to by contributing employee national insurance payments (see this, for example). This is an illusion, because whatever requirements the government may make to receive a pension are pretty arbitrary. It is really a reaction to much of the media describing state benefits as ‘handouts’. Seeing these benefits as a type of insurance is much more realistic.

However there is a sense in which people are entitled to all state benefits. Paying taxes when younger is part of a social contract that involves the understanding that you will receive various forms of insurance, usually but not always later in life. Insurance against ill-health (a free NHS), insurance allowing you to live a long life without financial hardship (a state pension), as well as insurance against unemployment, having a low wage job/poverty and so on.

If we see taxes in general as largely a form of insurance policy, and welfare benefits as a form of insurance payout, then the argument for workers paying national insurance contributions alongside income tax is diminished. Having two separate taxes on income leads to all kinds of distortions that make little sense, and for this reason many economists have long argued that the two taxes should be merged. [3]

The reason this sensible idea has not been adopted by most Chancellors is simple. It would mean that pensioners would pay more tax and workers would pay less. Pensioners tend to vote more often than workers, particularly younger workers. [4] In particular, given the current system pensioners would argue that such a merger would be unfair, because why should they contribute to their pensions once they start receiving those pensions?

However that argument could be turned around, suggesting that linking particular taxes to particular benefits is a bad idea. It is a bad idea because those paying for private education could argue they shouldn’t pay the taxes that go to fund state education, and those paying for private medical insurance shouldn’t pay so much for the NHS and so on. Arguing that state pensions are a return on earlier national insurance contributiions views taxes as just like personal insurance, where we pay taxes just for what we personally get back in return. Instead taxes can be seen, as I show above, as a form of social insurance, where society collectively insures all of its members. If that is the case, relating a particular tax to particular benefits makes little sense. 

[1] Could state spending on children be seen as a form of insurance against the cost of having kids? The reason I don’t think this works is the state doesn’t support a proportion of the cost of having kids, but instead funds all the cost of educating kids. A major reason it does this is because education has clear economic benefits for society. This is perhaps why the OECD sometimes distinguishes between public spending that is military (defence), economic (education) and social (much of the rest)

[2] Retire when the stock market is booming and your pension will be that much better than someone who has contributed exactly the same but retired when the stock market was bust. Defined benefit personal pensions avoid this problem, but are now increasingly rare outside the public sector. In addition annuity rates can vary widely depending on the level of long term interest rates at the time the annuity is taken out.

[3] In my post three weeks ago I questioned the wisdom on political economy grounds of economists, including the IFS, arguing for abolishing zero-rating of VAT, so I’m happy to support them on this particular issue. (Here is the IFS putting the case for merger.) The case for merging employers’ NI contributions as well as employees' is more complex, in part because in the short to medium term the incidence of this tax is only to a small extent on wages (see here and here).

[4] To avoid this an income tax and employees national insurance merger could be combined with a one-off uprating of pensions, perhaps combined with getting rid of the triple lock for future pension increases.