How Brown has taken from the rich to give to the poor

Julian McRae and Jayne Taylor on the chancellor's tax and benefit reforms

TUESDAY'S Budget marked a clear shift in the direction of tax and benefit policy. First, Gordon Brown, the Chancellor of the Exchequer, decided to redistribute income, against the trend of previous Budgets, from the rich to the poor.

On average, the poorest half of the population will be better off when all the Budget measures are implemented, while the richest half are going to see their incomes fall. And second, Mr Brown got down to the nitty- gritty of tax and benefit reform in a way not seen to this extent since Nigel Lawson left Number 11.

Perhaps the best illustration of these two trends was the changes announced to National Insurance. Like Nigel Lawson in the 1980s, Mr Brown used the Budget to remove some of the distortions from the system, in an attempt to enhance the operation of the much heralded flexible labour market. And, also like Lord Lawson, the current Chancellor took the opportunity to engage in some redistribution of the burden of National Insurance.

The remaining distortions in National Insurance arise primarily from the "entry fee" that becomes payable on all earnings once the lower earnings limit (currently pounds 62 per week) is reached.

This is clearly illustrated by the example of an individual whose weekly earnings increase from pounds 61.99 to the pounds 62 lower earnings limit. Someone earning pounds 61.99 pays no national insurance.

If their earnings increase by 1p, they have to pay employee contributions at a rate of 2 per cent on all their earnings, generating an employee NIC liability of pounds 1.24. At the same time their employer starts paying contributions at a rate of 3 per cent (or pounds 1.86).

So, as a consequence of this entry fee, a 1p rise in earnings leads to an increase in total national insurance contributions of pounds 3.10.

For employers, the national insurance system introduces even more distortions with further discrete "jumps" where a higher rate of national insurance becomes payable on all earnings as earnings rise. The top rate of employer national insurance contributions is currently 10 per cent.

Why should the operation of the current system be of concern to the Government? The reason is easily illustrated by looking at the graph.

It is evident that, for the most part, the distribution of weekly earnings in the UK is relatively smooth, the exception being the distinct spike just below the pounds 62 lower earnings limit.

This is proof positive that the current system of NICs is encouraging wage "clustering" at these low earnings levels, hardly in keeping with this or the last government's well-publicised objective of a flexible labour market.

In order to address this problem, Mr Brown removed the "entry fee" from both employers and employees. In addition, he announced that employer contributions would not start until earnings reached pounds 81 per week.

The removal of the employee entry fee cost the Chancellor just over pounds 1bn. However, he funded the reductions in employer NICs by introducing a single rate of 12.2 per cent on earnings over pounds 81.

This rate is higher than the current top rate of 10 per cent and as a result for people earning over about pounds 500 a year employers will have to pay higher contributions than at present.

For example, the employer of someone earning pounds 50,000 a year would pay about pounds 1,000 extra in contributions per year. On pounds 500,000 per year, the additional contributions would be over pounds 10,000. As such, the Chancellor has ensured that his reforms will generate substantial redistribution from high to low earners.

All this fits very nicely into the Government's wider policy aim to "make work pay" for those on low wages.

Mr Brown also hinted at further reforms to come. He announced that the Contributions Agency, the part of government that collects National Insurance, was to be merged with the Inland Revenue.

In addition, he stated that in the long term the Government intended to raise the point at which employees start paying national insurance to pounds 81 to match the change to employer contributions.

The pounds 81 figure was not simply chosen at random, but is the weekly equivalent of the income tax personal allowance. Given that national insurance is a tax on earned income in all but name, it has long been the goal of tax reformers to integrate the two systems. Whilst this move hardly represents a full integration, it is certainly a move in the right direction.

The first major Budget from a Labour Chancellor in nearly 20 years has finally completed the process of removing the unhelpful distortions from the National Insurance system - effectively finishing off the series of reforms begun by Lord Lawson in 1985.

But there is hope that Mr Brown will go even further, and finally bring about the integration of National Insurance and income tax. Were he to achieve this, Mr Brown would rightly take his place among the great reforming Chancellors of this century.

The authors are researchers at the Institute for Fiscal Studies