Office for Tax Simplification recommends radical structural change as distinction between national insurance and other levies becomes blurred

George Osborne is being urged to use his budget this month to announce the most radical shake-up of taxation since the birth of the welfare state, merging national insurance and income tax into a single system.

In a report on small business tax commissioned by the chancellor last July, the Office of Tax Simplification (OTS) – staffed by a team of fiscal experts – calls for an end to the parallel systems of national insurance and income tax.

"The overwhelming conclusion is that genuine and long-lasting simplification can only be brought about through major structural change to the UK tax system," the report said.

National insurance was established in 1911 to fund pensions and other welfare payments and was revamped after the second world war in the light of the Beveridge report to help pay for the NHS. But the "contributory principle", which links entitlement to some state bene fits to a worker's record of national insurance payments, has become increasingly eroded in recent decades.

The OTS points out only six state benefits depend on a worker's accumulated national insurance contributions (NICs).

National insurance is levied using a different definition of income to income tax – it is not paid on gains from capital, for example – and income tax is charged cumulatively over the year, while NICs are levied weekly. Businesses frequently complain that administering the two systems adds to the costs and complexity of their payroll.

"Our aim is to develop practical ideas that will make things easier for small businesses when it comes to their tax responsibilities," said John Whiting, the former PricewaterhouseCoopers accountant who led the study. "It clearly would be very radical to combine them totally, but there are stages you can go on along the way, each of which will bring a simplification dividend."

He said the idea of a flat-rate state pension, as recently suggested by work and pensions secretary Iain Duncan Smith, would further weaken the contributory principle in the years ahead. "If you're going for flat-rate pensions, why would you need it?"

A spokesman for Osborne said he would respond formally to the OTS's report in his budget on 23 March, but had an "instinctive sympathy" with the radical simplification plans.

"It would be nice for small businesses to hear that this is being taken seriously," Whiting said.

Stuart Adam, senior research economist at tax thinktank the Institute for Fiscal Studies, said the merger of the two systems was "an idea whose time had come".

"It would be a clear simplification: it would reduce administration and compliance costs and it would make the system more transparent," he said. However, he admitted that there would be tough political issues to solve – about whether employers would still pay separate NICs, for example.

The OTS also recommended in the report that the government reform the controversial IR35 tax rules. IR35 determines who must be treated as an employee of a company for tax purposes, and affects many contractors and small family firms.

Whiting said there had clearly been some abuses of the system, which the rules were aimed at solving, but "it's a bit like a lot of anti-avoidance, where a problem is spotted, and instead of picking up your carefully targeted rifle, you pick up a blunderbuss which splats everything in sight".

There are three proposals in the report: to suspend IR35 altogether, with a view to eventual abolition; leave the legislation in place but improve the way HM Revenue & Customs administers it; or introduce a new "business test", which would drastically reduce the number of taxpayers captured by the IR35 rules.

Chris Bryce, chairman of the pressure group PCG, which represents freelance contractors, said: "Should the chancellor accept the recommendation to abolish IR35 this would be a major advance towards honesty, transparency and fairness for the freelance community."

The OTS is chaired by ex-Tory Treasury minister Michael Jack, and led by Whiting, with four advisers from accountancy firms.