personal tax allowances as opposed to increasing tax credits are common to .... overseas markets has stunted domestic wa
Taxing decisions: the debate between tax credits and personal tax allowances Thomas Brooks with Chris Nicholson and Howard Reed
Taxing decisions
About the authors Thomas Brooks joined CentreForum in January 2011, and is the author of ‘Pathways to prosperity: making student immigration work for universities and the economy’. He studied PPE and previously worked for Sierra Leone’s Ministry for Foreign Affairs and International Cooperation. Howard Reed is Director of Landman Economics, which specialises in policy analysis and econometric modelling work. He is a research associate for both the Institute for Public Policy Research and Demos, and a trustee of the New Economics Foundation. His recent publications include ‘Fairness and Prosperity’, and ‘Plan B’, a report co-edited with Neal Lawson looking at alternatives to the current government’s austerity measures on the economy. Chris Nicholson has been Director and Chief Executive of CentreForum since 2010. Previously he was a Partner in the Corporate Finance Group and Head of Public Sector at KPMG, providing advice on a wide range of issues at the interface of public and private sectors. He started his career as an economist in the Department of Trade and Industry.
Acknowledgements The authors would like to thank James Plunkett from the Resolution Foundation for his advice throughout the preparation of the report. We are also grateful for use of the IPPR / Resolution Foundation tax-benefit model which underpinned our analysis.
Copyright 2012 CentreForum All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of CentreForum, except for your own personal and non-commercial use. The moral rights of the author are asserted.
Taxing decisions
: Contents
Executive summary
4
1 - The squeezed middle
8
2 - Raising revenues fairly
11
3 - CentreForum analysis
17
4 - CentreForum proposals
38
5 - Landman Economics proposals
52
6 - Landman Economics analysis
55
7 - Overall conclusions
80
Taxing decisions
: Executive summary “The squeezed middle” (Ed Miliband), “Alarm Clock Britain” (Nick Clegg) or “Hard working families” (David Cameron). Whatever term is used, it is clear that politicians are particularly focused on the squeeze on living standards of low and middle income earners. This squeeze has occurred over the past ten years and especially since the financial crisis in 2008. Despite the constraints on the public finances, there is a desire amongst politicians of all three main parties to support this group. There are wide ranging views, particularly in the run up to the March 2012 Budget, about the best way to do this. Some advocate cuts in VAT, others increases in child benefit. This paper focuses on the respective merits of increasing the personal tax allowance, as advocated strongly by the Liberal Democrats and some Conservatives, versus the benefits of increasing tax credits, one of the primary mechanisms used by the last Labour Government to improve the financial position of working families. The paper comprises analysis by CentreForum which makes the case for personal tax allowances and analysis by Howard Reed of Landman Economics who makes the case for tax credits. Chapters 1, 2 and 7 are jointly written, whereas chapters 3 and 4 and chapters 5 and 6 are written independently by CentreForum and Landman Economics respectively. The paper is a contribution to the Resolution Foundation’s Commission on Living Standards. We do not argue that personal tax allowances should replace tax credits, or vice versa. Both are key within the tax and benefit system. Personal tax allowances are important as a progressive way to provide individual incentives for work. Tax credits play a vital role in bringing a more needs-based approach to the taxbenefit system by operating at a household level. They ensure that, in particular, the needs of children are adequately provided for whilst giving individuals incentives to move into employment and off benefits. This paper examines whether the focus now should
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be on increasing one or the other. Table 1 summarises the relative advantages of the two approaches.
Table 1: Advantages of tax allowances and tax credits Personal Tax Allowances
Tax Credits
:
Simplicity
:
Less ‘leakage’ to high earners
:
Incentives for second earners
:
:
Workers keep more of extra income, which is determined by own effort
Strong incentive effect for households with young children
:
Greater reduction of child poverty
This paper is designed to show what could be done now, in the March 2012 Budget. As such, the analysis is based upon the existing Working Tax Credit and Child Tax Credit system rather than the Universal Credit system, which is due to be introduced in 2013, and for which the full details are not yet clear. Nevertheless, the fundamental issues raised about the relative merits of increasing personal tax allowances as opposed to increasing tax credits are common to both systems. Housing Benefit and Council Tax Benefit are not taken into account in our analysis of how tax credits and tax allowances affect incentives for example families. However, they are taken into account in the modelling of the costings and distributional effects of the policies. Housing costs and Council Tax do have an impact on the results but again, in our view, do not fundamentally affect the impact of the analysis on the issues raised. In order to fund increases in the personal tax allowances or tax credits we identify £11.9 billion of additional annual tax revenue and savings. These are generated from removing reliefs from the affluent and shifting the burden of taxation from income to wealth. In particular, they include £7 billion from removing higher rate tax relief on pension contributions, £1.7 billion from a mansion tax, £1.7 billion from limiting benefits such as winter fuel allowance and free bus travel for wealthy older people, £1 billion from increasing the rate of capital gains tax to align with income tax, and £0.5 billion from limiting tax free lump sums on pensions. This revenue could then be used to fund either of the 2 options which are the primary subject of our analysis: 1. Increasing the thresholds for income tax and national insurance allowances to £10,000, alongside a reduction of the higher rate threshold to £35,795.
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2. Increasing the basic element of WTC to £2,690 (rather than £1,920), the per child element of CTC to £3,500 (rather than £2,690) and the claimable proportion of childcare costs to 95 per cent (rather than 70 per cent).
Table 2: Distributional impact of primary proposals. RF type
PTA and NI £10,000
Tax Credits
Average Percentage change in change in weekly income weekly income (GBP)
Average Percentage change in change in weekly income weekly income (GBP)
Benefit dependent
0.91
0.44
19.08
7.45
Low-middle earner
12.20
3.26
23.73
5.21
High earner
12.54
1.47
2.04
0.21
1.67
0.46
0.68
0.18
Pensioner
Due to modelling limitations we have not been able to include the impact on different groups of the revenue raising measures. As revenue measures are the same between the two options it does not affect the comparative analysis.
Table 2 shows that based on a static analysis, increasing tax credits is more progressive than increasing personal tax allowances. This is not surprising. The extreme of a “progressive system” is taxing all income at 100 per cent and reallocating the income to households based on a complex needs-based formula. Such a system clearly would have a detrimental effect on incentives to work and better oneself, and hence on overall levels of income. Whether progressivity improves the income of low and middle income earners in the medium to long term depends on the effect on incentives. At the level of the individual the relative merits of personal tax allowances and tax credits in providing incentives differ. Tax credits provide greater incentives for first earners in household to work. But personal tax allowances provide a greater incentive for second earners in a household to work because they offer a double benefit to households, and limit the problem of credit clawbacks. In the longer term, CentreForum’s view is that proposals such as those set out by Howard Reed involve excessive reliance on a tax credit system. Firstly, it leads to the situation where, for example, the
Taxing decisions
state would pay an additional £17,400 to enable a single parent with two pre-school-age children to work 30 hours to earn a net wage of £10,000. Secondly, it would mean that a couple with two school-age children would still be receiving tax credits at an annual income of almost £39,000 and with pre-school-age children at a yearly income of £75,000. This, in CentreForum’s view, fails a “sense check” that any policy proposals should satisfy. At a political economy level, this leads to an economy where, with marginal effective tax rates of over 70 per cent where tax credits are awarded, an individual’s income is determined at least as much by the state as by their own endeavour. In CentreForum’s view, this is not desirable for long term incentives and growth. By contrast, Howard Reed takes the view that by itself, the income tax personal allowance suffers from a fundamental drawback as a redistributive tool and as a mechanism for improving work incentives. This is that the gain from raising the personal allowance goes mainly to people in the Resolution Foundation’s “high earners” group – people in the middle-to-upper reaches of the income distribution. This means that increasing the personal allowance by enough to make a substantial difference to work incentives is expensive. Given the tight state of the public finances, tax credit increases deliver more ‘bang for the buck’ in terms of improving work incentives for low-to-middle earners. Certainly, increasing tax credits does increase marginal deduction rates further up the earnings distribution as the credits are withdrawn. However, it is inevitable that if the generosity of a means-tested benefit or tax credit system increases, then more support has to be tapered away as income increases. The alternative – to give less to the poorest households – is distributionally unpalatable. Which is the most appropriate option is as much a political as an economic judgement.
Taxing decisions
: 1 – The squeezed middle Introduction “The squeezed middle” (Ed Miliband), “Alarm Clock Britain” (Nick Clegg) or “Hard working families” (David Cameron). Whatever term is used, it is clear that politicians are particularly focused on the squeeze on living standards of low and middle income earners which has taken place over the past ten years and particularly since the financial crisis in 2008. Since 2003 median wages in Britain have failed to rise with the growth of GDP, leading to a stagnation of middle and low incomes. This has particularly affected the finance, business and retail sectors, which have become increasingly important sources of employment in the British economy. There is a real concern that the UK might be mirroring the experience of the US where median wages have barely increased since the 1970s, despite large increases in productivity in the US economy. This stagnation has also been seen in other OECD countries such as Canada and Germany.
Who are the low and middle income earners we are concerned about? For the purpose of this report we are using the Resolution Foundation’s Commission on Living Standards’ definition of lowmiddle income earners. The Commission defines them as adults in households which are not primarily dependent on welfare payments for their income, falling between the 2nd and 5th income deciles, adjusted for family size. They are generally in work, but often time and money poor with low disposable incomes. They are also typically too rich to rely on means-tested state benefits, but too poor to have full access to housing and other markets. This group currently comprises 11 million working-age adults in Britain.
Couples with no children are considered to be low-middle earners if they earn £12,000 to £30,000, whereas a couple with three children are low-middle earners if they have an income of between £19,200 and £48,500. The first decile is defined as benefit reliant, and the 6th to 10th deciles are considered to be high-income.
Taxing decisions
Not only have low and middle wages stagnated, but inflation of costs for vital commodities such as housing and fuel has hit lowmiddle earners particularly hard. Childcare costs – well above the OECD average – have continued to rise above growth in wages.
Why have median wages stagnated? There are numerous possible explanations as to why this has occurred, although no single definitive theory has emerged. Some speculate that the outsourcing of middle jobs to more competitive overseas markets has stunted domestic wage increases, while others argue that new technology has engendered wage inequality. Technology complements highly educated workers and increases their wages. It also replaces routine manual and non-manual tasks such as those carried out by secretaries and bank tellers. But it has not yet eradicated non-routine tasks such as cleaning, which has contributed to a wider ‘hollowing out’ of the jobs markets with ‘lousy’ and ‘lovely’ jobs, but fewer middle ones. Although we can see the disparity in productivity growth and lowmiddle wages, a variety of what appear to be mitigating factors has masked this wage stagnation: a greater number of women in work, improved access to personal credit, and a more comprehensive tax and benefits system. While the economy was strong these helped to boost household incomes, hiding the real earnings lag. But since the economic downturn in 2008, the influence of these has reduced, exposing stagnation and threatening to reduce the living standards of low-middle earners. Between 1968 and 2008 the tax-benefit system accounted for 34 per cent of all growth in low-middle household incomes. As in many OECD countries, successive British governments consciously topped up wages with tax credits, assuming a greater burden over time. The child tax credit (CTC) has supported low income families, and the working tax credit (WTC) has supported those on low wages. In the past 18 months, however, credit withdrawal rates have increased, thresholds for eligibility for credits have been reduced, and benefits themselves have been cut or frozen. The pattern of the
J Plunkett, ‘Growth without Gain’, The Resolution Foundation, 2011, p. 18. M Goos and Al Manning, ‘Lousy and Lovely Jobs: the Rising Polarization of Work in Britain’, Centre for Economic Performance, London School of Economics and Political Science, 2003. In 1977. 29.5 per cent of all gross incomes went to low-middle earning households compared to 21.5 per cent in 2008. But after redistribution through the tax-benefit system, these figures were 30.5 per cent in 1977 and 25.2 per cent respectively. J Plunkett, Growth without gain?, Resolution Foundation, May 2011, p. 10.
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last decade of steadily increasing government support looks set to change.
Context Other papers submitted to the Commission on Living Standards have looked at alternative ways to boost low-middle household income, such as the contribution which second earners in a household have made to household income growth and what might be done to make it easier for second earners in a household (primarily mothers) to be in the labour force. This paper focuses on the potential for the tax and benefit system to help boost low-middle household incomes. Tax credits and allowances can offer more incentives to work and increase disposable incomes, as well as nudging individuals into different social and work patterns. In the short-term they can be used to ensure that low-middle income earners are not excluded from growth. In particular the paper looks at the relative merits of increasing personal tax allowances against using the tax credit system to boost low-middle household income. We consider the current tax credit system rather than Universal Credit. Many of the main traits of the current system will apply similarly to Universal Credit, although further study once the final details of the new credit system are clarified would be fruitful. Chapter 2 outlines our joint proposals to raise revenue for the government, which could be spent on tax allowances or tax credits. In chapter 3, CentreForum draw comparisons between allowances and credits. Then CentreForum (chapter 4) and Landman Economics (chapter 5) present their proposals for reform to the tax allowance and tax credit structure respectively. In chapter 7, Howard Reed of Landman Economics compares the implications of the proposals, before chapter 7 draws final conclusions. As stated in the Executive summary, chapters 1, 2 and 7 are jointly written, whereas chapters 3, 4, 5 and 6 are written independently.
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: 2: Raising revenue fairly In this section we set out ideas of how significant sums might be raised to finance tax cuts for low-middle earners and to boost incentives to work. We outline proposals that would raise a total of £11.9 billion for the Exchequer, achieved primarily by the removal of reliefs and allowances for high income earners and benefits for more affluent pensioners. We also advocate a shift in the burden of taxation from earned income to unproductive wealth, so as to provide a greater incentive to work whilst not adversely affecting low-middle earners. These are measures which could be adopted in the 2012 Budget if there were the political will. We also set out some areas where longer term additional revenue might be raised to promote further tax cuts. All the immediate proposals in this report are fully funded by revenue raised elsewhere, so there would be no adverse impact on the budget deficit.
Higher rate pension tax relief: £7 billion Higher rate pension tax relief should be abolished. It provides full tax relief to high earners paying into pension funds, and has a yearly allowance of £50,000 and, as of April 2012, a lifetime allowance of £1.5 million. This is a highly regressive system, as it encourages and subsidises the saving of higher rate taxpayers. We propose that tax relief is limited to the basic rate for pension contributions. Higher rate taxpayers would thus receive only 20 per cent tax relief on their contributions and would in most cases pay 20 per cent upon receipt of pension payments above the personal tax allowance.
This has been cut from £255,000 per year in 2010-11. See www.hmrc.gov.uk/incometax/ relief-pension.htm. The government offers immediate tax relief at 20 per cent, and higher rate taxpayers can apply for additional relief to take their rebates to 40 or 50 per cent. Only a small proportion of pensions lead to incomes above the higher rate threshold. See D Newby, ‘Tax and the coalition: responsibility and fairness?’, CentreForum.
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Ending higher rate tax relief on pension contributions would save the government £7 billion per year. The saving would come almost exclusively from savers paying higher rate tax, so would have a minimal impact on low-middle income households.
Pension tax free lump sum: £0.5 billion Pension lump sums receive relatively little attention in comparison with higher rate tax relief. Around 80 per cent of pensioners drawing private or company pensions choose to claim a tax-free lump sum upon their retirement. This will be up to £375,000 (from April 2012) and allows individuals to receive a large payment which has not been subject to tax. The current pension lump sum system subsidises wealthy pensioners, which is unfair at a time when individuals living on the state pension are being squeezed, and there are over a million young people unemployed. In a past CentreForum publication, Lloyd and Nicholson proposed that the tax-free lump sum allowance should be limited to the higher rate threshold of income tax, which is currently £42,475. Tax would then be levied at 40 per cent on any additional income claimed as a lump sum. It was estimated that this could lead to a yearly benefit for the Treasury of £0.5 billion. The average lump sum withdrawn is £21,000, meaning that this policy would only hinder those withdrawing lump sums twice as large as the average claim.
Mansion tax: £1.7 billion There are strong economic reasons why a shift in the burden of taxation from income to wealth would be beneficial and fairer, primarily because the distribution of wealth is more unequal than the distribution of income. Property represents the major source of saving for most homeowners and, as first homes are not subject to capital gains tax, is largely untaxed. Although Newby argued in his CentreForum paper that a land value tax in the long term is likely to be the most economically efficient, this would take a long time to implement. Amongst the options to introduce greater progressivity into the taxation of land and buildings would be to have a Council Tax revaluation (which has not been updated since 1991) and to introduce new Council Tax bands (currently the highest bracket is
M Lloyd with C Nicholson, ‘A relief for some: how to stop lump sum tax relief favouring the wealthy’, CentreForum, November 2011.
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for properties worth more than £320,000). It seems inconsistent and unfair that someone in a house worth £3.5 million pays the same tax as someone in a house worth less than one tenth of that price. However this is currently deemed to be politically impossible. In the light of this, a third best option is to introduce some form of mansion tax, charging a small levy on only the highest value properties. The government should impose a small levy of 1 per cent on the value of properties exceeding £2 million, meaning that a house worth £3.5 million would have an annual bill of £15,000. This is an appropriate source of taxation because it focuses on extreme wealth, and deters neither enterprise nor job creation. It also minimises the risk of tax avoidance because property cannot simply be moved offshore. It is estimated that this would raise £1.7 billion per year. This would have very little negative impact on low income households as it is only levied on those with very large capital assets. A large proportion of revenue will come from London and the South East, which are the only areas in England which have experienced a rise in living standards in the past 7 years. Indeed, 60 per cent of the properties sold for more than £2 million were bought by foreign nationals, who may not pay any income tax in Britain, and have price inelastic demand for property.10
Capital Gains Tax: £1 billion The rate at which capital gains tax (CGT) is charged should be increased so that it is equal to income tax. CGT taxes profits from the sale of individuals’ capital assets, and has been changed by the Coalition from a flat rate of 18 per cent to a two-layered system with a basic rate of 18 per cent and a second rate of 28 per cent for higher rate taxpayers. Basic and higher rate taxpayers can currently save 2 and 12 percentage points of their earnings respectively by recategorising income as capital gains. CGT rates should be aligned with income tax so that it is charged at the same rate, and that the personal annual exemption for CGT is
10
This is (£3.5 million - £2 million) / 100. By contrast, under current tax legislation the owner of a £3.5 million mansion in Wandsworth would only pay £1,363 a year in council tax. S Adam et al, ‘Taxes and Benefits: The Parties’ Plans 2010 Election’, Briefing Note No. 13, Institute for Fiscal Studies, 2010. D Newby, ‘Tax and the Coalition: Responsibility and Fairness?’, CentreForum.
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not larger than the personal tax allowance.11 However, to promote growth it is important that entrepreneurs’ relief is maintained. CGT is likely to raise £3.4 billion in 2011–12.12 Using a conservative assumption that two thirds of CGT contributions are paid by higher rate taxpayers (who are not eligible for entrepreneurs’ relief), we can estimate that levelling income and capital gains taxes would raise an additional £1 billion a year for the Treasury. An increase in CGT rates would be unlikely to affect the saving of low-middle earners, as the vast majority of their saving is done through untaxed pensions, ISAs and first homes. Moreover, any additional savings are unlikely to exceed the annual CGT allowance of £10,100. CGT is generally paid by the wealthiest members of society, so alignment with income tax would be progressive.
Subsidies for wealthy older people The proposals above seek to address tax avoidance and the subsidy of wealthy individuals’ pensions. But there are also significant subsidies going to those already in retirement who, in many cases, do not need state support more than those of working age with identical incomes. We propose that the winter fuel allowance and free bus passes should only be paid to those above state retirement age, rather than at age 60 as at present. Currently we have the inconsistent situation of people aged over 60 who are still working being provided with free travel and subsidised heating. In addition we would limit these benefits and free TV licences to only those individuals whose incomes are below the personal tax allowance. Anybody earning above this should not receive state benefits simply because of their age, as younger people on exactly the same incomes offer net support to, rather than receive benefits from, the state. This would continue to support pensioners with low incomes, but not to those who have a high enough income to pay tax. Currently more than half of all pensioners have an annual income exceeding the under 65 personal allowance, and even if the allowance was raised to £10,000 half of pensioners would continue to have an income greater than this.13
11 12 13
The CGT personal annual exemption (currently £10,100) should be aligned with the personal income tax allowance (Currently £7,475) because the current discrepancy is inconsistent and regressive. Institute for Fiscal Studies, Survey of the UK Tax System. www.ifs.org.uk/bns/bn09. pdf. The Department for Work and Pensions, The Pensioners’ Incomes Series 2009-10, Table 4.1: The median net income of pensioner units by quintile of the net income distribution, 1998-01 and 2007-10.
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Winter Fuel Allowance: £1 billion This government is expecting to spend £2.1 billion on winter fuel payments this year, to over 9 million pensioner households. The fuel allowance offers at least £200 to any household with an individual aged over 60, and £300 if there is an individual aged over 80.14 Unlike cold weather payments, the winter fuel allowance is entirely unrelated either to weather conditions or to fuel prices. Although it is designed to tackle fuel poverty - which is defined as spending more than 10 per cent of income on fuel bills - currently only 12 per cent of allowances go to old people who are actually living in fuel poverty. This is particularly odd considering that across households of all ages, 18 per cent were in fuel poverty in 2009.15 Winter fuel allowance should be given only to those aged over 65 whose incomes are below the PTA because those earning above this level are not near fuel poverty.
TV licences: £0.2 billion Currently any household with an individual aged 75 or over can receive a free TV licence, regardless of the income of that individual or household. This policy currently costs the government over £550 million a year, which could rise to £725 million by 2015.16 Licences should only be awarded to pensioners with an income below the personal tax allowance. On average, those over 75 have an income lower than pensioners as a whole, so this would be unlikely to raise half of the current cost, but would raise at least £200 million.
Bus Passes: £0.5 billion All individuals aged 60 and over are eligible for a bus pass, which offers free travel on local routes. This offers independence and can improve the lifestyles of retired people, but should not be given to all. The eligibility for the pass is going to rise gradually so that by the end of the decade both men and women are only eligible when they reach 65. This change should happen immediately to a scheme that currently costs £1 billion per year.17 As with the fuel allowance and TV license, this benefit should only be offered to those with income below the personal allowance. 14 15 16 17
Eligibility currently begins at 60, although this is due to rise with the pension age. www.poverty.org.uk/80/index.shtml. P Booth and C Taylor, ‘Sharing the burden - How the older generation should suffer its share of the cuts’, Institute for Economic Affairs, February 2011. It is complicated to forecast the future cost of this policy. On one hand the rise in eligible age to 65 could save £60m annually (BBC), but on the other a growing population of old people and rising transport prices could see the total cost rise to £1.3bn by 2015-16 (IEA).
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The tax gap The government should strengthen efforts to reduce the tax gap (also known as the theoretical liability), which shows the loss of tax revenue from individuals and companies failing to comply with either the spirit or the letter of the law. The total tax gap is estimated to have been £35 billion in 2009-10, which equates to around 8 per cent of the total tax liability for that year.18 Recent policy has helped to reduce this, such as the disclosure of tax avoidance schemes which was introduced in 2004. But the tax gap can still be reduced in a variety of ways. First, the number of HMRC staff collecting tax could be increased. The number of tax collection staff has fallen from 99,000 in 2004-05 to 67,500 in 2010-11 as a result of pan-departmental austerity measures. Second, staff should be given additional incentives to exceed their departmental revenue targets. As argued by Dick Newby, they could be offered a proportion of all additional income above their departmental targets, which could be invested in additional staff.19 Third, as the Treasury’s Aaronson Review recommended, a narrowly-focused General Anti-Avoidance Rule (GAAR) or AntiAbuse Rule (AAR) should be introduced.20 This would deter abusive tax avoidance schemes and reduce legal uncertainty around other tax avoidance schemes. Fourth, greater use of tax policies which are hard to avoid or evade would reduce the tax gap. As we have shown, a tax on mansions would be hard to evade because properties have a known and fixed location, and aligning CGT with income tax would reduce scope for conversion of income into capital gains for tax avoidance purposes. It is hard to provide an accurate estimate of how much revenue these four measures would raise. But it is clear that, with a tax gap of £35 billion, even an improvement of 5 per cent would add a significant amount to the public purse. The costs of reducing the tax gap would be felt mostly by those with the motive and means to avoid or evade tax. As such, this would be progressive and cause little harm to low-middle earners. Even excluding potential revenue from reducing the tax gap, these policies would raise at least £11.9 billion.
18 19 20
HM Revenue & Customs, ‘Measuring Tax Gaps 2011: An Official Statistics Release’, 21st September 2011 D Newby, ‘Tax and the coalition: responsibility and fairness?’, CentreForum. It should cover the main direct taxes: income tax, capital gains tax, corporation tax, and petroleum revenue tax, as well as national insurance contributions.
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: 3 – CentreForum analysis Introduction Making employment pay for low and middle earners The personal tax allowance (PTA) offers individuals an annual allowance before they start to pay income tax. Tax credits are used to support families based on household incomes, which better indicate family circumstances, but the process is bureaucratic and can skew work incentives. Both the current and previous government have recognised the benefits of balancing the PTA and tax credits for supporting incomes and work incentives of low-middle earner families. The current government, however, has taken a somewhat different view to its predecessor on the optimal balance. It has placed a greater emphasis on raising the PTA. For example, the Deputy Prime Minister in a speech to the Resolution Foundation in January 2012 criticised “the illogicality” that an individual earning £10,000 is seen by the tax system to be earning enough to contribute to the state, whilst at the same time receiving working tax credits. The purpose of this chapter is to compare how the personal allowance and tax credit systems can be used to boost the income of low-middle earners in a fair way that is simple and creates incentives to work.
Concepts Tax allowance The personal tax allowance is an allocation of income that an individual can earn each year before they start paying income tax. A major advantage of this is its simplicity for taxpayers and the taxman. Both self-assessing individuals and those paying tax through a job or pension receive a personal allowance automatically, without
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Taxing decisions
needing to complete any application forms. People know that their allowance – currently £7,475 for those under 65 years of age – will not be subject to any income tax.21 The tax allowance also creates a significant direct incentive for second earners in households to work, or to share the workload, to take advantage of allowances. Giving individuals an allowance of untaxed income is the first stage of a progressive tax system, recognising that as income rises, so should rates of contribution. The personal tax allowance means that tax is paid incrementally at a rate of 0, then 20, 40 and 50 percent as income increases. The Coalition Agreement established an increase in the PTA as a long term policy objective, and committed to making real terms increases in the allowance each year to reach £10,000 by 2015. This has been prioritised over other tax cuts, and is designed to help low-middle earners.22 Recently, some in the coalition have outlined the aim of increasing the PTA further beyond the coalition’s £10,000 commitment perhaps to the full time equivalent of the national minimum wage (NMW). Such a change would reduce the participation taxation rate (PTR) which is the difference between income out of work and income in work at specific levels, and mean those working full time on the minimum legal wage do not have their income reduced by tax.23 This has been supported by various commentators not just for moral reasons, but also because it would reduce problems of high marginal effective taxation rates (METR) for second earners, and would enable individuals to keep the money they earn rather than see it taxed and subsequently returned as credits.24
Tax credits The term tax ‘credit’ is a slight misnomer – households paying no tax can still receive tax credits, which are direct payments from the government. Whereas personal tax allowances operate at the level of the individual, tax credits operate at the household level. 21 22 23 24
Every individual is entitled to the full allowance until their income reaches £100,000, at which point the allowance is reduced by 50p for every additional pound earned. HM Government, The Coalition: our plan for government, May 2010, p. 30. The Participation Tax Rate is net gain from work as a proportion of gross earnings. This is reduced by greater personal allowances and work-related credits, whereas withdrawal of credits can increase it. The marginal effective tax rate is the rate of tax paid by an individual on an additional unit of labour based on income tax, national insurance and the withdrawal of means-tested benefits and credits. For examples of why the PTA should be increased beyond £10,000, see: www.reform.co.uk/client_files/www. reform.co.uk/files/reforming_welfare.pdf, www.adamsmith.org/sites/default/files/ images/uploads/publications/Working_Welfare_Final.pdf, and www.newstatesman. com/blogs/the-staggers/2011/09/alexander-treasury-chief.
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They are means-tested on an annual basis, and are designed to help low income households, based on the principle that money should be given to those who need it. The credit system enables more careful targeting of money to low-middle income households than increasing PTAs, which operate at an individual level. The importance of tax credits has grown in the past 15 years, following a general pattern across developed countries.25 Tax credits were reformed by the Labour government in 1999, which replaced the Family Credit with the Working Families Tax Credit. This was subsequently replaced by CTC and WTC in 2003. CTC is designed to support low income households with at least one child, and is not conditional on work. WTC is also means-tested on income, but also has the condition that households must include employed or self-employed individuals. It supports parents’ childcare costs, and seeks to create incentives to enter work. The government faces a trade-off between efficiency and equity: credits that are not work-related are likely to reduce incentives to work (efficiency) but promote living standards (equity), and in this way CTC may cancel out some incentives created by WTC.
In practice Tax allowance The PTA is currently £7,475, and Table 3 shows how the income tax structure has changed over the past 4 years. Before 2008 the tax allowance grew only with inflation, remaining constant in real terms, but has increased significantly above inflation each year since (apart from a freeze in the nominal allowance in 2010-11 which represented a reduction in real terms). The point at which individuals start paying higher rate tax – the higher rate threshold - was relatively consistent around £40,000 until 2009-10 when it increased in real terms to almost £44,000. Since then it has declined to its present level of £42,475. The increase of the PTA in 2011-12 was the government’s first step towards meeting its commitment to reach £10,000 by 2015. The allowance was increased by £1,000 and the higher rate threshold was reduced by £2,400, which the government claimed took 880,000 people out of paying income tax and created 400,000 new higher rate
25
The Mirrlees Review, ‘Reforming the tax system for the 21st Century’, Institute for Fiscal Studies, Chapter 1: Means testing and tax rates on earnings, p.2.
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taxpayers.26 The Institute for Fiscal Studies (IFS) has disputed these figures, estimating that 500,000 people were taken out of tax while 750,000 additional higher rate taxpayers were created.27 Individuals who were shifted into the higher rate of income tax faced an METR of 42 rather than 32 percent. This is because National Insurance (NI) is reduced from 12 to 2 per cent as tax rises from 20 to 40 per cent. 28 The government predicts that its proposed changes to increase the PTA by £630 in 2012-13 will take another 260,000 workers out of tax, and the IFS estimates that if the PTA reaches £10,000 by 2015, a total of 1 million people will be taken out of income tax.
Table 3: Income tax changes 2008 – 2012 Year
2008-9
2009-10
2010-11
2011-12
2012-13
PTA (under 65)
£6,035 (6,607)
£6,475 (£7,126)
£6,475 (£6,812)
£7,475 (£7,475)
£8,105 (£7,868)
Basic rate at 20%
£6,036 – £40,835 (£6,608 £44,704)
£6,476 - £43,875 (£7,127 £48,289)
£6,476£43,875 (£6,813 £46,159)
£7,476 £42,475 (£7,476 £42,475)
£8,106 -£42,475 (£7,869 - £41,237)
Higher Rate £40,835 Threshold (£44,704)
£43,875 (£48,289)
£43,875 (£46,159)
£42,475 (£42,475)
£42,475 (£41,237)
Higher Rate £40,836 + (£44,705)
£43,876 + (£48,290)
£43,876 £150,000 (£46,160 - £157,807)
£42,476 - £150,000 (£42,476) - 150,000)
£42,476£150,000 (£41,237 - £145,631)
Additional Rate
N/A
50% on £150,001+
50% on £150,001+
50% on £150,001+
N/A
Italics show levels adjusted for inflation to 2011-12 levels. 2012-13 figures based on assumption of 3 per cent inflation.
Tax credits Tax credits are withdrawn at a rate of 41 per cent after household incomes reach relevant thresholds: for WTC this is £6,420, and for
26 27 28
HM Revenue and Customs, Budget Update: Income Tax Rates, Rate Limits and Personal Allowances for 2011-12,. The IFS Green Budget, February 2011, Chapter 12: The impact of tax and benefit changes to be implemented in April 2011. The Upper Earnings Limit and Upper Profits automatically reduce the level of NI from 12 to 2 per cent to ensure that higher rate taxpayers do not pay 52 per cent, or that former higher rate taxpayers do not pay a marginal rate of 22 per cent if thresholds are raised.
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CTCs it is £15,860.29 These thresholds are designed specifically to ensure that households don’t have these two credits withdrawn simultaneously.30 Table 4 presents the key elements of the tax credit system.
Table 4: Key elements of Child and Working Tax Credits for 2012-13 CTC
WTC
Key elements
: Child Tax Credit Family element £545 : Child element (per child) £2,690 : Disabled child element £2,950 : Severely disabled child element £1,130
: Basic element: £1,920 : Couple and lone parent element: £1,950 : 30 hour element: £790 : Childcare element: 70% of £175 / week for 1 child : 70% of £300 / week for more than 1 child
Withdrawal point
£15,860
£6,420
Means testing
Income and children
Income and work
Effect on PTR High if income above is above for a first earner withdrawal point
Low (possibly negative) because benefit would not be paid if out of work
Effect on PTR for a second earner
High - will lose credits received by partner
High - will lose credits received by partner
The WTC income disregard of £6,420 is not dissimilar to the current PTA, but unlike credits, the benefit of the PTA does not diminish as earnings pass the threshold. Because tax credits are aimed primarily at families rather than individuals, withdrawals can create high METRs for second earners, which deter work. Just above the PTA they can face a METR of 73 per cent because of: 20 per cent income tax, 12 per cent national insurance, and 41 per cent tax credit clawbacks. Added to childcare costs, this can mean that work hardly pays, and acts as a deterrent for second members of households who are considering entering the labour market. To reduce disincentives to work, resources can be used to increase the point at which credits are withdrawn or on reducing the rate at 29 30
Although credits are withdrawn from this level, the family element is not tapered until household income reaches £40,000. A couple working over 16 hours a week are entitled to £3,870 through WTC, which when tapered at a rate of 41 per cent from £6,420 runs out at £15,859, just before CTCs begins to taper at £15,860.
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which they are withdrawn.31 But such changes would not remove the fundamental issue that household credits create withdrawals at some point, creating disincentives for second members of households to enter work.
Comparison: Personal Tax Allowances and Tax Credits In this section we analyse questions of principle about the two approaches, before discussing how they support low earners, how each approach affects work incentives (both in terms of first and second earners, and to enter or increase work) and how simple they are to administer.
To tax or not to tax? The issue of whether we should use personal tax allowances or tax credits to improve the living standards of low and middle income earners, to a significant degree, depends on a view of the appropriate role of the state. In particular whether the income of individuals or families should be primarily determined by their own efforts or whether the state should decide their income level. Simply because a particular policy is at any time more “progressive” than another policy does not mean that it is therefore the most appropriate policy. The extreme of such a stance would be that the state would tax everyone at 100 per cent and allocate income according to a household’s needs. The other extreme would be that there is no state support for individuals or households. Nothing close to either of these extreme positions is advocated in this report. However, these extremes illustrate the point that there will be a position between the two extremes where judgements will be made as to where the balance should lie. This is in many respects an essentially political decision, somewhat divorced from economic theory. The stance which we take as a liberal think tank is that the taxation system should be clearly progressive. Within the context of the tax and benefit system there should be some allowance for additional costs of having children at a household level to ensure that as far as possible they have an equal chance in life whatever their parents’ income. We also believe that additional financial incentive is justified in order to encourage people into work rather than being dependent 31
The Mirrlees Review: Reforming the tax system for the 21st Century, Institute for Fiscal Studies, Chapter 2: Means testing and tax rates on earnings.
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on benefits. The tax credit system therefore serves a useful purpose. There is, however, a concern that the development of the tax credit system has reached a stage where the balance between tax credits and personal tax allowances needs to be adjusted. How should we treat low-middle income households where people are in work but paid little enough to still receive state support? Is it best, both in principle and in practice, to tax low-middle earners only to pay them back in the form of credits? Or is it preferable to support them by increasing tax allowances rather than increasing credits? Currently an individual working full time on the NMW receives tax credits and pays taxes, and faces a METR including credit clawbacks of 73 per cent. This raises two distinct problems. First, the tax and credit systems do not interact coherently. Both first and second earners can continue to receive credits, while simultaneously facing withdrawals from the tax system through income tax and NI. In this way, the government is taxing with one hand only to give back with the other. It seems illogical that lowmiddle earners should be paying tax and NI on earnings whilst also receiving work-related credits. For example, an individual without children will still be receiving tax credits up to an income level of £13,000 (working 30 hours per week) having started paying income tax from £8,105 from April 2012. Currently, a childless couple with one member working 30 hours per week on the NMW would have to pay £672 in income tax and NI but would receive £3,255 from the WTC. This couple would continue to be eligible for the WTC until their income reached £17,785. Moreover, under the Landman Economics proposal B to increase the basic element of WTC to £3,450, a single person earning £16,000 a year would still receive WTC payments, despite paying tax and NI on half of their income. Attaining greater coherence between the tax and credit systems will require a rebalancing of tax allowances and credits. Whilst as the WTC and CTC are designed so that they are not withdrawn simultaneously, there is illogicality in the transition between withdrawal of credits and taxation of income. Second, there is arguably an inconsistency between what the state deems to be a fair wage and the point at which it starts to tax individuals’ wages. On one hand the government is implying that an individual cannot be paid less than the NMW, but on the other it is reducing their income through taxation. This happens because the PTA is currently considerably smaller than the income of an individual
23
Taxing decisions
working full time earning the NMW – around £12,000. Thus individuals earning the minimum wage - the lowest rate deemed acceptable by the government - still pay tax at 20 per cent and national insurance at 12 per cent on around half of their income. So there is a argument that the personal allowance should be increased to the income of an individual working full time on the NMW. As the PTA increases, more and more citizens are taken out of income tax and do not contribute to the state in this way. This, some have argued, is undesirable because untaxed citizens have less invested in society. However, individuals who do not pay income tax still continue to contribute in other ways such as through national insurance, VAT and council tax. We believe that ‘sense checks’ of the proposals made by Landman Economics illustrate how additional assistance given through the tax credit system would lead to undesirable results. We use two tests to illustrate this point. The first is to see at what point various households lose all entitlement to tax credits. The second test is to look at the cost to the Exchequer of getting an individual back into work. Table 5 shows the point at which various typical households lose all entitlement to working and child tax credits. It can be seen, for example, that under the current system a couple with two school-age children would lose their entitlement to tax credits at a household income level of around £31,000. This would rise to £38,000 under the Landman proposals. If the same household has two children below school-age under the current system they might receive tax credits until they are earning £58,000 – already a high amount. This would increase to £74,000 under the Landman proposals. Rather than concentrating state support to those low earners who require assistance, these proposals would make many families almost as dependent on the state determining their income level as their own endeavour.
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Taxing decisions
Table 5: Point at which household incomes cease being eligible for WTC and CTC32 Household
2012-13
Landman Proposal A
Lone single
£13,029
£14,907
Working couple with 2 children at school
£31,578
£38,724
Working couple with 2 pre-school children
£58,212
£74,871
Table 6 shows the cost to the Exchequer of getting typical single parents back into work under the Landman Economics proposals and assumptions, compared to CentreForum’s proposal and the government’s plans for 2012-13. In all cases the cost ignores the child tax credit, as this is not work dependent. Whilst most people would accept some Exchequer cost is justified to get people back into work, the Landman Economics tax credit proposals increase costs considerably beyond current government plans. For example, in our judgement for the Exchequer to bear a cost of around £17,500 to enable a single parent to earn less than £10,000 in net income from working 30 hours a week seems to fail the sense check. In our view, therefore, that the effect of the additional support provided by the tax credit system under the Landman proposals, whilst being more progressive in static distributional terms, fails the “sense check” of acceptability.
Table 6: Costs to government of a single parent of 2 children entering work Hours Total cost: Single Landman parent’s Proposal earned net wage
Total Cost: CentreForum Proposal A
Single parent’s earned net wage
Total cost: Government proposals 2012-13
Single parent’s earned net wage
16
£14,624
£5,824
£10,859
£5,824
£10,859
£5,824
30
£17,443
£9,958
£13,441
£10,625
£12,773
£9,958
40
£14,786
£12,433
£10,784
£13,200
£10,116
£12,433
32
Assumes households are in receipt of 30 hour element of WTC and that working couple spend £300 / week on childcare.
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Taxing decisions
Support of low-middle income households The distribution of benefit from increasing the PTA varies, depending on treatment of the higher rate tax threshold. Doing so without reducing the higher rate threshold gives equal additional benefit to those earning above the PTA and below £115,000, when the allowance fully tapers out.33 This helps low-middle income earners but does not target resources accurately at them. Criticism of increasing the PTA often assumes that this is the technique used.34 By contrast, in 2011-12 government increased personal allowances without benefiting higher rate taxpayers by reducing the point at which higher rate tax is paid.35 Although the PTA can be increased in a way that excludes higher rate taxpayers from the benefit, tax credits retain the fundamental advantage that they avoid ‘leakage’ of support to high earners and ensure that resources go to the neediest members of society.36 Need is also arguably better assessed at the household level rather than the individual. Increasing the PTA to £10,000 would increase the income of anybody currently earning above £7,475. Everybody earning between £7,475 and £10,000 would receive an extra 20 per cent of their gross income over £7,475, worth up to £505. All those earning between £10,000 and £15,000 would benefit by £505. Those earning between £115,000 and £120,000 would benefit by a proportion of £505, and those earning more than £120,000 would not benefit at all. So PTAs do support low-middle earners, but less than tax credits in the immediate term. The distributional impact should be considered taking into account the net effect of the tax system and how increases in the PTA could be funded. As consistently argued by the Mirrlees Commission and the IFS, tax changes should be measured in their entirety. So, if a larger tax allowance is funded by an increase in taxation of the affluent – such as abolition of higher rate tax relief on pension contributions – it can reduce the tax burden for low, middle and 33 34 35 36
The proposed expansion of the PTA to £8,105 for 2012-13 does not alter the higher rate threshold so will benefit everybody earning between £7,475 and £116,210. For example: K Lawton, ‘Coalition Tax Policy’, Institute for Public Policy Research, September 2011. This assumes that option A was used, that as the PTA grows the higher rate threshold is constant. This can mean that the very richest, earning over £120,000, lose money because their allowance tapers out fully but they face a lower threshold for higher rate tax. Two people earning £35,000 each would not receive any CTC or WTC, whereas a couple earning £17,500 each would receive some CTC. By contrast, if personal allowances were increased to £10,000 the couple with combined income of £70,000 would benefit the same as the couple with combined income of £35,000.
26
Taxing decisions
high earners whilst simultaneously being clearly a progressive reform. Furthermore, funding increases in the PTA through taxes on unproductive wealth will create both a more progressive society and a more dynamic economy. As a complete policy package, therefore, increasing the personal allowance is progressive. A larger personal tax allowance also ensures that the lowest earners pay no tax, which is currently often not the case even while they are receiving credits. The PTA particularly helps women; 60 per cent of those taken out of tax by the increase in PTA in 2011-12 were female.37
Incentives to work The WTC can offer strong incentives to work to certain levels, more specifically, to work the 16 or 30 hours necessary to receive it.38 But once these levels have been reached, credit withdrawals significantly reduce the incentive to work more. The disincentive is particularly for second earners in couples who have no income disregard.
Comparing first and second earners Additional income from the WTC generally increases incentives for first earners. But second earners generally lose the credits earned by the first earner when they work, as they are clawed back. WTC offers low PTRs for first earners in low-middle income households by offering support through the basic element, second or lone parent element and 30 hour element. It specifically creates strong incentives to work 16 hours or 30 hours, but has little positive effect at other work levels. Households then have their credits withdrawn at a rate of 41 per cent on income earned above £6,420 until their credit entitlements are fully withdrawn. So a primary earner with 2 children of school age will face a marginal taxation rate of 73 per cent – including NI, income tax and credit withdrawal – on earnings above the income disregard. The PTA offers incentive for first earners, but has less influence than tax credits because it does not offer a premium as WTC does. This is shown in Figure 1. Larger tax allowances offer slightly more incentive to work more hours than the status quo, but the benefits are dwarfed by those of tax credits. 37 38
HM Revenue and Customs, ‘Budget Update: Income Tax Rates, Rate Limits and Personal Allowances for 2011-12’. The 16 hour element for families will increase from 16 to 24 hours from April 2012.
27
Taxing decisions
Figure 1: Gains to work at various hours levels: lone parent with paid childcare 2012-13
Tax Credits A
Allowances
12000
Income (£)
10000 8000 6000 4000 2000 0
16 hours
30 hours
40 hours
Tax credits, however, create high METRs for first earners above their income disregard. An example is shown in Figure 2. The METR increases at £6,420, £7,592 and £8,105 as credits are withdrawn, NI is charged, and income tax is deducted respectively. The 73 per cent METR does not subside until earnings reach £29,651 when all WTC and CTC entitlements have been withdrawn. Increasing the value of entitlements would mean that the high rate of taxation would continue beyond £29,651. After reaching 16 hours of work, the WTC does not offer any incentive to work additional hours unless a worker can reach 30 hours, after which there is no further incentive to work.
28
Taxing decisions
Figure 2: Withdrawals rates of earnings for a first earner with two school-age children. 80 70
METR
60 50 40 30 20 10 0
0
10,000
20,000
30,000
40,000
50,000
Income (£)
Assumes a family eligible for WTC with 2 school-aged children but not eligible for the 30 hour element.
Undoubtedly in a static analysis, total net income is more important to low-middle earners than marginal rates of taxation. Most first earners will benefit from receiving the WTC even though it increases their METR at income levels above £6,420. But marginal rates of tax do affect incentives to work, and are particularly vital for second earners. Credits are problematic for second earners who are not eligible for additional credits but suffer withdrawals from their household credit entitlement that the first earner has already qualified for. This is because credits are based on household rather than individual income. Second earners do not have an income disregard so face withdrawals of credits immediately at a rate of 41 per cent, and their effective tax rate can rise to 73 per cent if they pay NI and income tax. After accounting for childcare, the average loss of earnings (through childcare, tax and credit clawbacks) for British second earners is 68 per cent, considerably higher than the OECD average of 52 per cent.39 Incentives for second earners are particularly important because 21.5 per cent of all households have one adult in work but another out of work and not seeking a job.40 Furthermore, work by the 39 40
OECD, Data sheet: Doing Better for Families: United Kingdom, The Office for National Statistics, Working and workless households, 2011, Table A.
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Resolution Foundation has shown the importance of second earners in a household to living standards. The overall number of women who work has levelled off, so the government can focus on encouraging those who are currently in part-time work to increase their hours in order to help boost living standards. Currently 39 per cent of British women hold part-time jobs, which is high by OECD standards. If, of the women who are working at all, the number in full time work met the OECD average, the full time equivalent labour contribution of women would increase by 10 percentage points. Women with low education and/or mothers are particularly unlikely to work full time.41 Incentives for second earners is also important for reducing child poverty: whereas 18.9 per cent of children with one parent working full-time and another not working are likely to live in poverty, this figure drops to just 3.9 per cent where the second parent is in part-time work.42 It seems undesirable that the second earner of a family with a low income should face a higher METR than an individual earning £150,000. Even if, as Landman Economics proposes, the childcare element of WTC is increased to cover 95 per cent of childcare costs, this does not mitigate the loss of earnings through credit clawbacks, income tax and NI. Rather, Tax allowances are preferable for second earners because they offer benefits to both earners in a household. This overall benefit is not available if just one partner works. And greater use of tax allowances, rather than credits, is preferable for second earners because it avoids creating additional disincentives for them. Figure 3 shows how tax credits offer more rewards to second earners than greater tax credits as they increase their hours in work
41 42
J Plunkett, ‘The Missing Million: The potential for female employment to raise living standards in low to middle income Britain’, Resolution Foundation, December 2011.. W Jin et al, ‘Poverty and Inequality in the UK: 2011’, Institute for Fiscal Studies, p. 48.
30
Taxing decisions
Figure 3: Gains to work at various hours levels: second earner in two earner couple, no paid childcare 2012-13
Tax Credits A
Allowances
8000
Income (£)
7000 6000 5000 4000 3000 2000 1000 0
16 hours
30 hours
40 hours
Incentives to enter or increase work Currently the work patterns of adults in low-middle income households are:43 Full-time
Part-time
Unemployed
Economically Inactive
56%
22%
5%
17%
In addition to encouraging those 22 per cent in part-time work to work more, policy could seek to encourage the 22 per cent who are not in any work to enter the labour market. Both credits and personal allowances can offer incentives to enter work. Tax credits can provide extremely strong incentives to enter work, primarily for first earners in households. This is because the Working Tax Credit can significantly reduce the PTR by offering an additional £1,920 for single people or £3,870 for couples or lone parents. Having said this, tax credits that are not work-related – such as the child tax credit - generally reduce incentives to work. For those considering entering work, a higher personal allowance increases incentives to work because less money is deducted through income tax, which reduces PTRs. These people would face 43
Family Resources Survey 2009-10, Department for Work and Pensions.
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Taxing decisions
no income effects, but would have a positive substitution effect if they expected to earn more than the current personal allowance. The uncompensated wage effect – the net effect of the substitution and income effects – would be positive for all of those earning below the new PTA. It has far more influence on decisions of whether to work at all than it does on decisions of exact labour contributions. This would be particularly strong for those considering low-paid work if the PTA was increased to the full time annual rate of the NMW. For those already in work, tax credits can create incentives to work 16 or 30 hours. But they create no incentives to work at levels other than this. By contrast, tax allowances offer incentives to work at least to the full value of the personal allowance. As Figure 3 shows, greater allowances offer the same benefit to a second earner working 16 hours a week, but greater benefits (and thus incentive) to work 30 or 40 hours a week. So PTAs have a strong incentive for low-paid workers to increase their hours worked. For all of those earning below the existing PTA - who are by definition working part-time – a greater allowance reduces the METR and thus encourages additional work, with a positive substitution effect.44 As marginal rates are more likely to affect those not in work at all than those in work, they are also more likely to affect those in parttime rather than full-time work, so this category is unquestionably important. A larger PTA could be particularly important for encouraging second earners to increase their labour contribution, whereas tax credits can discourage this. Individuals earning between the current and future PTAs will see a partial increase in their incomes, and a lower METR will increase the incentive to work to earn the full value of the PTA. The substitution effect would suggest that they would increase their working hours to reach the personal allowance limit, although the income effect may mean that they reduce their hours worked slightly to the point where their net income is the same as before. All of those benefiting fully from an increase of the PTA will receive greater rewards to labour but have an unchanged METR. Thus there will be no substitution effect, although the income effect may encourage them to reduce their labour contributions by a small amount. So if the PTA were increased to £10,000, individuals earning above this level will mainly gain in terms of income (£505) 44
Because the PTA is currently less than full-time value of minimum wage, nobody earning less than the PTA can be in full-time work, so would have more reward to working full time with a larger PTA.
32
Taxing decisions
rather than incentives to work. They may want to work an hour less a week to keep the same net income that they had prior, but are likely to lack the flexibility required do so and will most likely chose to work the same hours and increase their income. The effects of how individuals may change their working patterns if the PTA was increased to £10,000 without a change to the higher rate threshold are summarised in Table 7. The table combines the two sections above, both how low-middle earners benefit and how their incentives change.
Table 7: Implications on work incentives of increasing PTA to £10,000 Change in income
Change in METR
Substitution
Income Effect
Uncompensated
£0
None
0
Pro-work
None
Strong pro-work
< £7,476
None
0
Pro- work
None
Strong pro-work
£7,476 - £10,000
Improved by a proportion of £505
- 20
Pro-work
Pro-leisure
Pro-work
>£10,001 - £115,000
+£505
0
None
Positive
Very weak pro-leisure
£115£120,000
Improved by a proportion of £505
+20
Pro-leisure
Pro work
Pro-leisure
>£120,000
£0
0
None
None
None
Wage Effect
Increasing the threshold, or reducing the rate at which credits are withdrawn could reduce this problem of high marginal rates for some second earners. And as Landman Economics has suggested, increasing the value of credits will give greater support and defer the point at which credits are no longer paid. But these measures would only postpone, rather than remove, disincentives for second earners. For example, Landman Economics’ proposal B would mean that a woman who was considering entering work on the NMW - with 2 school-aged children and a partner earning £25,500 - would face credit withdrawals of 41 per cent on all of her earnings, even if she worked 40 hours a week. This is because increasing the value of the credits would increase the point at which household’s stop receiving WTC and CTC payments – in this family’s case from £30,310 (under current 2012-13 proposals) to £36,798. Increasing the PTA is preferable to increasing tax credits (or the
33
Taxing decisions
point at which they are withdrawn) and to reducing the withdrawal rate. PTAs do not create additional withdrawal problems, and offset existing credit withdrawals. Increasing NI and income tax allowances to £10,000 would ensure that any earner under this amount cannot face a METR higher than 41 per cent. Figure 4 shows the combined effect of credit clawbacks, NI and income tax for the second earner discussed above. Increasing the PTA to £10,000 would create a greater incentive to work to at least 32 hours a week than the current system. By contrast, a large increase in the value of credits would significantly increase marginal rates of taxation for many second earners well beyond current proposals.
Figure 4: Marginal withdrawal of income for a second earner with a partner earning £25,500 under different policies Landman Proposal B
2012-13
PTA £10,000 Option A
80 70
METR
60 50 40 30 20 10 0
5
10
15
20
25
30
35
40
Hours worked
Simplicity and effectiveness The government is seeking to promote a simpler tax and benefit system: the combining of WTC, CTC and other benefits into the Universal Credit system is a major sign of this intention. It has also mooted other simplifications, such as the idea of merging income tax and NI. 45 Universal Credits will, however, remain less clear than PTAs for taxpayers - and thus offer weaker incentives to work - as payments 45
HM Treasury, Budget 2011, March 2011.
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Taxing decisions
will be made in a lump sum based on similar calculations to the existing WTC and CTC. Although recipients will know the exact value of what they are receiving, it will not be clear why they are receiving that amount. A joint increase in the personal income tax and national insurance personal allowances would further simplify the system and present taxation in a clearer manner. This is beneficial in at least 4 ways. First, a clear advantage of using the personal allowance to support low and middle earners and provide work incentives is simplicity – both for taxpayers and for the Inland Revenue. A personal tax allowance is easier to understand, which means that tax policy has greater influence on people’s behaviour. Adam Smith set out four “canons” of a good taxation system – equity, certainty, convenience and economy.46 Whilst a tax credit system can be argued to perform better than the personal tax allowance system on the grounds of equity, it certainly performs less well on the basis of certainty (working out entitlement to credits can be complicated, and there have been frequent cases of individuals having to pay back large sums to the Exchequer) and economy (low costs of collection). Second, the PTA is cheaper to administer than credits because it is an automatic component of the tax system, and does not require additional information to be processed. Third, because it is administered automatically there is little problem of non take-up of benefits. All taxpayers automatically receive a PTA. But uptake is a problem for all means-tested benefits – people may not receive benefits they are entitled to because of oversight, lack of awareness, social stigma or effort. The table below shows the Inland Revenue’s estimates for take-up as a proportion of households eligible to claim: 47
CTC
WTC
Child Benefit
Take-up (cases)
81%
61%
96%
Take-up (total claimed)
90%
82%
96%
There appears to be a trade-off between high take-up of a benefit and means-testing it. The fact that there is non take-up suggests that practical or psychological costs of claiming means-tested benefits deter people, which in turn suggests that they value a unit of income 46 47
A Smith, ‘The Wealth of Nations’, Book 3, Chapter 7. HM Revenue & Customs, Child Benefit, Child Tax Credit and Working Tax Credit: Takeup rates 2009-10, 2011.
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Taxing decisions
of credits less than earned income. If this is the case and support can be targeted accurately, it is preferable to shift support from credits to tax allowances to offer taxpayers greater earned income. However, if tax credits can divert more units to low-middle income households, then these would be preferable to fewer additional units of earned income. Fourth, as a simpler system, the PTA is less vulnerable to fraud and error, which the Department for Work and Pensions estimates costs the taxpayer £5.2 billion a year through the welfare system as a whole.48 The method used to calculate the tax credit system is not reliable: credit payments are based on the previous year’s household incomes, and households must declare any changes in their income. This system vastly increases the risk of over- and under-payments of benefits. HM Revenue and Customs (HMRC) estimates that it had outstanding debts of £4.7 billion resulting from overpayments of tax credits as of March 2011, and that £1.7 billion of additional tax credit debt would be generated in 2011-12 alone.49 This is a significant proportion of the £27 billion spent annually on tax credits. This is bad for both low income claimants and the government. HMRC has recognised that recipients of tax credit overpayments may not understand why they have incurred a debt, and that it must better communicate how payment is calculated to all claimants.50 Errors particularly hurt poor families because they generally face greater liquidity problems. The personal allowance system can also suffer from fraud and error however, and there have been cases of large errors with the PAYE system. This works well for individuals with a consistent income, but is more complicated for those who are self-employed or who change employment status within a year. Having said this, the PTA retains the advantage that it does not require recipients to complete any additional forms.
Summary There is a balance between tax credits and allowances, and neither achieves perfect outcomes in the short and long term. Tax credits direct money more accurately at the families that need it most. In general terms, they offer incentives to work to 16 or 30 hours. 48 49 50
The Department for Work and Pensions, Tackling Fraud and Error in the Benefit and Tax Credits Systems, October 2010. HM Revenue & Customs: PAYE, tax credit debt and cost reduction 2010-12, House of Commons Committee of Public Accounts Report, 23 November 2011. House of Commons Committee of Public Accounts, Tax Credits and PAYE, 28 January 2008.
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Taxing decisions
However, they can also have strong disincentives for second earners. Tax allowances, on the other hand, have stronger effects on incentives for second earners, and encourage them to work up to the full allowance. They are simpler for taxpayers and the taxman, and avoid creating further withdrawal problems. Finally, tax allowances also retain stronger links between an individual’s own effort and income, which have significant longer term effects on the economy and society.
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Taxing decisions
: 4 – CentreForum proposals In this section we consider how income tax and national insurance personal allowances could be raised. Our primary recommendation is to increase immediately both personal allowances to £10,000. We then show how they could both be increased to £12,500.
Personal Allowance The government has committed to increasing the PTA to £10,000 by 2015. Estimated costs of doing so have varied because different techniques have been used, both in terms of when and how it should be done. In terms of when it is done, the pace of reform to the PTA is significant: inflation will mean that the longer it takes, the cheaper it will be to achieve a nominal threshold of £10,000. If the PTA is £8,105 for 2012-13, inflation of 4 per cent would require an increase of just £785 in today’s terms to reach £10,000 in 2015. The scenarios that we present are modelled on top of the Treasury’s plans for 2012-13 and on the assumption that they are introduced immediately. This is more expensive than later rises, but would speed up much-needed support to working families which would in turn stimulate the economy. It also avoids having to speculate on future conditions. In terms of how the PTA can be increased, we consider doing it by:
:
Option A: Increasing PTA and keeping the upper threshold the same;
:
Option B: Increasing PTA, and reducing the 40 per cent tax threshold to ensure that previous higher rate taxpayers do not benefit.
For discussion of impact of when PTA changes are made, see blogs.ft.com/westminster/ 2012/01/the-maths-of-nick-cleggs-multi-billion-tax-giveaway/#axzz1lyejRLjm. Allowances can also be raised alongside an increase in the higher rate threshold (this keeping the basic rate bracket the same) or by increasing PTA and reducing the higher rate threshold so that those paying higher rate tax are worse off. We rule out these options because the first is obviously regressive and wasteful and the second would leave higher rate and some basic rate taxpayers worse off.
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Taxing decisions
These are illustrated in Figure 5.
Figure 5: Different methods of increasing the PTA Taxed at 20%
Tax free
Taxed at 40%
£42,475 £38,685
£10,000 £8,105
0
Status quo
Option A
Option B
Table 8 presents the structure of each option as they would be if the PTA was increased to £10,000.
Table 8: Increasing the PTA to £10,000 using different methods Year
2011-12
2012-13 Government Proposal
2012-13 Option A
2012-13 Option B
PTA (u65)
£7,475
£8,105
£10,000
£10,000
Basic rate
£7,476 - £42,475
£8,106 - £42,475
£10,001 - £42,475
£10,001 - £38,686
Higher rate threshold
£42,476
£42,476
£42,476
£38,686
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Taxing decisions
Option A – maintaining a consistent higher rate threshold - benefits everybody earning between £7,475 and £120,000, and would not increase the METR of any basic rate taxpayers. This is the technique adopted by government for its proposed 2012-13 changes and does not create any new higher rate taxpayers. Basic and higher rate taxpayers above the new PTA benefit by an equal amount. Option B – lowering the higher rate threshold – was used alongside a change in NI in the 2011-12 Budget, and ensures that only basic rate taxpayers benefit. With fixed rates of tax and NI, the higher rate threshold must be lowered by twice as much as the increase in the personal allowance. This is because higher rate taxpayers save 20 percentage points of tax on additional PTA, but lose just 10 percentage points from lowering the higher rate threshold. Doing this would ensure that everybody earning between £42,475 and £114,950 would be completely unaffected in terms of their income and METR. This is cheaper than Option A because it excludes higher rate taxpayers from any benefits.
Increasing allowances to £10,000 We consider proposals to immediately: 1. Increase personal tax allowances to £10,000 using Option A (maintaining the higher rate threshold at £42,475). This would cost £9.7 billion; 2. Increase income tax and national insurance allowances jointly to £10,000 using option B (with a new higher rate threshold of £35,795). This would cost £11.15 billion. We use modelling to show the distribution and costs of increasing the PTA. This is a static analysis, and ignores effects of how different tax allowances, thresholds and rates would affect work patterns. In reality many of those below the PTA are likely to enter or increase work, and will thus earn and benefit more from the policies. But this shows what the distribution of policies would be if behaviour remained constant.
The PTA was increased by £1,000 but, rather than reducing the higher rate threshold by £2,000, it was reduced by £1,400 and the structure of NI was changed – the primary threshold and the Employees’ primary Class 1 rate between primary threshold and upper earnings limit were changed– ensuring that higher rate taxpayers did not benefit. A greater PTA means individuals are taxed at 12 per cent rather than 32 per cent, whereas reducing higher rate thresholds means individuals are taxed at 42 (40 per cent income tax and 2 per cent NI) rather than 32 per cent (20 per cent income tax and 12 per cent NI).
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Taxing decisions
Importantly, the modelling also fails to include the distributional effects of how revenue is raised to fund changes to tax and NI allowances. All distributions should be considered within the context of our full policy proposals, which are funded almost entirely by those with large incomes or wealth. For example, an individual earning £100,000 living in a house worth £2.5 million may gain £379 a year from a PTA of £10,000, but would lose £5,000 a year because of the mansion tax. So they would have a net loss of over £4,500, but our modelling would show that they had benefited.
Increasing the personal income tax allowance to £10,000 The government is planning to increase the personal allowance to £8,105 in 2012-13. Instead, an immediate increase of the PTA to £10,000 using Option A would benefit existing basic rate taxpayers by an extra £379 a year (£7.29 a week). This would increase the disposable income of low-middle earners by more than 2 per cent on average. By maintaining higher rate thresholds, no new higher rate taxpayers would be created. The PTA increase will not make people earning below the current allowance better off, but will offer them incentives to work more. Raising the PTA to £10,000 in the forthcoming Budget would cost £9.7 billion, and could comfortably be funded by our revenue-raising proposals. Table 9 shows the impact of this policy – in comparison to the 201213 proposals – on different groups.
Table 9: Impact of increasing PTA to £10,000 using Option A Income
Change in net income
Change in METR
£8,105 - £10,000
Proportion of £379
- 20 % points
£10,000 - £38,685
£379
None
£38,685 -£42,475
£379
None
£42,475 - £116,210
£379
None
£116,210 -£120,000
Proportion of £379
+ 20 % points
£120,000 +
None
None
This is before even considering our proposed amendments in other areas such as higher rate pension relief and capital gains tax. Using Option B would require the higher rate threshold to be reduced to £38,685. It would be cheaper because it does not give money to higher rate tax payers, and would cost £7.17 billion.
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Taxing decisions
Table 10 shows the distributional impact of using Option A to increase the PTA. It offers little support to the first decile, which is generally dependent on state benefits. The benefit of this policy increases with incomes. This is because those who have incomes below the current PTA will not benefit at all, and because households with two earners generally earn more (so are in higher deciles) and will benefit more from the two allowances. Although poorer couples may be encouraged to increase their hours worked – and thus benefit more from an increase in the personal allowance – this effect is not shown in the distribution.
Table 10: Using Option A to increase PTA to £10,000: Option A: PTA to £10,000 decile
Average change in weekly income (GBP)
Percentage change in weekly income
1st (poorest)
0.02
0.02
2nd
0.53
0.28
3rd
1.94
0.78
4th
3.51
1.14
5th
4.7
1.32
6th
5.85
1.43
7th
7.48
1.51
8th
9.16
1.5
9th
11.01
1.4
10th (richest)
12.08
0.83
Table 11 uses Resolution Foundation categorisation and illustrates the effects of using option A to increase the personal allowance on different income groups. It presents data after housing costs (AHC), which reflects the disposable incomes of households and thus gives the most accurate picture of the real impact of the tax system. The Table includes Landman Economics’ first proposal in the column ‘Tax credits option A’. The PTA Option A offers average low-middle earning households an additional £7.53 per week, and increase of 2.01 per cent. The tax credit Option A increases disposable income of low-middle income households by 5.21 per cent. So although both help low-middle earners, credits are more effectively targeted. Having said this, they
Table 13 and all of the subsequent tables showing decile distribution, present figures for households, not individuals.
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Taxing decisions
also offer significant support to the benefit dependent group, which will reduce work incentives. It is important to remember that low-middle earners with incomes below a new, higher PTA will have incentive to increase their labour contribution to benefit from the allowance, which is not shown in static analysis. Also, of course, almost all of the funding for the PTA increase has come from high earners, who also benefit. So although the PTA option offers high earners an additional £12.26 per week, many will lose considerably more through changes elsewhere in the tax system.
Table 11: Comparison of increasing PTA to £10,000 with tax credits (AHC)
RF type
Personal Allowance Option A
Tax credits option A
Average Percentage change in change in weekly income weekly income (GBP)
Average Percentage change in change in weekly income weekly income (GBP)
Benefit dependent
0.57
0.27
19.08
7.45
Low-middle earner
7.53
2.01
23.73
5.21
High earner
12.26
1.44
2.04
0.21
2.52
0.69
0.68
0.18
Pensioner
Increasing both NI and PTA to £10,000 It is true, but misleading, to state that having a personal allowance of £10,000 means that those earning this pay no income tax. This is because NICs are now effectively a tax, and individuals pay 12 per cent employees’ NICs on all earnings over £139 per week (£7,228 per year). So whilst NI and income tax allowances are currently similar, an increase in PTA threatens to outstrip the growth of the NI allowance. And if the PTA was increased to £10,000 without a corresponding increase in the NI allowance, it would create an effective starting rate of 12 per cent. Thus when increasing the personal allowance, it seems logical also to increase the NI threshold.
For 2011-12, NI and income tax allowances are £7,228 and £7,475 respectively. But the government’s proposals will increase the discrepancy, taking the NI threshold to £7,592 and the PTA to £8,105.
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Taxing decisions
Raising the national insurance threshold to £10,000 would give individuals earning above this level an additional £289 a year (£5.56 a week). Alongside an increase in the PTA to £10,000, it would make them better off by a total of £668 a year (£12.85 per week) compared to the government’s current proposals for 2012-13. We propose that both tax and NI allowances should immediately be increased to £10,000 using option B - with a reduction for higher rate threshold to £35,795, would cost £11.15 billion. This would create a significant number of new higher rate taxpayers, who would in fact have higher disposable incomes despite facing higher METRs. The effects of this policy are presented in Table 12.
Table 12: Impact of increasing PTA and NI to £10,000 using Option B Income
Change in net income
Change in METR
£7,592 - £8,105
Proportion of £43
-12
£8,105 - £10,000
Proportion of £668
- 32
£10,000 - £35,795
£668
None
£35,795-£42,475
Proportion of £668
+ 10
£42,475 - £116,210
None
None
£116,210 -£120,000
Loss of proportion of £758
+ 20
£120,000 +
Loss of £758
None
Table 13 illustrates the distributional impact of increasing both allowances to £10,000. Support in percentage terms rises from the 1st decile until the 7th, and then declines. The lowering of the higher rate threshold particularly limits the benefits to the richest decile households, which only benefit by an average of £1.36 per week.
Alternatively, the government could raise NI and income tax thresholds to £10,000 using Option A, but this would cost £16 billion. Cutting the higher rate threshold would ensure that existing higher rate taxpayers would not benefit. Taxpayers earning between £35,795 and £42,475 would be better off but would pay 42 rather than 32 per cent tax at the margin.
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Taxing decisions
Table 13: Distributional impact of increasing both NI and PTA Change in weekly income (GBP)
Percentage change in weekly income
1st (poorest)
0.02
0.03
2nd
0.89
0.47
3rd
3.15
1.27
4th
5.71
1.85
5th
7.58
2.12
6th
9.16
2.23
7th
11.12
2.25
8th
12.42
2.03
9th
11.14
1.42
1.36
0.09
10th (richest)
It is useful to compare the implications of the two options considered thus far - an increase in the PTA to £10,000 using Option A and a simultaneous increase in both the PTA and NI allowance using Option B. They are compared in Table 14, alongside Landman Economics’ Option A. Unsurprisingly, the joint increase in NI and tax allowances offer more support to low-middle earners than just increasing PTAs. After housing costs, disposable income of low-middle earners is increased by more than 3 per cent, compared to 2 per cent with PTA only. The rise of both allowances increases low-middle earners’ incomes by an average of £12.20 per week, rather than £7.53 for the increase of just the income tax allowance. Interestingly, it offers almost identical support to high earners as just increasing the PTA (£12.26 compared to £12.54), which suggests that the vast majority of the additional £1.45 billion spent is targeted accurately at lowmiddle earning households.
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Taxing decisions
Table 14: Change in PTA compared to PTA and NI allowance to £10,000
RF type
Benefit dependent Lowmiddle earner High earner
PTA to £10,000 using Option A Average Percentage change change in weekly in weekly income income (GBP)
PTA and NI £10,000 Using Option B Average Percentage change change in weekly in weekly income income (GBP)
Tax credits Option A Average Percentage change change in weekly in weekly income income (GBP)
0.57
0.27
0.91
0.44
19.08
7.45
7.53
2.01
12.20
3.26
23.73
5.21
12.26
1.44
12.54
1.47
2.04
0.21
0.69
1.67
0.46
0.68
0.18
2.52 Pensioner Cost of £9.7 billion policy
£11.15 billion
£10.8 billion
Table 14 shows that the Landman tax credit Option A offers a considerably larger benefit to low-middle earning households using a static model. This is to be expected, as credits are specifically targeted at lower earners. But credits also give significant resources (£19.08 per week) to benefit dependent households due to the increase in non-work-related benefits, which will reduce work incentives. While the use of tax credits significantly supports benefit dependent households, use of the tax allowance aids high earner households. Some may ask why this benefit should be acceptable when we are focusing on how to help low-middle earners. But as these proposals have been funded almost exclusively by the very wealthiest in society, it seems reasonable to allow high earner households to receive similar benefits on earned income. In addition, greater PTAs have a powerful effect on work incentives for second earners which would, in reality, encourage second earners to work more and thus offer a greater benefit to low-middle earners.
The longer term: aiming for National Minimum Wage A more ambitious aim is to increase the personal income tax and NI allowances to match the annual income of individuals working full time on the national minimum wage. Our primary longer term
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Taxing decisions
recommendation is that both PTAs and NI allowances are increased to £12,500. The Minimum wage is currently £6.08 per hour for adults over 21. We work from the assumption that this equates to a gross income of £12,500 per year for a full time worker.10 Increasing allowances to this level would improve the coherence of the tax-benefit system by ensuring that a single person earning the minimum wage would not simultaneously pay tax and receive tax credits. It would also add coherence to tax and income policy by ensuring that individuals earning what society implies is the lowest acceptable wage do not lose income through tax and NICs. We consider the implications of increasing the PTA to £12,500, and then of increasing the PTA and NI threshold simultaneously to this level. The changes we consider are: Policy
Higher rate threshold
Cost
PTA to £12,500
£42,475
£23.00bn
PTA and NI to £12,500
£42,475, but basic rate of 26 per cent
£12.6bn
Increasing the Personal Tax Allowance to National Minimum Wage Increasing the PTA to £12,500 would take more than 5 million individuals out of paying income tax altogether from the current level of £7,475. It would offer significant incentives for individuals to enter the labour market, and for the lowest paid workers to increase their labour contribution. As shown in Table 15, low-middle earners would benefit on average by £16.45 a week, which represents a 4.4 per cent boost to their income after housing costs (AHC).
10
This depends on how many hours constitute a full time week. An individual working 37.5 hours a week on NMW would have an annual income of £11,856. Somebody working 40 hours a week would earn £12,646.
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Taxing decisions
Table 15: Weekly impacts AHC of increasing the PTA to £12,500 using Option A RF type
Average change in weekly income (GBP)
Percentage change in weekly income
Benefit dependent
1.11
0.54
Low-middle earner
16.45
4.4
High earner
28.03
3.3
8.48
2.33
Pensioner
This policy is not ideal because it does not change NI allowances, meaning that those on the minimum wage would continue to pay significant amounts of NICs. Moreover, it gives high earners considerably larger benefits than low-middle earners, and would cost £23 billion to implement without changing higher rate thresholds11
Increasing PTA and NI to National Minimum Wage Our main longer-term proposal is that both NI and income tax personal allowances are increased to £12,500. This would be done alongside an increase in the basic rate of income tax from 20 to 26 per cent, and would make all households apart from the wealthiest decile better off. Increasing both allowances to £12,500 would take 5 million people out of paying tax or NICs. It would increase the disposable income of an individual working full-time on the minimum wage by £1,469 per year. The higher basic rate would subsequently reduce the benefit gradually to those on higher incomes, until the benefit tapered out at an income of £37,000. Those earning above £42,475 would be worse off by £500 a year. The distributional effects are shown in Figure 6.
11
The PTA increase could also be introduced alongside a reduction in the higher rate threshold (Option B) to ensure that higher rate taxpayers do not benefit. This policy would require the threshold to be cut to £33,685, and would cost £16.23 billion.
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Taxing decisions
Figure 6: Distributional impact of increasing both allowances to £12,500 (basic rate 26 per cent) 15 12 9 6 3 0 -3 -6
1st (poorest)
2nd
3rd
4th
5th
6th
7th
8th
9th
10th (richest)
This policy offers similar benefits in cash terms of over £10 per week to households from the 4th to the 8th deciles. It offers a benefit of more than £5 a week to those in the 3rd and 9th deciles. The 1st and 2nd deciles receive small benefits, and the richest decile loses £3.80 a week as a result of the higher basic rate (and those on the very highest wages will lose more as their personal allowance tapers out). As table 16 shows, low-middle earning households are the major beneficiaries. Their weekly incomes (AHC) are increased by almost 5 per cent, whereas high earners benefit by just over 1 per cent.
Table 16: Benefits AHC of increasing the income tax and national insurance allowances to £12,500 without a basic rate of 26 per cent. RF type
Average change in weekly income (GBP)
Percentage change in weekly income
benefit dependent
1.49
0.71
low-middle earner
17.77
4.73
high earner
10.95
1.3
3.03
0.83
pensioner
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Taxing decisions
This policy would cost £12.8 billion and would create a radically different tax-benefit structure for the UK. The benefits are plain. It would guarantee that the lowest paid individuals would keep all of their gross earnings, and would allow low-middle earners to keep far more of theirs. It would make the tax system significantly more clear for taxpayers, and would be particularly relevant if income tax is merged with national insurance. The allowances could be pegged to the NMW to ensure that this support for living standards is maintained. The cost of implementing this means that it could be introduced in this Budget. This is unlikely because of the political problems associated with increasing headline tax rates. But there seems to be growing acceptance that we must support the ‘squeezed middle’ and seek to rebalance the burden of taxation between labour and wealth. This policy has very similar foundations to the Landman Economics proposals to raise the basic rate of income tax and increase the personal allowance to £20,000, and should be considered as a development of our immediate proposals.
Conclusion This chapter has introduced and compared household tax credits and personal tax allowances. Tax credits can provide strong incentives to first earners, and increase household incomes, which in turn tackles child poverty. But we have shown that greater use of tax allowances is preferable, for four prime reasons. First, as a whole package raising and redistributing revenue from taxation of wealth, tax allowances achieve a better balance between supporting low-middle earners on one hand, and encouraging work (rather than unproductive wealth) on the other. Second, tax allowances offer second earners in households greater incentives to work than tax credits. They create incentive for all earners to work to at least the full personal allowance. For an allowance of £10,000, this would encourage the lowest earners to work 32 hours a week. By contrast, tax credits create incentives to work 16 or 30 hours for first earners only, and reduce incentives for second earners. Third, tax allowances are far simpler. This means that policy has more influence on behaviour, administration is simpler and cheaper, there is less risk of fraud and error, and there is greater take-up. Fourth, tax allowances are preferable on principle. They retain a
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Taxing decisions
greater link between amount of work and income for all individuals. They avoid the inconsistency of the state giving benefits while also taxing the same people. And they reduce the unfairness between wage and tax policy which currently means that those on national minimum wage pay tax on more than a third of their incomes. For these reasons, we support the immediate implementation of: 1. An immediate increase of personal allowances for both national insurance and income tax to £10,000, with a reduction of the higher rate threshold to £35,795. 2. A taxation regime focusing more on wealth rather than income. This would raise considerable revenue, as explained in the revenue raising chapter. In the longer term, we recommend that personal allowances are increased, which would remove 5 million individuals from tax and NI and could increase the average disposable income of low-middle earning households by almost 5 per cent.
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Taxing decisions
: 5 – Landman Economics proposals Targeted help for low-to-middle income families: the case for tax credits In Chapter 4 of this report, CentreForum make the case for increases in the income tax personal allowance (PTA) and the primary threshold for employee National Insurance Contributions (NICs) as the best way to help low and middle earner families. In itself, there can be little doubt that reducing the tax burden for families on low incomes is a laudable aim. Previous research has shown that the UK tax system is regressive taken as a whole:12 families on low incomes pay a higher proportion of their incomes in taxes than do families on high incomes.13 Income tax is (already) strongly progressive, but this is offset by the regressiveness of other elements of the system such as employee National Insurance Contributions, Council Tax, and indirect taxes. In this context, reforms which can rebalance the burden of taxation away from low-to-middle income families and towards highincome families are a good thing from a progressive perspective. The fundamental question with respect to CentreForum’s propoals is: are increases in the income tax personal allowance the best way to achieve this aim? In this chapter I make the case for using the revenue from the tax-raising measures proposed by CentreForum to fund an additional investment in tax credits as a better way to target help for low-to-middle income families than increasing tax allowances. I then go on to examine the longer-term potential for larger-scale increases in the income tax personal allowance combined with a higher basic rate of tax. Combined with a new structure for employee National Insurance Contributions, this 12 13
D Byrne, G Irvin, R Murphy, H Reed and S Ruane, ’In Place of Cuts: Tax Reform To Build A Fairer Society’, Compass, 2009. To be clear, the distributional effects of the tax system combined with transfer payments (benefits and tax credits) is progressive; but the tax system taken in isolation is regressive.
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Taxing decisions
would be a fundamental reform of the tax system which would significantly increase its progressivity.
Details of the reforms to tax credits The reforms to tax credits modelled in this chapter would increase the generosity of the system in three key ways: 1. Increasing the basic element of the Working Tax Credit (WTC) (currently £1,920 per year); 2. Increasing the per child payment in the Child Tax Credit (CTC) (currently £2,690 per year); 3. Increasing the generosity of the support for childcare for working households in the CTC (currently 70 per cent of childcare costs up to a maximum cost of £175 for families with one child and £300 for families with two or more children). I assume that the net cost of the reforms to tax credits cannot exceed £11.9 billion, which is the projected revenue increase from the revenue-raising measures considered by CentreForum in Chapter 4, which I discuss in more detail later in this chapter – specifically cuts to pension tax relief, the “mansion tax”, means-testing Winter Fuel Allowance, and raising Capital Gains Tax to income tax marginal rates. I consider two options for reform. Option A is the more straightforward of the two, increasing tax credits by around £11 billion. Option B is a more complex variation which abolishes Child Benefit (which currently costs around £11.6 billion) and reallocates an additional £11.6 billion to tax credits (for a total increase in tax credit expenditure of around £23 billion). Given that the Coalition government has already committed to remove Child Benefit from high income families, re-allocating the entirety of Child Benefit expenditure to tax credits seems like a more progressive way of redirecting additional support for children towards low-to-middle income families. Table 17 below gives the new rates of tax credits modelled in each of the reforms. The parameters not mentioned in the table – lone parent and family bonuses for WTC, basic element for CTC, disabled and severely disabled elements for both WTC and CTC, full time bonus for WTC, the income threshold, and the taper rate at which tax credit payments are withdrawn as gross income rises above the threshold (currently 41 per cent) – are held the same in the reform systems as in the April 2012 system. In addition, both tax credit reform options reverse the change to the tax credit system in April
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Taxing decisions
2012 whereby an additional combined working hours condition (24 hours in total) is imposed on couples with children, as this is a badly designed and unnecessary reform.
Table 17: Changes to Tax Credit and Child Benefit parameters under reform options A and B Tax credit parameter
Value of parameter in: April 2012 system
Reform option A
Reform option B
Working Tax Credit Basic credit
£1,920
£2,690
£3,450
at least one partner working 16 hours, partners’ total hours 24 or more
At least one partner earning 16 hours
At least one partner earning 16 hours
Childcare: maximum eligible cost (one child)
£175
£175
£175
Childcare: maximum eligible cost (two or more children)
£300
£300
£300
Childcare: percentage of expenditure eligible
70%
95%
95%
£2,690
£3,500
£4,400
First child
£20.30
£20.30
Abolished
Second and subsequent children
£13.40
£13.40
Abolished
£10.8bn
£11.3bn
Minimum hours for eligibility (couples)
Child Tax Credit per child element Child Benefit
Overall modelled net cost (relative to April 2012 system)
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Taxing decisions
: 6 – Landman Economics analysis Effects of the reforms on work incentives It is useful to examine the relationship between the number of hours worked and net income for a few example families to see how the reforms might affect work incentives for tax credit claimants. Below I compare net incomes for three example families under four different systems: 1. the tax-benefit system scheduled to take effect from April 2012 (called the ‘base system’ in the diagrams’); 2. tax credits reform Option A (as specified in Table 17); 3. tax credits reform Option B (as specified in Table 17); 4. CentreForum’s proposed increase in the income tax and employee and self-employed National Insurance thresholds to £10,000 per year (annual equivalent) – this is modelled in the CentreForum chapter as ‘Option 3a’, and is labelled ‘Allowances’ in the graphs below. First, I examine the impact of the reforms on the budget constraint for a lone parent family. I make the following assumptions about family circumstances:
14
:
The lone parent’s gross wage is £7 per hour and he/she works all year round;
:
The family has two children, neither of whom is eligible for any disability premia;
:
The family purchases childcare at a cost of £6 per hour for the number of hours the lone parent is in work,14 eligible for childcare subsidy in the Working Tax Credit if the
Results from the Daycare Trust’s 2012 childcare costs survey show that average childcare costs for a part-time childcare place (25 hours per week) for one child now exceed £100 per week in many parts of Britain. In this context, using a figure of £6 per hour for childcare costs for two children does not seem excessive. A summary of the Daycare Trust survey results can be found at www.daycaretrust.org.uk/pages/ childcare-costs-survey-2012.html.
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lone parent is working 16 hours or longer. (In this case, the general shape of the budget constraint is relatively unaffected by whether the family uses paid childcare or not). :
For simplicity the analysis ignores housing costs and Council Tax, and also Housing Benefit and Council Tax Benefit. Later in the chapter I discuss how Housing Benefit and Council Tax Benefit increase the marginal withdrawal rates faced by low-to-middle income families in receipt of these benefits.
Figure 7 shows the resulting budget constraint for the family under each of the four tax-benefit systems analysed. The horizontal axis shows weekly hours of work while the vertical axis shows annual net income (including net earnings after tax and NICs, income support/Jobseekers Allowance, tax credit payments and child benefit, minus gross childcare costs).
Figure 7: effect of reforms on budget constraint for example lone parent with childcare costs Base system
Tax credits Option A
Allowances
Tax Credits Option B
25000 20000 15000 10000 5000 0
0
5
10
15
20
25
30
35
40
Under the base system in Figure 7, net income falls over the range of the graph where the lone parent is working between 3 and 15 hours per week, for two reasons. One is that Income Support or Jobseekers Allowance15 is withdrawn pound-for-pound against 15
Under current rules, lone parents working less than 16 hours per week with children under 5 are entitled to Income Support, whereas lone parents with children aged 5 or older claim Jobseekers Allowance instead.
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Taxing decisions
increases in earned income. The other is that the cost of childcare, assumed to be £6 per hour here, reduces net income (after childcare costs) still further. At 16 hours and above, the lone parent is substantially better off in work than out of work because of the boost to income provided by the main element of WTC and also the subsidy for childcare expenditure in the WTC. Income then rises relatively slowly above 16 hours per week due to the taper on tax credits when the lone parent’s gross earnings are above £6,420 per week (which in this case occurs at 18 hours per week and above). Comparing the reform options, tax credits option A boosts outof-work income (i.e. the vertical intercept of Figure 7) slightly, but provides a larger boost to in-work incomes due to the enhanced WTC main payment and also the increase in the proportion of childcare subsidy (from 70 to 95 percent). Tax credit option B provides a small boost to out-of-work income compared with Option A (due to the replacement of Child Benefit by higher CTC payments) and a larger boost to in-work incomes at 16 hours and above due to the further increase in WTC main payment. CentreForum’s proposed allowance increase does not affect out of work income, or the incentive to work 16 hours, because a lone parent earning £7 per hour does not earn enough to benefit from the increase in the personal allowance from £8,105 to £10,000 (or the parallel NI primary threshold increase). However, there is a boost to the incentive to work 23 hours or more compared with less than 23 hours because above this point, the lone parent’s gross earnings are above £8,105 per year. The full payoff from the allowance increase is obtained when the lone parent’s gross earnings reach £10,000, which is at 28 hours of work. Table 18 below presents, for the same example as Figure 7 above, the exact figures for income out of work and the gains from working 16, 30 and 40 hours per week in cash terms and as a percentage gain in net income compared with being out of work. Under the base system, there are substantial net gains (in cash and percentage terms) to the lone parent from working 16 hours and 30 hours. However, the additional gain to working 40 hours compared with 30 hours is tiny because of the combination of the tax credit withdrawal taper, income tax and NICs, and the cost of childcare (net of WTC subsidy). Under tax credits Option A and B, the cash and percentage gains to working 16 and 30 hours per week compared with being out of work all increase substantially compared with the base system, and there is also a larger gain to working 40 hours compared with 30 hours (because of the more generous support for childcare). The reform to increase allowances improves the gain to
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Taxing decisions
working 30 hours relative to 16 hours compared with the baseline but once again the incentive to work 40 hours rather than 30 hours is relatively marginal.
Table 18: Gains to work at various hours levels: lone parent with paid childcare Base system Hours
£ per year
out of work
£11,187
Tax Credits option A
% gain £ per year
% gain
£12,807
Tax Credits option B £ per year
Allowances
% gain £ per year
£12,855
% gain
£11,187
16 hours
£4,686
41.9%
£6,704
52.3%
£7,464
58.1%
£4,686 41.9%
30 hours
£6,455
57.7%
£9,565
74.7%
£10,325
80.3%
£7,123 63.7%
40 hours
£6,501
58.1% £10,391
81.1%
£11,151
86.7%
£7,169 64.1%
It should be noted that childcare costs make a large difference to work incentives for lone parents. To illustrate this, Figure 8 below presents the budget constraint under the different reform scenarios for a lone parent under exactly the same assumptions as Figure 7, but this time the family has no childcare costs (this could be the case if for example the family relied on informal childcare, or had school-age children with no additional out-of-hours childcare costs). This reduces the family’s WTC payment at 16 hours or above, but also increases the net gain to work (because childcare costs are no longer a factor). The relative pattern of gains to work for the various reform options compared with the base system is similar to Figure 7, but in each case the budget constraint is steeper, indicating stronger gains to work.
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Taxing decisions
Figure 8: effect of reforms on budget constraint for example lone parent without childcare costs Tax credits Option A Tax Credits Option B
Base system Allowances 25000 20000 15000 10000 5000 0
0
5
10
15
20
25
30
35
40
Table 19 shows the exact gains to work at 16 hours, 30 hours and 40 hours compared with not working for this example lone parent. In the base system, the cash and percentage gains to working 16 and 30 hours are both larger than for the previous example lone parent with childcare costs of £6 per hour. There is also a reasonably large net gain to working 40 hours instead of 30 hours under the base system. Tax credit reform A increases the cash gains to working 16, 30 and 40 hours compared with the base system but in percentage terms the gain is reduced because out-of-work income is higher under reform A than the baseline. Under reform option B, the gains are higher than the baseline in cash and percentage terms due to the more generous WTC payment in this case. Finally, the allowances increase delivers work incentives that are lower in cash terms than Tax Credit reform option A but higher in percentage terms – again because out-of-work income is higher under tax credit option A than for the allowances increase.
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Taxing decisions
Table 19: Gains to work at various hours levels: lone parent, no paid childcare Base system
Tax Credits option A
% gain £ per year
Tax Credits option B
% gain £ per year
Hours
£ per year
out of work
£11,187
16 hours
£6,184
55.3%
£6,954
54.3%
£7,714
60.0%
£6,184
55.3%
30 hours
£9,263
82.8%
£10,033
78.3%
£10,793
84.0%
£9,931
88.8%
40 hours
£10,245
91.6%
£11,015
86.0%
£11,775
91.6% £10,913
97.6%
£12,807
% gain
Allowances
£12,855
£ per year
% gain
£11,187
Next in this section I examine the impact of the reforms on work incentives for the second earner in a couple where one adult is already in work. I make the following assumptions about family circumstances: :
The first earner in the couple works 40 hours per week all year round at a gross wage of £7 per hour;
:
The second earner in the couple also earns a gross wage of £7 per hour if in work;
:
The family has two children, neither of whom is eligible for any disability premia (as above);
I use two examples for second earners to illustrate the changes in the budget constraint facing second earners depending on whether the family uses paid childcare or not. In the first example (shown in Figure 9 below), the family purchases childcare at a cost of £6 per hour for the number of hours the second earner is in work, eligible for childcare subsidy in the Working Tax Credit as long as the second earner is working 16 hours or longer. The shape of the budget constraint in this case is reasonably similar to Figure 8 except that all the budget constraint lines start from much higher up the graph; this is because the first earner’s net earnings from working 40 hours per week at £7 per hour (plus Child and Working Tax Credit payable in that situation) mean that the family’s net income is much higher even if the second earner decides not to enter the labour market. This is likely to act as a disincentive for second earners to enter the labour market. However, as with Figure 8 it is nonetheless the case that the family still receives a net income boost if the second earner is working 16 hours or more per week because this makes the family eligible for childcare support in the WTC.
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Taxing decisions
Under the base system, growth in net income (after childcare costs) for the family is extremely flat above 20 hours per week because the combination of the tax credit taper, childcare net costs of £1.80 per hour (after taking account of the 70 per cent subsidy in WTC) and income tax and employee NICs means that the family is only £5 per year better off in net income terms for each extra hour per week the second earner works. Under tax credits option A and B, the increase in the subsidy rate for childcare to 95 per cent of gross costs means that the net cost of childcare to the family falls to 30p per hour, meaning that the family is £83 per year better off for each extra hour per week worked by the second earner. The allowance increase reform also helps increase the net gains to work over the range 20 to 28 hours per week because the second earner is taken out of direct tax compared with the base system. In addition, the reform which increases tax and NI allowances has a double impact on in-work incomes because each of the two earners gains from the increase in allowances.
Figure 9: effect of reforms on budget constraint for example second earner, assuming paid childcare Base system
Tax credits Option A
Allowances
Tax Credits Option B
40000
n
35000
m
30000
n
25000
n
20000 15000 10000 5000 0
0
5
10
15
20
25
30
35
40
Table 20 shows the gains to work for the second earner at 16, 30 and 40 hours compared with being out of work for each reform option. The first thing to note here is that the gains to work are much smaller for the second earner example than for either of the lone parent examples presented previously. In the case of the percentage
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Taxing decisions
figures, this is partly because the level of out-of-work income is much greater in this case (because of the first earner being in work). The percentage and cash gains are also smaller because the family is already receiving WTC (due to the first earner being in work) even when the second earner is out of work, and so the second earner does not receive the same boost to net incomes at 16 hours of work (although the family does receive some income boost because it becomes eligible for the childcare element of WTC at that point). In this case, tax credit reform option A offers the highest percentage gain to work compared to the baseline. The cash figures for gains to work are the same for Option B and Option A but the gains to work in percentage terms are lower for Option B because income when the second earner is not working is higher (due to the enhanced CTC and WTC payments). The allowances reform increases gains to work compared to the baseline, but not by as much as the tax credit reforms.
Table 20: Gains to work at various hours levels: second earner in two earner couple, paid childcare Hours
Base system
Tax Credits option A
£ per year
£ per year
% gain
Tax Credits option B
% gain £ per year
Allowances
% gain £ per year
% gain
out of work
£22,305
16 hours
£1,939
8.7%
£3,187
10.1%
£3,187
9.7%
£1,939
8.4%
30 hours
£2,672 12.0%
£5,012
16.0%
£5,012
15.3%
£3,340
14.5%
40 hours
£2,719 12.2%
£5,839
18.6%
£5,839
17.9%
£3,387
14.7%
£31,415
£32,699
£22,973
Figure 10 below shows the impact of the reforms for a family which does not use paid childcare and hence receives no childcare assistance in the WTC. In this case, the increases in tax credits are likely to reduce the incentive for the second earner to enter work. By contrast, the increase in the personal allowance and NICs Primary threshold in the CentreForum reform provides some additional incentive for the second earner to enter work (if working more than 20 hours per week). Under the existing structure of tax credits (as well as the proposed structure for the Universal Credit to be introduced next year) there is no provision for encouraging second earners to enter the labour market if they do not use paid childcare provision. However, one could envisage an additional ‘second earner credit’,
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Taxing decisions
payable to couples where (for example) both parents are working 16 hours or more per week, which would promote second earner work incentives.16
Figure 10: effect of reforms on budget constraint for example second earner, assuming no childcare costs Base system
Tax credits Option A
Allowances
Tax Credits Option B
40000 35000 30000 25000 20000 15000 10000 5000 0
0
5
10
15
20
25
30
35
40
Finally in this section, Table 21 shows the gains to work at various hours levels for a second earner in this example. At 16 and 30 hours, the cash gains to work are the same across all the base and all reform systems. However, the base system provides the strongest percentage work incentives because income when the second earner is out of work is lowest under this system. The allowances reform provides a stronger incentive to work 40 hours (both in cash and percentage terms) than any other system; this is because of the second earner’s increased income tax and NICs allowances which improve gains to work for the second earner. Under the tax credit reforms, gains to work for the second earner are weaker than under the base system or the allowances reform.
16
A proposal to introduce a ‘personal tax credit allowance’ into the WTC to improve incentives for second earners can be found in G Cooke and K Lawton, ‘Working Out of Poverty: A study of the low paid and the ‘working poor’, Institute for Public Policy Research, 2008.
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Table 21: Gains to work at various hours levels: second earner in two earner couple, no paid childcare
Hours out of work 16 hours 30 hours 40 hours
Base system
Tax Credits option A
Tax Credits option B
Allowances
£ per year
£ per year
£ per year
£ per year
% gain
£27,615
% gain
£31,415
% gain
£32,699
% gain
£28,283
£3,436
12.4%
£3,436 10.9%
£3,436
10.5%
£3,436
12.1%
£5,480
19.8%
£5,480 17.4%
£5,480
16.8%
£6,148
19.4%
£6,463
23.4%
£6,463 20.6%
£6,463
19.8%
£7,131
25.2%
To summarise the relative impact of the tax credit reforms compared with the reform option of increasing personal allowances: :
For single parents with childcare the effect of the tax credit reforms is better targeted than the personal allowance in terms of the size of gains to work than for the allowance reform. This is also the case under reform option B for single parents without childcare.
:
For two-earner couples the allowances option performs better than for one-earner couples because of the double personal allowance. It is also the case that the increase in the WTC and CTC provides a bigger disincentive to work for the second earner because the family already gets these additional credits with just one earner in work (under the existing tax credit rules and also under universal credit).
:
For two-earner couples with childcare the increased childcare payment when the second earner reaches 16 hours provides an additional incentive to work compared with other systems.
Distributional effects of the reforms Drawing budget constraints and looking at gain-to-work calculations for example households is a useful exercise for illustrating the effects of reforms to work incentives in specific cases, but to get a picture of how the reforms might actually affect net family incomes in the UK, it is necessary to use a microsimulation model of UK households and the tax-benefit system. To produce such an analysis, each of the four systems described previously was run through the ippr/Resolution Foundation tax-benefit model using Family Resources Survey data for 2008-09.
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Taxing decisions
It should be noted that all these distributional effects are ‘static’ rather than ‘dynamic’ – i.e. they assume that families’ choices over whether to work or not, and hours worked, are not affected by the reforms. In reality there are likely to be labour supply effects from each reform, with two countervailing effects going on with the tax credit reforms. On the one hand, in most cases the cash gain to work will increase and this should increase employment as working becomes more financially worthwhile. On the other hand, increasing the level of out of work income reduces the incentive to enter work. This is particularly an issue for second earners in couples. The personal allowance increase delivers increased incentives to work for primary earners provided that their earnings level is sufficient to take them over the earnings threshold. For second earners, again there are countervailing effects; the increase in the first earner’s net income is likely to act as a disincentive for the second earner to enter work relative to the baseline, but as both partners get the personal allowance increase, it will also act to increase incentives for the second earner to enter work and also for the second earner to increase his or her hours of work Having said that, previous econometric evaluations of the effects of tax credit reforms suggests that the effects on the number of people entering work are likely to be reasonably small.17 It should also be noted that, while the analysis of budget constraints for example families in the previous section did not include Housing Benefit and Council Tax Benefit, the distributional analysis and costings presented here do take the effects of the tax credit and personal allowance reforms on these benefits into account, modelling the combined effects of the reform across benefits, tax credits and direct taxes. Figures 11 and 12 below show the average effects of each of the reforms on income according to family net income decile.18 Figure 11 shows the changes in cash terms, while Figure 12 shows the changes as a percentage of net income under the April 2012 system. 17
18
See for example the evaluation of the tax credit changes introduced by the Labour Government in between 2000 and 2003 in R Blundell, M Brewer and A Shepherd, ‘The Impact of Tax and Benefit Changes between 2000 and 2003 on Parents’ Labour Supply’, IFS Briefing Note No 52, Institute for Fiscal Studies, 2004. The deciles were derived by running each family in the 2008-09 FRS through the base system, calculating net incomes, equivalising for family size and then ranking the households from lowest to highest income. All income measures used in this section are before housing costs (BHC).
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Taxing decisions
Figure 11: Distributional effects of reforms in cash terms Tax credits Option B
Tax allowances
Tax credits Option A
30
25
20
15
10
5
0 -5 -10
1st (poorest)
2nd
3rd
4th
5th
6th
7th
8th
9th
10th (richest)
In cash terms, it is clear that options A and B provide a particular boost to the net incomes of families in deciles 2 to 5 of the income distribution, with the income effects tapering off in the 6th decile and above. The abolition of child benefit in option B means that families in the 8th, 9th and 10th deciles lose on average from this reform. The increase in the income tax personal allowance and national insurance primary threshold to £10,000 produces the largest cash gains for families in the 7th, 8th and 9th decile – mainly two earner couples.
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Figure 12: Distributional effects of reforms as a percentage of net income Tax credits Option A
Tax credits Option B
Tax allowances 10
8
6
4
2
0
-2 1st (poorest) 2nd
3rd
4th
5th
6th
7th
8th
9th 10th (richest)
Figure 12 presents the same distributional effects as Figure 11, but as a percentage of net income rather than in cash terms. Because families in the lower deciles of the income distribution have much lower net incomes than families in the upper deciles, the percentage increases in income for families in deciles 2 through 5 arising from the tax credit reforms are much higher than the percentage increases in income for families in deciles 7 through 9 arising from the income tax and national insurance cuts. Overall, it is clear that the tax credit reforms have a much more progressive impact by income decile than the increases in tax and NI allowances. In terms of the division of the household income distribution along the lines suggested by the Resolution Foundation, Table 22 shows that tax credit options A and B deliver the highest average boost in cash terms to low-middle earners. Benefit dependent households also receive a significant cash boost (higher in percentage terms than for low-middle earners because benefit dependent households have lower incomes than low-middle earner households on average). High earners receive a much smaller cash boost under Option A than either benefit dependent households or low-middle earners, and an average reduction in income under Option B due to the abolition of child benefit. Pensioners’ income is hardly changed at all under both reform options. By contrast, the increase in the income tax personal allowance and national insurance threshold
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delivers hardly any cash boost to benefit dependent households (not surprising as very few of them pay tax or national insurance), with the cash gains from the policy split more or less equally between low-middle earners and high earners. Again, the average gain to pensioner households from the policy is minimal.
Table 22: Effects of reforms by Resolution Foundation household type division RF household type
Tax credits option A
Tax credits option B
Income tax / NICs (CentreForum option 3a)
£ change
% change
£ change
% change
£ change
% change
Benefit dependent
19.08
7.45
22.25
8.69
0.94
0.37
Low-middle earner
23.73
5.21
34.67
7.62
12.28
2.7
High earner
2.04
0.21
-5.36
-0.56
12.54
1.31
Pensioner
0.68
0.18
1.22
0.32
1.67
0.43
Why are tax credit increases more progressive than personal allowance increases? The results from the last section show that increased tax credits are, overall, better targeted as a mechanism for securing improvements in the standard of living on the low-to-middle income group that the Resolution Foundation is particularly concerned with than is the policy of increasing the PTA and the primary threshold of NICs to £10,000 per year. There are two main reasons why this is the case. Firstly, it is important to remember that a large number of workers do not earn enough to pay income tax even as things currently stand – even before the Coalition government began its programme of above-inflation increases in the PTA. Analysis of data from the UK Family Resources Survey for the final fiscal year of the Labour government in 2009/10, when the income tax personal allowance was set at £6,745 per year, shows that, out of 27.2 million people aged under 6519 with income from employment or self-employment, 3.6 million workers – around 13 percent of the total – had weekly earnings that, if representative of their annual earnings, would place them below the £6,475 threshold. Uprating the data from the FRS to take account of increases in average earnings between 2009 and 2012, the increased personal allowance of £8,105 for the 2012/13 19
The analysis has been restricted to people aged under 65 because the personal allowance for people aged 65 and over is already quite close to £10,000.
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Taxing decisions
tax year means that approximately 4.4 million workers – around 16 percent of the total under-65 workforce – do not pay any income tax. Hence, a further increase in the income tax personal allowance is of no direct individual benefit to one-sixth of the under-65 workforce (although they may of course benefit in terms of family income if partnered with someone who does earn more than the personal allowance). This implies that the personal allowance is a badly targeted tax instrument in terms of raising the net incomes of the lowest earners. The FRS data suggest that around 850,000 households in the Resolution Foundation’s group of Low to Middle Income Earner households contain at least one person in work who earns less than £8,105 per year. Secondly, most of the people who do earn enough to benefit from increasing the PTA to £10,000 are not particularly low paid. Of the £11.3 billion cost of the CentreForum proposal to increase the allowance from where it is now to £10,000, combining the figures in Table 22 with data on the number of households in each of the Resolution Foundation’s categories shows that 37 percent of the gain from the allowance increase goes to households in the lowmiddle earner group compared with 54 percent for the high earner group, 2 percent for the benefit dependent group, and 7 percent for pensioner households. By contrast, for tax credit reform A, 61 percent of the gain from the reform goes to low-middle earners, 7 percent to high earners, 29 percent to the benefit dependent group and 2 percent to pensioners. This suggests that the tax credit reform is much better targeted on the low-to-middle earner group than the PTA increase. It should also be noted here that the fact that tax credit reform option A is better targeted to low-to-middle income earners (with some spillover to benefit-dependent households) means that it is a much better instrument for reducing child poverty than is the allowances increase. Although households in child poverty (defined as below 60 per cent of median equivalised BHC net income in the government’s Households Below Average Incomes analysis using the FRS) are concentrated towards the bottom of the income distribution, around 30 per cent of households in poverty are in the Resolution Foundation’s LME group – so the extent to which taxand-benefit policies can reduce child poverty is certainly relevant to a discussion of helping low-to-medium earners. Combining the government’s HBAI data on poor families with the results from the tax-benefit model analysis of each reform shows that the number of children in poverty would reduce by just over a million under tax
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credits reform A (from around 2.8 million to 1.8 million), but would reduce by only around 80,000 under the reform which increases tax allowances to £10,000.
Is increasing the personal allowance the fairest way to cut tax? One argument used by advocates of increases in the PTA as the best way to help low-to-middle income households which deserves special attention is the oft-repeated claim that the increase in the PTA from its level under the last Labour government to £10,000 has “taken poor people out of tax”. It is true that around 800,000 lowpaid employees have been taken out of income tax, but all these households still pay other, indirect taxes – most obviously VAT, which is a regressive tax in terms of its impact on households as a proportion of current income. This is mainly because VAT has no tax-free personal allowance but is instead levied as a flat percentage of expenditure on all goods which are not zero-rated or exempt. Ranking households in terms of expenditure rather than income (perhaps a better measure of long-run living standards), VAT is mildly progressive (as shown by the Institute for Fiscal Studies).20 On the other hand, increases in the PTA are certainly a more progressive policy than cuts to the basic rate or higher rate of income tax, and to this extent, the CentreForum focus on raising the PTA as the primary focus for income tax reform (and its parallel focus on the employee NICs primary threshold) is to be welcomed. Above-inflation increases in the PTA enjoyed a brief period of popularity during the early years of the Thatcher government – the four Budgets between 1982 and 1985 all increased the income tax personal allowance in real terms. However, from 1986 onwards, governments of both major parties appeared more concerned with lowering the basic rate of income tax (from 30 per cent to 20 per cent by 2007) rather than over-indexing the personal allowance.21 Viewed from this perspective the Coalition’s focus on the PTA is a relatively progressive step.
20 21
T Crossley et al, “Chapter 10: Value Added Tax” in Green Budget 2009, Institute for Fiscal Studies, 2009. Reforms to National Insurance Contributions were somewhat more progressive over this period – in particular, ending the ‘entry fee’ in the system where all earnings above the lower earnings limit were subject to NICs rather than just marginal earnings above the UEL.
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Weaknesses of tax credits Despite the fact that tax credits are a well-targeted measure for redistributing towards low-to-middle income families while also improving incentives to enter work (for lone parents and first earners in couples), they are certainly not a perfect solution to the problem of how to support the incomes of low-to-middle income families. The chapter by CentreForum identifies particular problems with tax credits as a vehicle for supporting low income families in and out of work, with some justification. It is true that certain features of the way tax credits were implemented by the Labour Government in the UK – for example the shifting of responsibility for the administration of the credits from the Department for Work and Pensions to HMRC in 1999 – were bizarre. In particular, the division between the DWP’s responsibility for out-of-work benefits for adults – Income Support, Jobseekers Allowance and Employment and Support Allowance – and HMRC’s responsibility for tax credits was confusing to claimants and an unnecessary complication for administrative purposes. The Coalition government’s Universal Credit, which replaces means-tested benefits (except for Council Tax Benefit) and tax credits into a single payment under the management of DWP, is a big improvement in terms of making the system easier to understand, and goes a long way towards addressing the criticisms of the current tax credit system in the CentreForum chapter. It is also true, as CentreForum argues, that the administration of tax credits is more complex than the administration of PAYE income tax, because HMRC needs to know more about the circumstances of tax credit claimants to be able to allocate the correct tax credit payment to them than it needs to know about the circumstances of an employee to be able to deduct the right amount of PAYE income tax. However, partly this is because tax credits are designed to take account of family circumstances – including family, net income and hours of work– whereas income tax only needs to take account of an individuals gross earnings. Any feature of the tax-benefit system designed to allocate resources according to need (such as income support, JSA, tax credits, or indeed the forthcoming Universal Credit) will always need to collect more information about family circumstances than will the income tax system. By the same token it would be impossible to run an effective benefit system using only the information collected for PAYE purposes, because no account is taken of family size, for
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example. So the comparison between tax credit ‘bureaucracy’ and PAYE ‘simplicity’ is not comparing like with like. Moreover, the income tax system becomes considerably more complicated when it has to deal with the large number of earners in the UK who do not fit into the simple model of a salaried employee working just one job all year round. People with multiple jobs and those who go in and out of work over the course of the year have considerably more complex tax dealings, as do the self-employed, who need to fill in self-assessment forms which are just as complicated as the tax credit claim form. So while there undoubtedly is a certain amount of necessary bureaucracy associated with the tax credit system it is important not to bash the system unduly for features that are endemic to any redistributive welfare system.
Raising revenue in a progressive way I fully endorse and support the options proposed by CentreForum for raising the revenue needed to implement the policies to help low-to-middle income families featured in this chapter. The “mansion tax” is a good short-run option for raising revenue on the most expensive houses in the UK. In the longer run, as CentreForum point out, a revaluation of Council Tax bands is long-overdue, as well as a restructuring of the relationship between house banding and Council Tax bills to make the tax truly progressive with relation to house values (at the moment it is regressive, as houses in higher bands attract a lower tax bill as a proportion of house value than houses in lower bands do). Even after longer term reform, it may be desirable for mansion tax to continue alongside a revamped Council Tax as a “super tax” on extreme wealth. More radical reforms of taxation of property and land, such as a land value tax, are also well worth considering in the longer run. Restricting higher rate pension rate tax relief to the basic rate has been criticised in some quarters for being too complex as a policy.22 While not wishing to dismiss these criticisms, I would argue that they are trumped in this instance by distributional considerations; the reform would be strongly progressive, and it is difficult to justify the current scale of tax relief for pension contributions at a time of austerity such as the UK is now experiencing. The reforms to Capital Gains Tax to equalise CGT rates with marginal rates of income tax close a serious loophole in the progressiveness 22
See for example Institute for Fiscal Studies, “A response to the Treasury consultation on restricting pensions tax relief”, press release, 1 March 2010. www.ifs.org.uk/pr/ tax_relief.pdf.
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of the existing tax system, whereby people who have the option of receiving their remuneration as capital gains rather than income (for example private equity partners) pay a much lower tax rate than people who receive similar amounts of remuneration as a salary. The Coalition government’s increase in CGT to 28 per cent for higher rate taxpayers in 2010 was a step towards closing this loophole, and aligning CGT rates with income tax rates is a logical progression of this policy. Finally, reforms to target subsidies such as the winter fuel payment, free TV licences and free bus passes to poorer older people rather than keeping them universal would be cheaper and more progressive distributionally than the current universalist approach. Taken together, these revenue-raising measures mean that the overall package of reforms proposed by CentreForum is a lot more progressive than it appears from looking at Figures 11 and 12. Combined with the proposed increase in income tax and NI allowances the overall effect would be a redistribution away from high income families and towards middle income families. Spending the additional revenue from the measures in this section on increasing tax credits instead of allowances would redistribute more towards low-to-middle income families (particularly those with children).
Longer run reforms: using increased tax allowances to rebalance the tax system Based on the analysis in preceding sections I have argued that increases in tax allowances by themselves are not a particularly progressive policy, and are less effective at promoting work incentives (at least for lone parents and first earners in couples) than increases in the Working Tax Credit. However, there is one element of the CentreForum critique of tax credits, hitherto unmentioned in this chapter, which has particular resonance. This is the problem that tax credits contribute to a high marginal effective tax rate (METR) for working low-to-middle income families – the steepness of the tapering of net income as family gross income rises. Currently, tax credits are withdrawn at a rate of 41 percent for each additional pound of gross income. Combined with a basic income tax rate of 20 percent and an employee NICs rate of 12 percent between the primary threshold and upper earnings limit, this means that many families face an METR of 73 pence for every pound of extra income earned. In other words, net income rises by only 27 pence for each pound of net income earned. For families in
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receipt of Housing Benefit (HB) and Council Tax Benefit (CTB) the taper is even worse than this as the combined taper on net income (including WTC) for these benefits is 80 percent. This means that the METR can reach 94.6 percent for families in receipt of tax credits, Housing Benefit and Council Tax Benefit and paying income tax and national insurance. In the context of Figures 7 to 10 earlier in this chapter (which ignored HB and CTB), including them would mean that the budget constraint lines were much ‘flatter’ (under both the tax credit reforms and the personal allowance increase) than is the case in the graphs as they stand. Clearly, to the extent that increases in the tax-free allowances for income tax and national insurance mean that families receiving tax credits do not have to pay income tax or NICs, they reduce marginal rates (from 73 per cent to 41 per cent for families not in receipt of HB or CTB and from 94.6 per cent to 88 per cent for families receiving HB and CTB). When Universal Credit (UC) is introduced in autumn 2013 the withdrawal rate will be set at 65 per cent of net income, with housing support (but not Council Tax Benefit) included in the main UC taper. This means that households paying income tax and NICs while on the UC taper will have an METR of 76.2 per cent compared with 65 per cent for households on the UC taper but not paying income tax and NICs. Raising the income tax PTA is clearly a good move in terms of reducing METRs for low-income households, which increases the incentive to work more at the margin. However, as we have seen earlier in this chapter, the sticking point with the policy is that increases in the personal allowance are expensive because the gain from the increase goes to all basic rate taxpayers – not just those on the tax credit taper. However, if the basic rate of income tax is raised at the same time the allowance is increased then the policy becomes more affordable. One of the reform options considered in the CentreForum chapter shows this: increasing the income tax and national insurance allowances to £12,500 costs £12.6 billion if the basic rate of income tax is raised to 26 per cent at the same time. The logical conclusion of such a direction of travel for policy is to replace the current structure of the income tax system – with a 20 per cent basic rate and a 40 per cent higher rate – with a new structure with one rate, of 40 per cent (up to £150,000 gross income) combined with a much bigger tax-free personal allowance. Below I show the distributional effect of a package of reforms comprising the following elements:
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:
An income tax personal allowance of £20,000 per year;
:
Income tax at a 40 per cent rate for taxable incomes between zero and £130,000;
:
Income tax at a 43 per cent rate for taxable incomes above £130,000;
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Abolition of the current tapering away of the income tax personal allowance above gross incomes of £100,000 per year;
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Reduction in employee NICs from 12 per cent to 9 per cent between the primary threshold and the upper earnings limit;
:
Employee and self-employed NICs at 9 per cent above the upper earnings limit and upper profits limit.
This policy is relatively expensive, costing around £15 billion, and could not be introduced in the short run for cost reasons. In the short run, the priority should be to use the tax-raising reforms to taxation of pensions, CGT and the mansion tax to fund the increases to tax credits suggested earlier in the chapter. However, in the longer run, net revenue from other sources such as reducing tax avoidance and evasion, environmental taxes such as a tax on carbon emissions, land value taxation, and efficiency savings in public expenditure could be used to finance a move towards the system outlined above over (say) a decade, with CentreForum’s 26 per cent basic rate of tax as a staging post along the way. If and when completely implemented, the new structure of tax and National Insurance would deliver a fundamental shift in the balance of direct taxation in the UK. Calculations based on the 2009/10 Family Resources Survey (correcting for earnings growth between 2009 and 2012) show that a personal allowance of £20,000 would mean that 49.8 per cent of employed people in the UK – almost half the workforce –would pay no income tax. Figure 13 shows combined income tax and employee NICs for employees under the current system and the proposed new system. Under the reformed system individuals with less than £36,000 gross incomes per year would pay less than they do now, whereas those with higher than £36,000 gross incomes would pay more. Analysis of the 2009-10 FRS shows that, allowing for inflation, around 80 percent of people in work have gross earnings below £36,000 a year.
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Figure 13: Direct tax payments under current system and proposed new system Current system
Proposed system 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0
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The proposed reform to income tax and NICs also changes the marginal rate structure of the tax system, as shown in Figure 14. Under the current system, most income tax payers face a combined income tax and NICs rate of 32 per cent, rising to 42 per cent above the higher rate income tax threshold (which in weekly terms is the same as the NICs upper earnings limit). The METR then increases to 62 per cent above £100,000 gross income as the income tax personal allowance is withdrawn, dropping back down to 42 per cent just above £116,000 gross income and then rising to 52 per cent above £150,000 gross income. Under the proposed reforms to income tax and NICs in this section, the marginal rate would be just 9 per cent on gross incomes between around £7,600 per year and £20,000 per year.23 Taxpayers would pay a combined income tax and NICs rate of 49 per cent between £20,000 and £150,000 per year, above which point the combined rate would rise to 52 per cent - the same as it is now. This is a considerable simplification of the current system. Furthermore, the increase in the PTA to £20,000 means that the tax credit taper 23
The system could be simplified even further if the employee NICs primary threshold were raised to the weekly equivalent of £20,000 per year – or indeed, if employee NICs were integrated into a 49 per cent income tax. However, raising the NICs primary threshold to this level would make the reform significantly more expensive.
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and the income tax system would be much less likely to interact for individual families than they are at present. The trade-off would be a higher marginal rate for the most of the half of the working population still paying income tax in this system.
Figure 14: Combined income tax and employee NICs marginal rate structure under current system and proposed long-term reform 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0
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Figure 15 shows the distributional effect of the proposed long-term reform. It would produce a boost in percentage terms for most of the population, with the gains most pronounced in the middle of the income distribution. The top decile is the only decile which loses (on average) from the reform. While this distributional result once again demonstrates that income tax allowance increases are a poor vehicle for helping low earners (as opposed to middle earners), the effects are more progressive than the PTA and NICs primary threshold increases modelled by CentreForum because the move to a single 40 per cent rate on annual incomes between £20,000 and £150,000 means that people with incomes above £36,000 pay more under the reformed system than they do under the current system.
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Figure 15: Distributional effects of proposed long-term tax and NI reforms 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 1st (poorest) 2nd
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Conclusion This chapter has made five main arguments. Firstly, enhancements to tax credits are a better targeted means of boosting net incomes for low income families with children (both in and out of work) than increases in the personal allowance for income tax and/or NICs. Secondly, tax credit enhancements also deliver stronger work incentives for lone parents and first earners in couples than increases in the personal allowance for income tax and/or NICs. Thirdly, increases to tax credits are a much more effective vehicle for reducing child poverty than increases in tax allowances. Fourth, a long-term programme of reform to the tax system focusing on increasing the personal allowance to an extent that takes many recipients of tax credits out of direct tax altogether is an effective (if expensive) way of reducing the high marginal rates faced by many families in the lower-to-middle reaches of the income distribution. Finally, a large-scale increase in the income tax personal allowance combined with a flat income tax rate of 40 per cent on gross incomes between £20,000 and £130,000 redistributes the burden of income tax away from earners in the middle of the income distribution and towards top earners. In conclusion, a desirable short-run combination of reforms to the tax and tax credit system would involve the following two elements:
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1. Increases in tax credits along the lines explored in reform option A or B (in the case of option B, partially paid for by abolishing child benefit) 2. Increased wealth taxes along the lines suggested by CentreForum (e.g. mansion tax, restrictions to higher rate pension relief and increases in CGT to income tax marginal rates). In the longer run, I also recommend a third reform: 3. Rebalancing the burden of direct tax away from low-tomiddle income families and towards high-earning families by combining a large increase in the personal allowance with a flat 40 per cent income tax rate across most of the rest of the income distribution. Radical reforms along these lines should ensure that the tax system becomes progressive, taken as a whole.
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: 5 – Overall conclusions This report has set out the arguments for and against an increase in personal tax allowances or an increase in tax credits. The analysis shows that: :
At a household level based on a static analysis, increases in tax credits result in a more progressive outcome than an increase in the personal tax allowance
:
The incentive effects on entering the labour market and working more hours are in the short term stronger for primary earners from increases in tax credits than from personal tax allowances for single earners and first earners in couples. In contrast, the incentive effects are stronger from increases in the personal tax allowance for second earners in households.
Beyond that, the conclusions on which is the preferable approach depend on both a political view of the role of the state and also on a view of the dynamic impact of the tax credits versus personal tax allowances on overall incentives within the economy, and hence growth and income levels. This is a question of balance and tradeoffs. CentreForum are not arguing for abolition of tax credits and Landman Economics are not arguing for abolition of personal tax allowances. CentreForum’s view is that whilst there is an important role for the state in seeking to ensure that basic household needs and particularly children’s needs are met, but once that is done income should be determined, where possible, by the effort of individuals rather than by the state. The view of Landman Economics is that the state should take a more active role in securing greater needs based redistribution. The dynamic impact of the two systems on overall incentives within the economy and hence growth and income levels are a political economy judgement. CentreForum’s view is that the high marginal
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effective tax rates over a wider range of the income distribution over time have a significant disincentive effect on work and income. CentreForum therefore sees the static distributional analysis as not representative of a longer term dynamic impact on incomes of low and middle earners. From this perspective low and middle income earners are likely in the longer run to be better off through increases in the personal tax allowance. By contrast Landman Economics’ view is that whilst this is theoretically possible, there is no firm evidence on which this view can be supported. Indeed, it may be the case that by prioritising employment for groups such as lone parents and primary earners in workless couple households, tax credits actually improve the incentive to participate in the labour market over the longer run, through encouraging greater attachment to the labour market. The trade-off is that the high marginal withdrawal rates created by the tax credit system may blunt the incentive to increase hours or progress towards higher paid jobs for WTC claimants. In the longer run this report explores the arguments for funding larger increases in the personal allowance than £10,000. To be affordable, this can only be done by raising the basic rate of income tax or the NICs contributions rate. For example, CentreForum suggests a basic rate of 26 per cent combined with an increase in the income tax PTA and the NICs Primary Threshold to £12,500 per year, while Landman Economics suggests a personal allowance of £20,000 with a single rate of income tax of 40 per cent combined with 9 per cent employee NICs. While reforms like these are unlikely to be on the table in the short run for political reasons, in the longer run there is a clear case for shifting the burden of direct tax away from low earners and towards middle-to-high earners.
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