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Why are tax credits so difficult to understand?

Published on 14 November 2005

The government over the last few years has described the tax credits system as "simple", "responsive", and "targeted". In large parts of the system it is none of those things. Very often it does things which are unexpected and irrational if you are a recipient or potential recipient. One of those things is the way in which the system calculates income so that it represents, not what the claimant is actually getting at any given point during the tax year, but what their income would be if the tot

This is because the system aims to be integrated with the tax system, which also measures income from one 6 April to the next, but it can do some surprising and unpredictable things to tax credit entitlement.


Take, for example, the case of Lucy who is 27, she lives on her own and since leaving school she has had a number of low paid and part-time jobs. She has worked four days a week for the last year or so and she is paid £6 per hour (she is a voluntary worker and trainee in a hospice in the evenings). The hospice has offered her a five day a week job at £8 per hour from 1st October. She takes the job. Let's see what happens to her.

Period April to September 2005
Lucy has gross pay of £168 per week and is not entitled to tax credits because she does not work enough hours.

Period October 2005 to March 2006
Lucy has gross pay of £280 per week and is entitled to tax credits because she is working 30 hours and her income for 2004/05 and 2005/06 puts her into the right income bracket.

Period April 2006 to September 2006
Lucy has gross pay of £280 per week and is not entitled to tax credits because her income for 2005/06 and 2006/07 is too high. Depending on when and what she tells HMRC about her income changes she may receive tax credits all the same (at least for a while).

Period October 2006 to March 2007
Lucy has gross pay of £280 per week. Assuming she has by now dealt with her renewal papers for 2006/07, her tax credit entitlement will cease. It is likely that she will have an overpayment.

From Lucy's perspective, it seems odd that when she was on her lowest income she was not entitled to tax credits; but when she gets a better job and a higher income, then she starts to qualify.

She may continue to receive the tax credits in the new tax year (2006/07) and that will be logical to her as her income has not changed, yet she is receiving tax credits to which she is not entitled.

The explanation

Period April to September 2005
When Lucy was on her lowest income, she was not entitled to working tax credit because she did not work 30 hours, which as a single claimant she must do to establish an entitlement.

Period October 2005 to March 2006
Then she started working more than 30 hours a week, so she qualified for working tax credit. Her initial award is based on her income for the previous tax year, 2004/05. Her income for that year was £8736 which is low enough to qualify her for working tax credit.

Even if her income for the current year, 2005/06, is taken into account (which it can be if Lucy tells HMRC about it), Lucy's average income for that year is still low enough to give her an entitlement. Her rate of pay did not go up until half way though the tax year, making her pay for that year £11,648. Under the rules she is able to ignore £2,500 of the increase in her income, making her tax credits income for that year £9,148, which is - again - low enough for her to claim working tax credit.

Period April 2006 and following 
But in the next tax year, 2006/07, if (and it is a big if) she continues to earn at the same rate and her personal circumstances remain the same, Lucy will not be entitled to working tax credit. Her average income over the whole year will be £14,560, which will put her outside the qualifying income bracket even with the £2,500 disregard.

Nevertheless, HMRC may continue to pay her. This is because when one tax year ends and another begins, HMRC carry on paying tax credit on the basis of what they already know about the claimant's income and circumstances, until the claimant sends back the renewal forms which are normally issued in April and May. These are known as provisional payments.

If HMRC do not know that her income for 2005/06 and 2006/07 is too high to give her an entitlement, her provisional payments at the beginning of 2006/07 will still reflect her 2004/05 income. When she sends back her renewal forms and the computer calculates that she is not after all entitled to tax credits for 2006/07, she will have to repay all the provisional payments she has received.


What can Lucy do?

If on the other hand, after Lucy puts in her claim in 2005/06, someone adjusts her claim for that year to take into account her likely current year income figure for that year (£11,648) she will not get provisional payments in 2006/07 and her overpayments will be substantially avoided.

The only overpayment which is likely to arise in that case is for 2005/06, when she had been getting payments based on her 2004-05 income of £8,736 though finally entitled to payments based on her 2005-06 tax credits income of £9,148 (£11,648 less £2,500).

In Lucy's case, keeping the Tax Credit Office informed about her current income situation would have minimised her overpayment and caused her payments to be closer to her entitlement than if she had left things until renewal time in April and May 2006-07.

But it is not always to a claimant's advantage to do this, and it is virtually impossible for a claimant to tell when it is, and when it isn't, without a detailed knowledge of the system. Also, for some tax credit recipients (e.g. the self-employed and those on fluctuating incomes) it is impossible to know what the annual income will be until after the end of the tax year.

HMRC has undertaken to improve the information given to claimants about the responsiveness of the tax credits system. But even the most sophisticated data will barely give people like Lucy much of a clue about what is going on.

There is no doubt that it is just very complicated to explain how the annual measure of income will affect an award. But HMRC must invest the time and energy in explaining the system to people like Lucy, in words and examples that they can understand.


Contact Name: John Andrews (Tel: 0844 579 6700 Fax 0844 579 6701)

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