Can tax cuts alone make people better off?

Published on 8 February 2012

The Coalition Government has a policy of raising the personal tax allowance for the under 65s by stages to £10,000 per annum. In 2012/13 the allowance will have reached £8,105. The Lib Dem part of the Coalition wants the allowance to be raised faster and the £10,000 figure reached sooner than just before the next election. But how much does raising the tax allowance by itself improve the household finances of those on low to middle incomes?

Low earners and the personal allowance

Raising the personal allowance is in itself a worthy objective. It will ease bureaucracy in that fewer people will find themselves being taxed by one arm of the State and paid benefits with the other. It can also be effective in putting more money into the pockets of low and middle income earners whose financial affairs are reasonably straightforward.

For example, a young couple with no children, both of whom are under 25 years of age, with a mortgage and earning (say) £15,000 a year each, will not be eligible for working tax credit or housing benefit. They would certainly benefit from an increase in their tax allowance.

However, there are some more complex situations in which raising tax allowances may not be the most effective means of boosting family finances. Many factors combine to influence the income of a household within lower income brackets – tax and national insurance contributions, tax credits, income-related or means tested benefits among them. It is important not to fall into the trap of considering just one of them in isolation.

Because entitlement to means-tested benefits is based upon net, after-tax income, the less tax a person pays, the less they are entitled to receive by way of benefits. If net household income goes up, benefits are progressively withdrawn.

There is a third consideration. If you are raising the tax allowance while at the same time implementing cuts in welfare benefits, the households targeted by the tax-cutting measures may still be no better off overall.

Let us take an example of a lone parent, with one child, working 30 hours a week and earning £10,000 a year out of which she pays £150 a week in childcare costs.

This lone parent pays £200 less tax in 2011/12 than in 2010/11 owing to the £1,000 increase in the personal allowance. She also pays about £140 less NICs. But the reduction in her housing benefit and council tax benefit which flows from the increase in her net income means she will only see 15% of that increase.

Now, tax credits do not erode the value of a tax cut in the same way as means tested benefits, because tax credits are calculated on gross, pre-tax, income. So the lone parent in the example will not lose any tax credits as a result of the decrease in her tax bill.

However, because of changes to the rates and thresholds of tax credits, in particular the increase in the withdrawal rate from 39% (2010/11) to 41% in 2011/12 and the decrease in childcare support from 80% of costs to 70%, the lone parent in the example above will lose more than £500 of her tax credits entitlement from one year to the next. This is despite the above-inflation increase in the child element of the child tax credit.

The loss of tax credits will be partly made up for by a corresponding increase in housing benefit and council tax benefit. But overall, taking into account changes in tax, NICs, tax credits and benefits, all of which affect her household income, our lone parent on £10,000 a year could be slightly worse off in 2011/12 than she was in 2010/11.

Middle earners – the higher rate threshold

The point on the income scale at which an individual becomes a higher-rate taxpayer – the higher rate threshold – was reduced from £43,875 in 2010/11 to £42,475 in 2011/12, and will be frozen at £42,475 in 2012/13. This means the band of basic rate taxpayers is narrowing, and proportionately more people can expect to become higher rate taxpayers in 2011/12 and 2012/13, thereby entering the world of self-assessment or complicated PAYE codes to recoup higher rate tax on small amounts of non-employment income.

It is tempting to think of higher rate taxpayers as being among the more wealthy. However, if you are the only earner in your household, the fact that you are a higher rate taxpayer does not necessarily take your household above the lower half of the income distribution. The tax and benefit changes, taken together, are likely to exacerbate their situation.

For example, an individual earning just £43,000 each year and with no other income might pay just under £100 less tax from 2010/11 to 2011/12 because of the increase in the personal allowance, even though he has become a higher-rate taxpayer for the first time in 2011/12. But once changes in the tax credits payable to his household are taken into account, the members of that household will find themselves worse off overall because they will lose the £545 family element of child tax credit to which they were entitled in 2010/11. Their situation will again change for the worse once their child benefit is withdrawn from January 2013.

Summary

In short, it is impossible to predict whether a single tax or benefits measure will result in a household being better off or worse off overall, until it is established how that one change will interact with other parts of the tax and benefits system affecting that household’s finances. It is also necessary to take account of other concurrent changes in the welfare system.

While means tested benefits remain based on net income – a situation which is likely to continue under universal credit – and while welfare cuts are being implemented, it is unlikely that tax cuts alone will do much to improve the position of low- to middle-earning households who also claim benefits or tax credits.

However, on a more positive note, increasing the personal allowance will at least ameliorate the extent to which benefits and tax credits claimants may lose out as a result of other measures in the welfare system.

(08-02-2012)

Contact: Robin Williamson (please use form at http://www.litrg.org.uk/ContactUs )