Nick Clegg’s speech yesterday set out his plan to push the pace on raising the personal allowance to £10,000. From the 2012-13 level of £8,105, that would put an extra £380 in the pockets of most basic rate taxpayers.
That sounds nice. But even if they find the cash to implement the higher allowance, it’s hard to give the Government credit for lavish generosity. Its ongoing freeze on the Working Tax Credit – extended in November’s Autumn statement – means that lower-income working families are set to be about £390 per year worse off by 2013.
So the tax cut will, for the most squeezed of the squeezed middle, just take them back to square one.
The value of simplicity?
There are valid philosophical and pragmatic arguments for cutting income tax rather than raising tax credits. In justifying raising the personal allowance, the Lib Dems may argue that targeted support simply isn’t worth the complexity, after all, who really understands tax credits?
But at £9bn, if introduced from this April, it’s a hugely expensive way to do it. Every basic rate taxpayer would get some money from the move, including some dual-earner households on as much as £85,000 – hardly the squeezed middle, you might think. If you want to help the hardest-pressed working families you need a sharper instrument.
Support where it’s needed
The Working Tax Credit is a much more targeted mechanism to help working families on lower incomes.
It’s available to families with two children on an income of up to about £32,000 (slightly more for three children and less for one). And because it’s trained on more hard-pressed working families – those in the bottom half of the income distribution roughly – reversing the current freeze would be a lot cheaper than Clegg’s proposal, costing about £1.3bn.
IDS’s Universal Credit versus Clegg’s tax plan
But the news gets worse for the hard-pressed families from 2014, with the introduction of Universal Credit. There’s another arcane change in the pipeline that will take away most of any tax cut lower-earners might get.
Currently, a family’s tax credit entitlement is reduced by 41p in every gross pound of earnings (i.e. income before tax) when people start earning above £6,420 a year.
Under Iain Duncan Smith’s Universal Credit (UC), that system will change and the Department for Work and Pensions will instead withdraw 65p in every pound of net income (i.e. income after tax) once people earn more than a given amount. And an income tax cut has a very different impact for families if you assess benefit entitlement on pre-tax rather than post-tax income.
Taxing the tax break
So under the current tax credits system, if basic rate taxpayers get a £380 income tax cut by Mr Clegg’s plan, that has no impact on their tax credits award since their gross income is unchanged. Household finances come off the boil and everyone is happy.
But under UC, a £380 tax cut raises the family’s post-tax income by the same amount, which then cuts their UC entitlement by 65% of that £380. All in, families on UC with a basic rate taxpayer can expect to be something like a mere £2.50 per week better-off. Meanwhile, those in the top half of the income distribution will get the lion’s share of the tax cut.
When all the changes are in, the Clegg plan to raise the personal allowance will mainly benefit people in the top half of the income distribution. If it’s hard-pressed families we’re worried about, surely there’s a better way to spend £9bn?
This post was first published on the Public Finance blog.