The case for taking an axe to tax credits

With £12bn of welfare cuts on the horizon, tax credits look set to take the hit. What are they? And what effect will slashing them have? Matthew Partridge reports.


Iain Duncan Smith: raise the minimum wage

With £12bn of welfare cuts on the horizon, tax credits look set to take the hit.What are they, and what effect will slashing them have? Matthew Partridge reports.

What's going on?

As part of a plan to balance Britain's budget, the work and pensions secretary, Iain Duncan Smith, is proposing to cut £12bn from the welfare budget. The changes will be outlined in the post-election Budget on 8 July and the spending review in autumn, but with pensions and child benefit both protected, the most likely target for cuts is the tax credit system. Prime Minister David Cameron this week criticised the system, which currently costs £30bn a year, as a "merry-go-round", where low-paid workers pay taxes only to get them handed back in the form of credits.

How do tax credits work?

Gordon Brown introduced the scheme as chancellor, with the main aim of making work pay more than staying on benefits. Since April 2003 there have been two components Working Tax Credit (for those on low incomes who work at least 16 hours a week) and Child Tax Credit (for those with children under 16, or under 20 and in full-time education or training). Both are means-tested, so the more you earn, the less you get, and both are complicated explaining in depth would take the whole page.

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The Working Tax Credit contains several elements, including a contribution to childcare costs. In 2015-2016 a single person on £10,140 a year (equivalent to 30 hours a week at the minimum wage) would get £1,250, while a couple would get £3,260. However, a single person on more than £14,000, or a couple on £19,000, would get nothing. Child Tax Credits have a flat "family element" of £545 a year, plus a "per child" element of £2,780 a year (plus higher bands for disabled children). If your household income is below £16,105, you can claim the maximum.

Above that, it's tapered one-child households get at least some money up until they earn £26,200; two-child families up to £33,000; three-child families £39,750; and so on. Around 4.5 million families claim, with an average award of £6,340 a year, notes the BBC, and it's perfectly possible for recipients to get far more in credits than in actual wages.

Why cut them?

A cynical answer would be that, as pensioners are more likely to vote than younger voters, the government has chosen the least electorally unpopular option. But critics of tax credits argue that they have four main flaws:

They are complicated (and so costly) to administer, involving taxing the wages of low-paid workers only to return their money (and more) in the form of welfare payments.

They are open to fraud, estimated at £1.2bn last year.

By topping up the wages of the low-paid, they are in effect subsidising employers who can then get away with paying low wages.

The rapid withdrawal of tax credits as a worker's wages rise means those who take on extra hours or responsibilities for more pay, face a very high marginal tax rate (more than 80% in certain cases). That's a deterrent to working more, and may help to explain Britain's poor productivity part-timers tend to be less productive than full-timers, as James Ferguson of the MacroStrategy Partnership has pointed out before.

Are tax credits a bad idea then?

Supporters admit there are problems, but argue that credits "make work pay". Without them, many of the unemployed would be little better off (and in a few cases, worse off) if they found a job. Working for as little as 16 hours a week voids eligibility for Income Support and Jobseeker's Allowance.

This 'cliff-edge' effect means that many people (especially those with low skill levels) would remain on unemployment benefits, costing taxpayers even more. Some research suggests that tax credits also have a small positive impact on hours worked.

A 2006 Institute for Fiscal Studies (IFS) report noted that "the number of adults in previously workless families who moved into work probably outweighed the number... in previously two-worker families who decided not to work". A 2012 report by the Resolution Foundation argues that credits do not depress wages, noting "no general wage slippage in the part of the earnings distribution where tax credits bite".

What's likely to happen?

The IFS reckons that returning Child Tax Credit to the level it would have been if it had risen only by inflation (rather than above it) since 2003 would save around £5bn a year. The IFS estimates this would reduce the incomes of 3.7 million families by an average of £1,400 a year although, as the BBC notes, some of these would be future, rather than current, recipients.

The IFS adds: "like most cuts to means-tested benefits this... would tend to strengthen work incentives families would have less tax credit income to lose by increasing their earnings or to gain by reducing their earnings".

Are there any alternatives to tax credits?

One alternative is to raise the personal tax-free allowance, sothat the poorest are taken out of paying income tax. But withthe allowance at £10,600, a minimum-wage worker alreadyavoids income tax. A better idea may be to raise the minimumwage.

Some argue that this will reduce the number of jobsavailable, thus increasing unemployment and therefore thebenefits bill, but there's no clear evidence that the minimumwage does in fact have this effect, despite its introduction in1998. The idea also has support on both the left and right ofthe political spectrum.

Indeed, reports Rachel Sylvester inThe Times, IainDuncan Smith, the Secretary of State for Work and Pensions, has argued that any tax credit cut "shouldbe coupled with a rise in the minimum wage or greaterencouragement for businesses to pay the higher, living wage".

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri