Tax credits: unaffordable and unfair

The government has come in for criticism over plans to reform tax credits, says James Ferguson. But the system as it stands is unaffordable.


It all started with Gordon Brown

Michelle Dorrell, a self-employed single mother of four, attacked Conservative minister Amber Rudd on last week's Question Time over cuts to tax credits. These tax-free benefits for the low-paid (see below) will be scaled back from 2016, while the minimum wage is being raised. The idea is to cut the deficit (the government's annual overspend) and ensure that "work pays". While claimants fear they will see their income drop, the government fears the welfare system has become not only unaffordable, but unfair and an impediment to growth too.

Tax paid in the UK (2014/2015) comes to £604bn. Total government revenue is £646bn. Against that, "total managed expenditure" is £736bn, leaving us with a deficit of £90bn (politicians usually talk of the "structural" deficit, ignoring the £45bn debt interest bill). Clearly things can't go on as they are. So why, in the seven years since the crisis, has the UK's national debt risen by more than £900bn more than doubling? The answer is the soaring welfare budget, which now funds widespread under-employment.

In 1999, then-chancellor Gordon Brown extended benefits to those already in work with Working Families Tax Credit, which became the more generous tax credits system in 2003. Since 1999, UK welfare spending, post-inflation, has risen by 50% to £214bn. This extra £71bn (in today's money) of welfare spending is £26bn more than the structural deficit, and threatens everything else the government is trying to fund, such as the NHS, education and defence. We just can't afford it.

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The UK's tax take today is equivalent to a third of GDP. British history shows that you can't raise the tax rate by more than 1%-2% above this without disincentivising productive workers (remember the 'Brain Drain'?) and driving the tax take down. So deficit reduction must come mainly from spending cuts, not tax hikes. But what about inequality? According to the Office for National Statistics, the average earnings of the richest 20% of the population are 15 times higher than those of the bottom fifth. But this is pre-tax earnings data, which are irrelevant.

After the richest pay their taxes and the poorest get their benefits, the income disparity drops to 3.7 times. And on a per-hour-worked basis, the richest only earn about 60% more than the poorest. It's hard to see how much more equal our society can get without excluding work altogether. As well as being unaffordable and unfair, tax credits are hurting productivity. Productivity growth averaged almost 2.5% a year for the three decades before the crisis. Yet it hasn't grown at all since, even though GDP is at new highs and unemployment has fallen to 5.4% from a peak of 8.5%.

Why not? Because although the one million full-time jobs that were lost in the crisis have been regained, the 1.4 million net new jobs (roughly equal to net immigration over the period) have been split between part-time and self-employed. Why? Because to get in-work benefits, including tax credits, claimants must either work two days a week or, if self-employed, say that they do. The work is unproductive because it has become secondary to the benefit income.

Here's how it works. Part-time work on average pays around £6,500 a year, entitling claimants to the maximum tax credit, which on average pays another £6,340. This in turn entitles renters to housing benefit (£14,260) and council tax (£1,400), making total benefits of £22,000, with a cap of £26,000. The average part-time couple may only earn £8 an hour for two days' work, but that's tax-free. On top, benefits can take the family's post-tax income up to more than £36,000 before they hit the cap, equivalent to earning almost £50,000 pre-tax the same as a GP or barrister.

Because part-time workers on benefits can earn the equivalent of £30 an hour for the three days they don't work, compared to the £8 an hour they earn for the two days they do, there's no incentive to work more than 16 hours. Sure enough, the median number of hours worked by part-timers is 16.1. Not much will change: even the new cap is £23,000, more than the average after-tax wage. So a minimum wage, part-time worker can still take home almost £30,000. Little wonder tax credits cost us £30bn a year.

What are tax credits?

There are plenty ofvariations and what you get dependsvery much on your circumstances,but for the current tax year (to April2016), for example, according toHMRC, a household with two children,no childcare costs, and one partnerworking at least 30 hours a week couldearn up to £30,000 a year and still bepaid £1,230 a year in tax credits.

The main changes to the system arethat the amount you can earn beforethe working tax credit starts to taperfalls from £6,240 to £3,850 from April2015, and the taper rate rises from41% to 48% in other words, theentitlement drops off more rapidly.Child tax credits will only apply to twochildren from April 2017, but existingclaimants won't be affected by that.

James Ferguson is a founding partner of the MacroStrategy Partnership LLP.

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.