The Independent View: Lib Dems should look beyond the tax system to help low-to-middle income families

The Liberal Democrat conference has seen the party reiterate its commitment to using increases in the income tax personal allowance to raise the incomes of low-to-middle income families. Senior party figures have used conference to stress their long-term ambition to work towards an allowance of £12,500, roughly equivalent to the earnings of a full-time worker on the minimum wage.

This would be a significant tax cut that the Institute for Public Policy Research estimates would cost around £24 billion if implemented today. The Liberal Democrats argue that raising the allowance demonstrates ‘fairness’ by removing many low wage workers from income and cutting the tax bills of many more.

The move would also improve work incentives for many low earners and people out of work who may expect to move into low paying jobs. The symbolic figure of £12,500 also suggests there is a moral case against asking minimum wage workers to pay income tax.

The Liberal Democrat policy is based on a well-founded concern to support low-to-middle income families. The problem is that their chosen method is untargeted, and therefore very expensive, with most of the money spent going to better off families. Everyone earning more than £12,500 and less than £100,000 gains the same amount from raising the personal allowance to £12,500 – £1,005 a year compared to the current allowance of £7,475.

People earning between £12,500 and £100,000 are concentrated in the top half of the income distribution, whereas people who do not work or do not earn enough to pay income tax are concentrated in the bottom half. Therefore more of the money spent on increasing the allowance has to be spent on the wealthiest half of families – about two thirds of the total, according to the Resolution Foundation.

This could be reduced by lowering the threshold at which taxpayers start paying the 40 per cent rate, although this would be very unpopular and probably out of the question for the Liberal Democrats’ Coalition partners. But there is no avoiding the fact that taking some low earners out of income tax necessitates spending large sums on tax cuts for higher earners, while doing nothing to help the lowest earners.

The Liberal Democrat proposal is also directly contradicted by the Coalition’s policy of short-term cuts to working tax credits, which are well-targeted at low-to-middle income working families. Cuts of at least £1.6 billion are planned for 2012-13, reducing work incentives and incomes for these families.

The Coalition is committed to spending £1 billion on a further increase in the personal allowance in 2012-13 but this money could be better spent by reversing some of the damaging cuts to working tax credits, particularly cuts to financial support for childcare.

In the longer term, the Liberal Democrats should consider alternative ways to support the incomes and work incentives of low-to-middle income families, which are more focused and avoid the need to give significant tax cuts to families in the top half of the income distribution.

The party is rightly seeking to put support for low-to-middle income families at the heart of Coalition policy but relying primarily on the tax system to achieve this means the money it has carved out for this policy is not being spent as effectively as it could be.

Alternatives could include investment in free, universal childcare and early years education, which enables parents to work and supports children’s development. It could also mean looking again at the Universal Credit to see if additional and more targeted support can be offered to working families on low-to-middle incomes, including those who would not benefit from an increase in the personal allowance.

* Kayte Lawton is a Senior Research Fellow for the Institute for Public Policy Research.

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13 Comments

  • Bill Kristol-Balls 20th Sep '11 - 10:18am

    Every change in tax has these quirks but in essence, raising the personal allowance to £12,500 would give someone working full time on the minimum wage a 4% tax cut whereas for someone earning say £50,000 it would only be 1%.

    Having said that, the way to mitigate those who pay 40% tax from benefiting is to reduce their pension tax relief to the basic rate which should be done anyway.

  • Paul McKeown 20th Sep '11 - 12:05pm

    No thought given here to the cost of the immense government machinery necessary to tax poor people just to give the money back again, barely a mention of the back to work incentive that a large raise in the income tax threshold creates, with a resultant eventual fall in claimant count and cost. Some very worthy ideas such as free, universal childcare and early years education, but the only answer seems to be to tax those in working poverty to fund them. How about raising additional taxes against wealth, particularly unearned wealth? How about freeing up money for government spending by the reduction of bureaucracy? I’ve heard the author’s arguments for decades from Labour indoctrinated friends, but have never been convinced by them. I prefer a general redistribution from affluence to poverty, rather than some sort of a micro shuffling from the poor to the destitute. It’s called fairness.

  • Daniel Henry 20th Sep '11 - 4:59pm

    Last year’s increase in the allowance was accompanied by a lowering of the higher rate.

    The way it worked out was that lower rate tax payers were about £200 better off while higher rate tax payers were about £100 worse off.

    I’d say it’s been quite well targeted indeed.

    Paul also made the important point that it’s much more efficient than.paying people to take money from the poor and then to redistribute it as credits.

  • I surprised you haven’t suggested extending the tax allowance to £12,500 but increasing the basic rate of taxation to compensate, considering you seem to believe it’s a shame that families with an income of more than £12,500 benefit from increasing in the tax allowance.

    I’m never in favour of universal benefits when it’s put forward as a universal tax cut that proportionally favour the poorest. One extends the state, the other shrinks it. Economies suffer more the larger the public sector gets, and this damages the life chances of the poor you’re trying to help. Keep the state small and targeted on what it needs to do and reap the benefits of a healthy economy that allows working class children to become middle class adults.

  • Apologies that should read “when it’s put forward against a universal tax cut”.

  • Common sense tells you that the best, most efficient, least wasteful way to reduce the net tax burden on low earners is simply to take them out of tax altogether by raising the personal tax allowance. But common sense also tells you that the world is flat. Sometimes common sense gets it wrong.

    To address some of the points people have been making in response to this post:

    1 -” No thought given here to the cost of the immense government machinery necessary to tax poor people just to give the money back again”; “creating a vast bureaucratic machinery to tax the poor then work out how to give it back to them is wasteful”

    First of all: the piece of “government machinery” we’re talking about – the tax credits system, presumably – does not simply tax poor people and then give their money back to them.

    A family on £15,000 a year with two children, for instance, is entitled to £6,805 in Working Tax Credit and Child Tax Credit, assuming one adult is working at least 30 hours a week. (Source: http://www.hmrc.gov.uk/leaflets/wtc2.pdf.)
    But they are paying, at most, £1,505 in income tax (source: http://listentotaxman.com/index.php). If we chose simply to lift that family out of tax, rather than maintaining the “vast bureaucratic machinery” of the tax credits system, they would be left £5,300 a year worse off.

    Of course, even poorer families pay even less tax and receive even more in tax credits; for instance, a single parent of two earning £5,000 a year from part-time work pays no tax at all, but receives £9,535 in tax credits.

    For an example of a family that was getting back in tax credits only what it was paying in tax, you’d have to look further up the income scale: a two-child family with one full-time earner on £21,000 and one part-time earner on £4,000 would, for instance, be at the ‘break-even’ point, paying out and then getting back £2,705.

    Secondly: the government spends just under £24 billion a year on Tax Credits (source: http://www.guardian.co.uk/news/datablog/2010/jun/02/liberal-conservative-coalition-welfare). No doubt a proportion of that money is “wasted”, in the sense that it is spent on administration of the system, or lost to fraud and error, rather than going into the pockets of the low and middle earners the system is intended to help. I can’t find a figure for administrative costs, but figures of around £1 – £2 billion have been bandied around over the years in relation to fraud and error. We could take an educated guess that, say, £4 billion of that £24 billion is spent “wastefully” in the sense just defined.

    By happy coincidence, the cost of raising the tax threshold to £12,500 has also been calculated at £24 billion. So we can do a direct comparison: for the same cost, which system does a better job of getting money into the pockets of low and middle earners?

    Having considered a few representative examples of tax credits awards, the answer should be screamingly obvious. Spending £24 billion on tax credits boosts the income of a typical low-income family, on £15,000 a year, by £6,805; spending £24 billion on raising the tax threshold boosts their income by just £1,005. Obviously, then, most of the £24 billion it costs to raise the tax threshold is ending up somewhere other than in the pockets of low-to-mid earners. It’s being “wasted” – not spent on bureaucracy or lost to fraud and error, but simply left in the pockets of people outside the low-to-middle income group the policy supposedly targets.

    2 – ““People earning between £12,500 and £100,000 are concentrated in the top half of the income distribution” – demonstrably wrong. This is obvious because the median wage is £25k. But if for some reasons it’s not obvious to you then look at the UK income distribution here: http://upload.wikimedia.org/wikipedia/commons/a/a2/British_household_income.jpg
    * So in fact UK income earnings are concentrated in the £12k-£25k bracket.”

    (A quick point first: that bar chart doesn’t show earnings, it shows “net income after all taxes and including any social security benefits,” based on a household with two adults and no children (source: http://en.wikipedia.org/wiki/Income_in_the_United_Kingdom#cite_note-4). It’s those net incomes, not earnings, that it shows to be concentrated in the £12k – £25k bracket.)

    An individual’s position in the income distribution reflects the composition of her household, not just her personal income. A single person earning £25,000 would be around the 82nd percentile, not the 50th; a person who had a partner also earning £25,000 would be around the 98th percentile. On the other hand, someone supporting a family of two adults and two children on £25,000 would be around the

  • Oops, posted by accident! But it’s long enough already I think. Just to point out: my figures for where people on £25,000 sit on the income distribution are some way out, because I forgot to deduct tax and NI. But the point stands: some people earning less than 25k are in the top half of the income distribution, while others earning more than £25k are in the bottom half. It all depends on what their partner earns (if they have one) and how many dependent children they have. So Mark Wright, the point you think is “obvious” is not obvious at all; whether the bulk of this £24 billion tax cut goes to households lower down the income distribution or to households higher up is going to depend on things like what proportion of people live alone, what proportion of households include dependent children, whether households with children are more likely to contain at least one adult who doesn’t work or only works part time, etc.

    It’s really as simple as this: pretty much every household in the top half of the income distribution will gain at least £1,005 from this tax cut, with a high proportion gaining £2,010. But a high proportion of households in the bottom half – households in which people are unemployed, retired, working part-time, dependent on disability benefits, etc. – will either miss out altogether or gain very little. *Of course* most of the money will go to people in the top half.

  • Mark Wright

    One more go at explaining this, since I still don’t think I’m making it as obvious as it should be. (This issue really gets to me, as you may have gathered!)

    Grant that 50% of people are earning less than 25k and 50% are earning more.

    Which are there going to be more of:

    1 – people earning more than 25k who are nonetheless in the bottom half of the income distribution. These would be individuals who have dependent children, but who do not have a partner or have a partner on a relatively low income (less than 25k or so,depending on number of children).

    2 – people earning less than 25k who are nonetheless in the top half of the income distribution. These would include: single people on around 23k or 24k; people living with a partner, but without children, and whose joint household income was

  • Sorry, another duff post. I’ll shut up.

  • Mark Wright:

    To be clear: it does not follow from the fact that the median wage is 25k that everyone in the top half of the income distribution is earning more than 25k. Some people on less than 25k will belong to households with *combined* incomes of (roughly) 50k plus, putting them in that top half. So it is mathematically quite possible that there should be more people earning 12.5k-plus in the top half of the income distribution than in the bottom half.

    A simple thought experiment should settle this: suppose I go off to knock on the doors of 100 representative households from the bottom half of the income distribution, and you go off to knock on the doors of 100 representative households from the top half. Who is going to meet more people who earn 12.5k or more? Bear in mind that among those 200 households there will be dozens in which no-one is waged at all – pensioner households, student households, unemployed households, households consisting of a disabled person and a carer – as well as many more in which no-one is working full time. Generally speaking, who is going to be knocking on their doors – you or me? Of course what we would find is that people earning 12.5k plus are concentrated in your group.

    And that bar chart does not show that most people earn wages of around 12k – 25k; it shows that most households’ incomes after tax and benefits have been taken into account are equivalent, in terms of how ‘well off’ the household is, to an income of 12k-25k for a household with two adults and no children. That includes households for which the sole or main source of income is benefits rather than wages.

    (I do apologise for banging on; I really think this policy is monumentally dangerous and misguided.)

  • Paul McKeown 23rd Sep '11 - 1:12pm

    @G.O.

    First of all: the piece of “government machinery” we’re talking about – the tax credits system, presumably – does not simply tax poor people and then give their money back to them.

    A family on £15,000 a year with two children, for instance, is entitled to £6,805 in Working Tax Credit and Child Tax Credit, assuming one adult is working at least 30 hours a week. (Source: http://www.hmrc.gov.uk/leaflets/wtc2.pdf.)
    But they are paying, at most, £1,505 in income tax (source: http://listentotaxman.com/index.php). If we chose simply to lift that family out of tax, rather than maintaining the “vast bureaucratic machinery” of the tax credits system, they would be left £5,300 a year worse off.

    Sorry, but that – and much of the rest of your long argument – makes the assumption that if the income tax threshold is raised that those on low incomes do not continue to receive various benefits, which is simply not true. The low paid keep more of their earned income and Steve Webb and Iain Duncan Smith are working damn hard to make sure that benefits are not withdrawn at a faster rate than income..

  • Surely a common sense approach would be to raise the threshold for lower and middle earners thus producing more confidence in spending.

    12500 is fair and the middle threshold should be raised to those earning 55k or more not 42 as the current thresholds give very little incentive to those wishing to progress careers

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