The Independent View: Taxing decisions – the debate between tax credits and tax allowances

As debate ahead of the Budget rages on about the merits of tax allowances and tax credits, a CentreForum report published this week provides new, detailed analysis of both.

The media has focused on the plight of the ‘squeezed middle’, Ed Miliband wants to help the “squeezed middle” and Nick Clegg is concerned for “alarm clock Britain”. But ‘Taxing decisions: the debate between tax credits and personal allowances’ uses modelling to illustrate the implications of tax allowances more rigorously and objectively than the day-to-day analysis of Fleet Street or Westminster.

The report’s authors, Thomas Brooks and Chris Nicholson of CentreForum, and Howard Reed of Landman Eocnomics, together propose a range of measures which could be introduced to raise almost £12 billion. They focus on raising revenue fairly (from the very wealthiest in society) and on promoting efficiency (by shifting taxation from earned income to unproductive wealth). Measures include scrapping higher rate tax relief for pensions, aligning capital gains tax with income tax, and introducing a mansion tax on properties worth more than £2 million.

CentreForum show how the personal allowances – both for income tax and national insurance – can be raised to £10,000 immediately. They would be accompanied by a reduction in the higher rate threshold of income tax to ensure that current higher rate taxpayers do not benefit.  In doing so, it shows that allowances can be increased ‘faster and further’ even than Nick Clegg has hoped.

This policy package could be introduced on a cost neutral basis in Wednesday’s Budget, and would make a couple working full-time on the national minimum wage better off by more than £1,300 a year.

In contrast, Howard Reed argues that money raised should instead be spent on increasing child tax credits, the basic rate of working tax credit and the amount claimable against childcare. This would reduce childcare costs for working families, and help to reduce child poverty.

The report’s modelling shows that both approaches help those on low to middle incomes although, unsurprisingly, tax credits direct support more accurately towards the lowest earners.

In terms of work incentives, however, the picture is less clear. The Working Tax Credit creates incentives for first earners in couples to work. But second earners can routinely face marginal deduction rates of 73 per cent as credits are clawed back and income tax and national insurance are deducted from their wages. By contrast, greater tax allowances avoid creating further withdrawal problems, and offer a double benefit for families with two earners.

The report also discusses the benefits of a simpler tax system. Allowances are clearly preferable as they are simple to calculate, and are awarded automatically through the tax system. They also underline the state’s commitment to a progressive tax system that encourages productive labour. Tax credits, on the other hand, complicate the system, both for families and for the tax man. They also have unintended consequences – is it sensible that it can cost government far more to get an individual into work than they would earn themselves? Greater tax credits entrench this, and could mean that a family with 2 children continue to receive credits as their income surpasses £60,000.

Questions of principle are also involved. The role of the state is at the heart of this debate. CentreForum present the liberal argument that the individual, rather than the state, should be the prime determinant of income. This is not always the case with tax credits. In this sense, tax allowances are preferable in the long term interests of society.

The Government have an opportunity to change Britain’s tax structure for the better. They should do so while they can, and do it proudly.

The Independent View‘ is a slot on Lib Dem Voice which allows those from beyond the party to contribute to debates we believe are of interest to LDV’s readers. Please email [email protected] if you are interested in contributing.

* Tom Brooks is a researcher at CentreForum, the liberal think tank

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16 Comments

  • Daniel Henry 20th Mar '12 - 7:48pm

    Another nice feature about raising the tax threshold is that a person doesn’t have to claim to benefit.

    There are some people entitled to working tax credits who just don’t believe in handouts or taking money they don’t feel they’ve earned.

    Reckon this report will make any impact on the budget at all?

  • Chris Nicholson 20th Mar '12 - 9:34pm

    Dan, look at Howard Reed’s section of the report and he has modelled £20k personal allowance and a 40p tax rate. Chris

  • Doesn’t most of the money coming from upping the threshold go to those with two workers and so not to the poorest.

    Could it not be argued that it makes a nice soundbite and, although I am not objecting per se, the money could be better spent if the desire is to help the low paid

  • bazzasc: the most progressive option is a zero personal allowance, a 100% tax rate, and very big tax credits. That is, after all, how we could implement the Marxist idea of “from each according to their ability, to each according to their own”. But it doesn’t seem very sensible when you think about it.

  • “But it doesn’t seem very sensible when you think about it.”

    Agreed. In fact, I suspect it’s so silly that it could accurately be described as a straw man.

  • Tim Lenig

    ?

    I was making the point that in stark ‘who does the money go to benefit’ terms increasing the tax threshold is a break for everyone, especially those with two middle earners.

    I am not saying it is the wrong thing to do but I keep hearing that it is targeted at the poorest in society and that is not correct

  • Daniel Henry 21st Mar '12 - 8:00am

    I don’t think we’re saying “poorest” – we’re saying “lowest paid”. Anyone who works full time will receive the full benefit of the tax break.

  • Oranjepan – I agree, I was just making the point (badly as it turned out) that the logical position of opposing raising allowances was to cut them, and takes you to a very unfortunate place.

    I favour raising IT and NI thresholds to the national minimum wage for a full time employee. These are people we need to price into work for the employer without making work less attractive to them. Tax credits can do it as well, but they are much more complex.

  • Income tax is a tax on income. It is not a tax on jobs. The unfortunate place that removing the tax free allowance gets you to is that all individuals in receipt of an income make some contribution to the services provided by the state. 100% taxation is not progressive, it is a flat tax.

    Whilst it may sound desirable to remove taxation from the lowest paid it does not come without a price. Part of that price being that it increases the body of the populous open to the charge of free-loading, a divisive charge that has been employed to attack the wages and pensions of public sector workers, the right to call social housing your home, the social justice of receiving unemployment benefits, universal child benefit, tuition fees, housing benefits, tax credits, educational maintenance allowance, free bus travel for pensioners, health care for the obese and smokers, the winter fuel allowance, the unemployed, the publicly employed, the under-employed, the over-housed, and many many more.

    Another part of that price is that the shrinking of the pot of public money reduces the provision of those services that the poorest most rely upon whilst at the same time only offering temporary increases to the income of the poorest, which are then whittled away through inflation and lower wage increases thereby leaving the spending power unchanged but the supply of necessary social goods diminished. If the increase in take home pay were to extend to a permanent benefit for the earner then it would necessarily be wrong to say that increasing allowances would incentivise employers to take on more staff as their cost would remain the same.

  • Tom Brooks,

    You and Chris Nicholson are to be commended on a highly instructive piece of work in this important area, with well argued summations.

    I would echo the comments of JRC “Whilst it may sound desirable to remove taxation from the lowest paid it does not come without a price. Part of that price being that it increases the body of the populous open to the charge of free-loading…”

    Personally, I have long favoured a minimum income guarantee administered by way of negative income tax, flat tax combining NI with Income tax and substitution of higher rate taxes on incomes with wealth taxes.

    The Centre Forum research together with the Mirlees tax review, should inform Liberal Democrat thinking as a comprehensive program of tax reform proposals is developed in advance of the 2015 elections.

  • In the comment above, I inadvertently omitted to commend Howard Reed of Landman Eocnomics on his excellent contribution to this report.

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