Taxes, tax credits and welfare spending

In his budget speech today, Chancellor George Osborne, claimed that ‘we will make work pay’. This blog evaluates that claim. We examine the impact of the changes to income tax thresholds and tax credits together with the introduction of a National Living Wage (NLW).

The government has announced the following changes to the tax and tax credit system:

• Increase the income tax threshold from £10,600 to £11,000
• Increase the higher rate (40p) threshold from £42,385 to £43,000
• Restrict eligibility for child tax credit to the first two children
• Decrease the threshold income at which tax credits are withdrawn from £6420 to £3850
• Increase the ‘taper’, the rate at which tax credits are withdrawn for income exceeding the threshold from 41% to 48%

The main impacts of this package of changes are:

1) The changes to tax credits intensify the disincentives to work for all tax credit claimants earning more than the new threshold of £3,850, except for those earning in the very narrow range between £10,600 and £11,000.

2) The following types of families will be worse off in 2017/18 after the changes:

• Childless and non-disabled individuals currently working 30 hours on the national minimum wage (NMW)
• Lone parents and couples with children currently working 30 hours on the NMW
• Lone parents and couples with children currently working 40 hours on the NMW
• The average lone parent on in-work tax credits, who works 26 hours at an hourly wage of £8.53
• The average single-earner family on in-work tax credits, working 37 hours at £8.78 an hour

All of these families will lose more in tax credits than they will gain from the changes to income tax and the new living wage.

3) The following types of family will be better off in 2017/18 after the changes:

• Childless and non-disabled individuals currently working 40 hours on the national minimum wage (NMW)

Work disincentives

We believe that the measures announced are inconsistent. While the changes in income tax thresholds should modestly strengthen the incentives to enter or stay in work, the government has  worsened the work disincentives embedded in the tax credit system.  Increasing the taper from 41% to 48% increases the effective tax rate faced by families claiming tax credits to 48% for incomes between £3,850 and the NI threshold, to 59% for families paying NI but with annual incomes below £11,000 (£12,500 in 2020/21), and to a whopping 79% for families earning in excess of £11,000 (£12,500 in 2020/21) but still in receipt of in-work tax credits.

Moreover, the changes to tax credit worsen the work disincentives faced by 2nd earners in couples receiving tax credits. Currently, the first £1 that these (usually) mothers earn is taxed at the rate of 41%, the rate at which their additional income reduces their family’s tax credits. Increasing the taper to 48% also increases the entry rate of income tax for this group to 48%.

Impact by family type

The tables below show the combined impact of the change from the NMW to the NLW, the reduction in income tax thresholds and the reduction in tax credit thresholds for a range of family types.

Table 1a: 30 hours at NMW to 30 hours at NLW, childless non-disabled individual

Table 1b: 30 hours at NMW to 30 hours at NLW, one-earner family with one child[1]

* Assumes that the thresholds for child tax credit only will shift in line with the working tax credit thresholds.

Table 1c: 30 hours at NMW to 30 hours at NLW,single-earner family with two children[2]

* Assumes that the thresholds for child tax credit only will shift in line with the working tax credit thresholds.

Table 2a: 40 hours at NMW to 40 hours at NLW, childless non-disabled individual

Table 2b: 40 hours at NMW to 40 hours at NLW, single-earner family with one child[3]

* Assumes that the thresholds for child tax credit only will shift in line with the working tax credit thresholds.

Table 2c: 40 hours at NMW to 40 hours at NLW, single-earner family with two children[4]

* Assumes that the thresholds for child tax credit only will shift in line with the working tax credit thresholds.

Table 3: Average lone parent recipient of tax credits with one child

* Assumes that the thresholds for child tax credit only will shift in line with the working tax credit thresholds.

Table 4: Average couple family recipient of tax credits with one child, assuming one-earner

* Assumes that the thresholds for child tax credit only will shift in line with the working tax credit thresholds.