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Type: IFS Press Releases
Authors: Robert Chote
A shortened version of this article appeared in the Sunday Telegraph on Sunday 20 April 2008.
Gordon Brown's decision to finance a 2p cut in the basic rate of income tax by abolishing the 10p starting rate drew some criticism for sleight of hand when he announced it in his swansong Budget last year. But no-one foresaw quite how far the controversy would escalate when the change took effect earlier this month.
Labour MPs report "pages of venom" in their postbags; more than 70 have signed motions urging a rethink; and party whips fear a rebellion on this year's Finance Bill. On Thursday, Mr Brown had to persuade a hitherto loyal ministerial aide not to resign in protest.
The lobby group Church Action on Poverty has put the case for the prosecution starkly: "It is immoral and wrong for the Government to increase taxes on the lowest paid, whilst those on much higher salaries benefit from the cut in the basic rate of tax", it argues. "This is a Robin Hood policy in reverse - robbing from the poor to reward the rich."
Cabinet minister Ed Miliband has tried to make the case for the defence - but with rather less conviction: "When you make a big set of changes in the tax system, some people do lose out. That is a matter of regret. Of course it is. But overall these changes make the tax system fairer."
So who is right? Why has it taken a year for people to get so upset? And what, if anything, can Mr Brown do to calm them down?
Let us start by looking at exactly who wins and loses. The impact of Mr Brown's income tax changes on an individual taxpayer goes as follows: last year people under 65 paid no income tax on the first £5,225 they earned, 10% on the next £2,230, and 22% on the next £32,370; this year they will pay nothing on the first £5,435 and 20% on the next £36,000.
Taken in isolation, this means that people on incomes between £5,435 and £19,355 this year would be worse off, because they lose more from the abolition of the starting rate than they gain from the cut in the basic rate. The loss is greatest at £232 a year for someone earning £7,755.
Most people on incomes between £19,355 and around £40,000 would gain noticeably from the reform, with the biggest gain of £337 a year at £36,140. Changes to the levels of income at which people stop paying the full rate of National Insurance contributions and start paying the higher 40p rate of income tax mean that most people on more than £40,000 will gain only marginally once all the Budget measures take effect next year.
If Mr Brown had left it at that, he would indeed have been robbing the poor to pay the rich. But he also spent £1 billion raising tax allowances for those aged 65 and over, £1 billion raising the child tax credit and £1.3bn raising the income at which tax credits start to be withdrawn.
Taking the whole Budget package into account, the poorest third of the population actually emerge as the biggest winners, thanks to the increase in tax credits. The richest third also gain, thanks to the income tax changes. The middle third are largely unaffected.
So why all the fuss? Well, Mr Brown has not been equally generous to all poor families. He has protected most pensioners and families with children, but has done little for childless adults of working age.
This explains why - in what was on average the "pro-poor" Budget that the Government claims it was - there are 5.3 million families left worse off and most of them in the poorer half of the population. Roughly one family in five loses; two in five gain and the rest are unaffected.
Most of the losers are of two sorts. First, childless single people who do not qualify for the working tax credit because they are under 25, work less than 30 hours a week, or earn too much. Second, childless couples who lose twice from the income tax changes, but gain at most once from the working tax credit because it is a family payment rather than an individual one. Another vocal category of loser is early retirees, who do not receive tax credits, but who are too young to benefit from the increase in the tax allowance for those aged 65 and over.
This difference in generosity between different family types is nothing new. Indeed, it is entirely consistent with Mr Brown's previous reforms.
Look at the cumulative impact of Labour's tax and benefit changes since 1997: they have increased the average incomes of the poorest tenth of the population by 12% and cut those of the richest tenth by 6%. But, within the poorest tenth, pensioners have gained 24% and families with children 18%, while childless working-age adults have gained only 1%. Indeed, childless working-age adults lose on average from Labour's tax and benefit changes across nine-tenths of the income distribution.
This has had a predictable effect on poverty. Measured as the number of individuals living in households with incomes below 60% of that enjoyed by the average (median) household, poverty has fallen by 600,000 among children, 200,000 among working-age parents and 200,000 among pensioners since 1996-97. But poverty has increased by 500,000 among working age adults without children.
You can certainly make a case for focusing help on pensioners and parents. The former have little scope to increase their incomes. And helping the latter helps their children, who are powerless to alter their own circumstances. You could also argue that many poorer childless working age adults will only be so temporarily, as they will climb the earnings ladder, have children, or reach pension age. But that is of little comfort to those feeling the hit in their pay packets this month.
It is perhaps not surprising that the individuals directly affected should only protest when the measures take effect. It is slightly less clear why Labour MPs did not pipe up earlier, as the number of losers has not been in dispute since the Budget measures were announced a year ago.
One obvious reason is that Mr Brown was seen as a leader in waiting last spring, but is seen as a leader on the wane now. Another is that since last year's Budget the Government has cut inheritance tax and executed a U-turn on capital gains tax reforms to which the Confederation of British Industry and other lobbyists objected. Many Labour loyalists feel the government should listen at least as sympathetically to the grievances of their natural supporters as to those of entrepreneurs and the wealthy.
So what if anything may be done now?
Restoring the 10p rate would cost nearly £7 billion - money the Government does not have to spare. That is no bad thing. The 10p band should never have been introduced in the first place. It complicated the income tax system and was poorly targeted on those it was claimed to help. Whatever else you might say about last year's Budget, it did leave the income tax and National Insurance system in simpler and better shape.
If Mr Brown does feel the need to reduce the number of families losing, one candidate would be to extend the working tax credit to the under 25s and/or those working less than 30 hours. To do both would cost £2.2 billion and remove 1.2 million losers if everyone took up the working tax credits to which they were newly entitled. In practice, the cost and the number of losers removed might be much smaller. And some of those no longer losing would be over-compensated and gain a lot.
A similar option would be to increase the working tax credit for single people without children by 50%. This would cost around £600m and remove 300,000 losers, again implausibly assuming full take-up.
But in neither case would the Government necessarily derive much political benefit. Constituents complaining about the removal of the 10p band frequently add that they do not wish to become entangled in a tax credit system that they see as complex, bureaucratic and stigmatising.
A more popular way to reduce the number of losers would be to increase the personal allowance people can earn before they start to pay income tax and National Insurance. This would also be more cost-effective, as it would in effect partially unwind the Budget reform that created the losers in the first place. Increasing the income tax and NICs allowance by £100 would remove 1.3 million losers and cost £800 million; increasing it by £300 would remove 3.3 million losers and cost around £2.5 billion; increasing it by £750 would remove almost all the losers and cost around £6 billion.
None of these options are cheap. Raising the personal allowance would be the most cost effective way to reduce the number of losers, although it is not the way Mr Brown would usually target money on the groups he favours. The political calculation is whether he could compensate enough losers to stem the protests, without having to spend so much money that he would need to do something even more unpopular to pay for it.
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