Now is not the time to fudge on tax credits

Public policy questions are often difficult, with significant trade-offs between equally important objectives. As a result most people who have spent time taking decision in government know that, despite its bad reputation, the fudge can sometimes be the right answer. It can buy time on issues where the policy substance is unclear or reconcile competing interests when splitting the difference is a viable option.

So the fudge has its place. But that place isn’t in the decision the Treasury will take on tax credits at the Autumn Statement. Instead the Treasury needs to reverse the most damaging elements of these changes, and the good news is that they could do so without undermining their fiscal objectives.

It is now generally recognised that the tax credit changes planned for April 2016 would leave a large number of working families significantly worse off overnight, with 3.3 million families losing an average of £1,300 next year. Even before defeat in the House of Lords, the Chancellor was said to be listening to concerns from across the political spectrum. Indeed he has now committed to revising these plans to better protect low income households.

But he has a range of options for how he does that. The research we have published today looks comprehensively at those options – judging each by its impact on the low income working households affected, on work incentives and on the public finances.

First it’s worth flagging what definitely will not work. As previous work has suggested, further tax cuts or minimum wage rises cannot compensate effectively for tax credit losses. The chart below shows that families lose an average of £900 next year even with the extreme option of delivering a much higher minimum wage in 2016 and the full £12,500 personal allowance four years early at a cost of some £9bn.

For similar reasons the often mentioned fudge of phasing tax credit cuts in over a number of years will not solve this problem. Those arguing for this approach recognise that the increase in the minimum wage and tax cuts being introduced this April are not sufficiently large to compensate for tax credit losses next year, but note that further minimum wage rises and tax cuts have been announced (or promised) for later in the Parliament. The hope is that the benefits of those forthcoming changes might accumulate sufficiently to match tax credit losses being slowly phased in.

The first thing to say about this approach is that it would have the welcome effect of reducing the overnight losses families face in 2016 – what you might call the income shock problem of immediate changes on this scale. The flipside of that fact is that the savings to the Exchequer would be much lower in this Parliament.  Assuming an equal five year phasing, introducing 20 per cent of the cut each April until 2020, the reduction in savings would amount to £8bn over the Parliament.

But the real issue for a phasing fudge to work, given that it has a major political downside of cuts being introduced much closer to another election, is whether it significantly reduces the number of households losing out by allowing time for a higher minimum wage and lower taxes to provide compensation. And the answer is it does not, even if we allow for the full £12,500 Personal Allowance pledged for 2020 (despite it not being formally included in Treasury plans) and include general earnings growth (even though this is clearly not a direct function of policy).

The graph below shows the results – mapping how many tax credit claimants would lose different amounts if the policy was implemented as planned in 2016, compared to the same measures being introduced in full only in 2020 after 4 more years of earnings growth and tax cuts. It shows that without the £12,500 Personal Allowance 2.6m families lose more in tax credits in 2020 than they have gained from the higher minimum wage, wider earnings growth or tax cuts. And even including it, the best case scenario, makes very little difference. The phasing fudge therefore still sees most families worse off, but at significant expense to the Exchequer.

The next fudge option is to push ahead with the policy, but apply it to new tax credit claimants only– protecting the incomes of those already receiving tax credits.

In many ways this ‘transition protection’ is the easy option for the Chancellor. It has the attraction of combining a major reduction in political pain (removing both the immediacy and visibility of losses) with the possibility of arguing that the changes are still going ahead in full. By way of context, there are around 300,000 new in work tax credit claims a year who would be – compared to a stock of a little over 3m claimants.

But our research highlights some serious practical problems that make this option far less attractive than it may appear at first glance. Exactly because every existing tax credit claimant is protected, the level of savings secured is only a fraction of those currently anticipated. Next year the changes would save just £400m – compared to the original plan of £4.4bn. And even by 2020 only £1.4bn would be saved. So these would be big complex changes being made to save very little money in this parliament.

This approach has another major flaw in creating a new and very strong perverse incentive for claimants to remain on tax credits – what you might call an aspiration freeze. This would heavily discourage them from working or earning more if that meant moving off tax credits because they would face a major financial penalty should they need to return to claiming benefits at a later date (for example following a job loss).

Both the phasing and transitional protection fudges would also leave long term damage to the still to be rolled out replacement for tax credits, Universal Credit (UC). The eventual system would mean that, for example, a single mother coming onto UC will only be able to work 10 hours a week before she loses 76p in benefits for each extra pound she earns – a problem UC was invented to solve.

But if a fudge won’t work what should the Treasury do? The priority should be to reverse the most damaging of the changes – the cut to the income threshold which will cost £2.9bn in 2016, rising to £3.4bn in 2020.

Some have suggested funding this by further increasing the taper in tax credits, or indeed raising it in UC. This is a very bad idea for tax credits because it would leave many families facing marginal deduction rates of close to 100 per cent- so they would keep nothing of each additional pound they earn. While we would not see these extreme deduction rates for an increase in the taper within UC, it would lead to deduction rates exceeding the levels seen in tax credits before the financial crisis – the abolition of which was a key objective for inventing UC in the first place. As a general rule you can’t make good a tax credit cut by taking additional funding from tax credits, or indeed UC.

The good news, thinking of the Chancellor’s original purpose in introducing these cuts, is that the Treasury can avoid these options and still reverse the tax credit changes while meeting its fiscal objectives. Below is just a small sample of how additional funds could be found. For example it shows that the government’s two income tax pledges, for which more than four-fifths of the gains go to the richest half of households, are set to cost roughly £6.2bn in 2020. This alone would provide more than enough to reverse the tax credit cuts, and release additional funds for moving the point at which individuals pay National Insurance (NI) towards the income tax threshold. Such a move would provide more concentrated support for those on low to middle incomes and help around 1.8 million low earners who pay NI but not income tax. Even if none of these changes or others are seen as suitable by the Treasury, they could simply reverse the tax credit cuts and still deliver their fiscal objective of a surplus by 2019-20.

In 20 days we will find out how the Treasury intends to limit the losses from tax credit changes for low income working families. The key is not to fudge that decision. While that might help to defuse the political row in the short term, this is a substance problem of serious damage being done to the way the welfare state supports people into work and to progress once they are there. It should be treated as such.