Tone down, phase in or transition to: the options facing the Treasury on tax credits

Following developments in the House of Lords, we’ve entered a new phase in the tax credits debate. Whatever the constitutional rights and wrongs, everyone can agree that the ball is firmly back in George Osborne’s court. Indeed last night he promised to look again at the changes. The real question now is to what extent the action he takes will protect low income working families.

The deadline for action is in practice the joint Autumn Statement and Spending Review on 25^th November. So what avenues will the Treasury be looking at in the 29 days before then? We will explore this question in detail at an event on 5^th November, but it’s worth sketching out the terrain.

As previous Resolution Foundation work has shown, this tax credits problem can only really have a tax credits answer. The (very welcome) higher minimum wage and (very expensive) increases to the personal allowance cannot compensate for the sheer scale of the losses implied by saving £4.4bn from 3.3m families. The average loss of £1,300 is only reduced to an average of £1,100 by these other measures. Other changes (for example cutting National Insurance for the lowest earners) might be good things to do for other reasons, but they cannot deal with the tax credit crunch itself.

So if the answer lies in the tax credit system, the history of welfare reform provides a helpful menu of what can be done. There are three broad approaches open to the Chancellor – that bring different impacts both for the households concerned but also for the public finances.

First, tone down the scale of the tax credit cuts. This is by far the most straightforward option because it permanently reduces the hit to families – getting to the core of the problem with these changes. Of course reducing the hit to family incomes means making less savings for the Exchequer, which would require money to be raised elsewhere, or for any good news on borrowing in the Autumn Statement to take the strain. But there is a long history of governments taking such action – from lone parent changes in the early Blair years to the decision in the last parliament to undo the damage of reduced in-work childcare support.

As an example, was the Chancellor minded to halve the savings to £2.2bn, he would reduce the average loss for families to below £700. Still significant but a major reduction. Indeed, on current forecasts, he could cancel the £4.4bn altogether and still meet his target of eliminating the overall deficit by the end of the parliament.

If this toning down option is being considered the priority should be to reduce the scale of the cut to the so called ‘income threshold’ (the point at which someone in work starts to lose tax credits). This cut not only hits poorer households harder, but also leads to a major reduction in the rewards to going out to work in the first place.  Undoing some of that damage would allow George Osborne to say he was prioritising working households on the lowest incomes.

Second, the Treasury could phase in the changes over a number of years. This approach would get to the same end point in terms of savings and family losses but avoid a large overnight hit to family incomes this April. It would however cost money in the early years (equal phasing over three years would cost in the ball park of £4bn cumulatively).

This approach would be similar to the real terms cuts that have been made to most working age benefits during the last Parliament with below inflation increases year on year adding up to a big hit. However it would feel much more difficult for families, who would see actual cash cuts in their incomes, rather than slower rises.

Governments tend to not phase in cash cuts of this nature because the political pain is dragged out (think of the cut to child benefit in the last Parliament). Crucially, phasing in some of the changes being introduced this April would make little sense – the increase in the tax credits taper for example only saves serious money in the first three years, before tax credits are rolled into Universal Credit.

Third, transitional protection for existing recipients of a benefit is a well-worn path for welfare reformers looking to softly introduce controversial changes. This is the approach being taken by the Government on limiting tax credit support to two children per family, and was a key feature of reforms to disability benefits in the 2000s. Unlike phasing in, where everyone gets affected immediately but by a smaller amount initially, transitional protection means only a small number of people are initially affected but by a large amount

The principle is that only new tax credit claimants would be affected by the changes. This provides much more protection as no family faces a year on year cash loss. But it expensive because many families claim tax credits for several years. For example the government will only be saving £675m a year from the abolition of the family element of tax credits for new claimants in 2020, when it would save around £2bn to abolish overnight. It also gives existing tax credit claimants a strong incentive not to increase their hours in case they stop being entitled to tax credits – and lose out if they then need to claim them again in future.

So the Treasury has three options – tone down, phase in or transition to these tax credit changes. In reality they may chose a combination of all three. Which you think is preferable will depend on how you balance off the costs to the Exchequer with the hit to family budgets, and whether you think the problem with these changes is the timing of the losses, or the sheer scale of them. In 29 days we’ll find out which the Government cares about more.