We can’t (tax) cut our way out of the tax credit problem

When it comes to this April’s tax credit cuts we’re now swiftly approaching t‎he point where everyone accepts there is a problem, and starts to ask the real question – what is the solution? ‎

Forthcoming work from the Resolution Foundation will look at the issue in detail, but it’s worth sketching out the parameters to that debate given that proposals are being thrown around thick and fast for how the government could ease the pain. If we’re deciding to play football people should at least know what the pitch looks like and the shape of the ball.

Proposals for compensating losers from a tax and benefit take-away should always be judged according to whether they actually affect the same people that lost out (the Who Test), and whether the compensation is in the same order of magnitude as the loss (the How Much Test). With 3.3m families losing an average of over £1,000 this April, these are not easy tests to pass.

‎Let’s take three of the suggestions being made – cutting taxes, helping people to work longer hours or using the ‘National Living Wage’ to compensate. Could any of these be the answer to those people, like new Conservative MP Heidi Allen, who believe that “too many people will be adversely affected. Something must give”?

First tax cuts. This sounds like a simple idea – working people losing out from tax credit cuts can surely be compensated by having their tax bill reduced. This is at the heart of the idea of letting people keep more of what they earn rather than taxing them and then giving them some money back. Increasing the personal allowance is touted as the obvious way of doing this.

Unfortunately ‎personal income tax cuts don’t come close to passing the Who Test of effective compensation. That’s in general because the tax you pay is based on your individual earnings while tax credit entitlements are based on household incomes. But more importantly because recent increases in the personal allowance (which rose from £6,475 in 2010 to £10,600 today) have significantly reduced the overlap between the populations of tax payers and tax credit recipients.

Here’s a way to think about it – in April you will only pay income tax if you individually ear‎n more than £11,000, but you will start to lose tax credits if your household earns as little as £3,850. In some ways these are different tribes and you cannot compensate one entirely by giving money to the other.

Even for those in both tribes, tax cuts fail the How Much Test. A couple with children in which one person is working full-time at the National Living Wage will get a £1,000 pay rise this April because of the introduction of the higher wage floor. Yet their overall income will fall by around £1,500 because of tax credit cuts, significantly more than their entire £800 income tax bill. So even if they had their entire tax bill wiped out by raising the personal allowance – at a cost of over £20bn – it still wouldn’t compensate for the losses.

Increasing the point at which people start paying National Insurance would do a better compensation job (people will pay NI from £8,164 compared to £11,000 for income tax) but it’s still not the answer to compensating for tax credit cuts.

Second, what about the idea that people should be supported to work longer hours? Reasonable people will disagree about how realistic that is for all those millions affected (and remember that  3 million people already say they can’t get the hours they want), but let’s focus on how much extra people would have to earn to compensate for the cut in state support – to pass the How Much Test.

Again think of our single earner family on £15,000. Not only do they face a drop in income of £1,500, the changes next April also mean that for every extra pound they earn 80p is lost in reduced benefits and higher taxes. So working a couple of extra hours every week would mean earning £750 more, but taking home just £150 – well short of passing the How Much Test.

Third, what about ramping up the planned and welcome higher minimum wage faster? Again there are problems for the Who Test – many people on tax credits aren’t on the minimum wage. But let’s focus on the How Much Test again.

What if we were to leap straight to the expected £9.35 wage floor for the over-24s from next April instead of waiting until 2020? For our single-earner family with one full-time worker, umping from the minimum wage to a new elevated National Living Wage would produce a gross pay rise of some £5,200. But this would result in a reduction in their overall loss from close to £1,500 to around £620. Improved definitely, but still a very painful drop even assuming this hugely unrealistic level for the wage floor.

We could go even further and combine options one and three – jumping to a £9.35 wage floor and fast forwarding the government’s plans for raising the income tax threshold to £12,500 by the end of the parliament. Apply both in April, and our family still loses money – around £320 in this instance. And of course, this ‘solution’ will have a huge cost. Indeed at £9bn that cost is double the savings being made from the tax credit change in the first place.

Next April many households will face a big hit to their family incomes. There are only three routes to making good that loss – higher earnings, lower taxes or higher benefits.

On the first two options of higher earnings or lower taxes, the above should make us think twice when we hear simple answers being bandied around. Of course they’ll make some difference. But there is no easy way to compensate for the loss of £4.5bn of state support for working families. Raising the personal allowance, minimum wage or hours worked isn’t it.

Nor is free childcare (less than 10 per cent of tax credit recipients receive childcare support for a child under 5) or lower social sector rents (housing benefit already takes most of that strain so tenants wouldn’t see much benefit).

That points towards changes to the benefits system itself, to which we’ll return in that work mentioned earlier. Here the key is that any given proposal can only achieve two of saving money, reducing poverty and improving work incentives. So if the compensation isn’t being paid for by additional government spending it must be having a negative impact on one of the other two. If you really agree with Heidi Allen MP it’s going to cost to do something about it.