Five things you need to know about the personal allowance increase

The Budget is expected to confirm rumours that the personal allowance – the amount you can earn free of any income tax – will increase to £11,000 next month, rather than the £10,600 laid out at the Autumn Statement in December. In this brief note we run through five things worth noting about this possible change.

1. It would be the latest in a series of income tax cuts

This would be the second change to the 2015-16 allowance, which was increased in the Autumn Statement from £10,500 to £10,600. Given the short notice for any change (we are only two or three weeks from the new tax year) it may be – as the Times reports – that the tax cut will not be able to be implemented immediately, instead being felt from June or July. We may also learn at the Budget what the – at least provisional – level of the allowance for 2016-17 will be.

In any case, 2015-16 would be the fifth year in a row of above-inflation increases, since the coalition inherited a level of £6,475 in 2010-11, leaving it considerably above where it would have been (this is true even if RPI uprating had been retained). The coalition goal of reaching £10,000 was achieved last year.

Increasing the allowance from £10,600 to £11,000 would cost around £2 billion. On top of the roughly £12 billion already spent, this would push the combined cost to around £14 billion in 2015-16 – around the same cost as the revenue gained from increasing the standard rate of VAT to 20%.

2. None of the gains go to the lowest paid 5 million employees

The policy is often promoted as ‘taking the lowest paid out of income tax’. It does this, but the increases also mean a tax cut for everyone earning up to around £120,000 (where the personal allowance is fully withdrawn in any case), meaning that most of the people who benefit aren’t, for example, on the minimum wage. On the other hand, five million of the lowest earning employees (plus many of the self-employed) already pay no income tax and don’t gain a penny from further income tax cuts, including anyone on the minimum wage and working 31 hours or fewer. For the first time, however, another personal allowance increase would benefit all taxpaying pensioners, as the frozen age-related personal allowances are finally overtaken (and therefore effectively abolished).

Three quarters of the gains flow to richer families who are more likely to have two people with incomes above the allowance. Only a quarter of the gains go to the bottom half of households. We should bear in mind that all of the main parties are promising some form of equally poorly targeted income tax cut at the election.

We have recommended that increasing National Insurance thresholds would be slightly more helpful for low earners. But even better would be to increase how much households can earn before their benefits start to be withdrawn by increasing work allowances in Universal Credit. This is all the more important because under Universal Credit around two thirds of the gains from any tax cut would be clawed back from poorer families.

Source: RF analysis using IPPR tax-benefit model, from ‘Missing the target’

3. By going further in this parliament, the £12,500 target for the next becomes easier to reach

The Liberal Democrats and Conservatives have proposed to raise the allowance to £12,500 over the next parliament, if elected (and UKIP have proposed to go further).

The tax cut expected in the Budget – if confirmed – will help them towards this goal and lower the cost of their proposed policy ahead of their election manifestos. Indeed, if the personal allowance only rose with CPI inflation from April 2016 onwards (as is its default) then an allowance of £11,000 in 2015-16 would be expected to reach roughly £12,000 by 2020-21.

If the allowance rose in line with earnings, which are now finally rising faster than inflation again, it would actually be over £13,000 by 2020-21. This means that a £12,500 allowance would not necessarily mean fewer taxpayers or lower average tax rates, nor increase the number of tax-free hours on the minimum wage (a measure the Prime Minister has used to contextualise this target).

Notes: Using MPC (Q4) and OBR CPI forecasts

4. The reduced cost of reaching £12,500 in the next parliament could prove relevant to any post-election party talks

Because of the role inflation plays in pushing up the personal allowance even without active tax cuts, recent falls in inflation had been expected to push up the cost of reaching the £12,500 target by 2020-21. From a base of £10,600 the cost of moving to £12,500 would be just over £5 billion relative to increases in line with inflation. But if the Chancellor does announce an immediate jump to £11,000, the remaining cost would be only £3 billion. While still a significant sum, this might be less of an obstacle to possible coalition agreements than a tax cut with an even larger price tag (and in the case of the Liberal Democrats raises the possibility that they could move onto their secondary target of raising the National Insurance thresholds within the next parliament).

Source: RF analysis using IPPR tax-benefit model, 2020-21 prices

5. But the National Insurance anomaly remains

There had been speculation that the Budget might include an increase in the equivalent threshold for National Insurance. This now seems unlikely, but it would make sense. As the personal allowance has increased, more and more low income workers have been left paying National Insurance but not income tax. Further income tax cuts in the Budget and in the next parliament would exacerbate this anomaly.

If the personal allowance rises to £11,000 instead of £10,600, an extra 200,000 employees will be left paying national insurance but not income tax, taking the total from 1.3 million to 1.5 million. Next year, almost 1 in 3 employees who don’t pay income tax – by definition the lowest earners – will nonetheless pay 12% employee National Insurance.

Source: RF analysis using Family Resources Survey