FREE NEWSLETTER: Econintersect sends a nightly newsletter highlighting news events of the day, and providing a summary of new articles posted on the website. Econintersect will not sell or pass your email address to others per our privacy policy. You can cancel this subscription at any time by selecting the unsubscribing link in the footer of each email.

posted on 05 November 2015

Explainer: What Are Tax Credits?

from The Conversation

-- this post authored by Christopher Coles, University of Stirling

The Conservative government has suffered two defeats in the House of Lords over plans to cut tax credits for 3m households.

Cue a row over the constitutionality of what has taken place and, more importantly, uncertainty over how tax credit reform will take place. But what are tax credits, and how will cutting them affect people? Here's a break down of what's at stake.

First off, the term "tax credits" is a misnomer. It does not mean tax relief, because you don't have to pay tax in the first place to get tax credits. Rather, they are a benefit that is administered by HM Revenue and Customs. Having HMRC doing this not only removes the stigma of "the social" from claimants but is also highly convenient for administration, as knowledge of a person's annual employment details and income is needed to accurately work out tax credit entitlement.

There are two main types of tax credits:

  1. Working tax credit for people on low incomes, which includes separate elements for circumstances such as disability and payments for childcare.

  2. Child tax credit, which can be claimed by all UK residents with children.

Entitlement to credits reduces and even ceases as claimants' earnings increase - and the claims mechanism is rather complex. Claimants receive their payments based on their income in the previous tax year (April 6 to the following April 5), so overpayments and underpayments are not uncommon, leading to some people having difficult experiences with HMRC

Tax credits are not new, nor are they confined to the UK, with similar systems in place in Canada and Ireland. They were introduced in the UK by the Labour government in 2003. The then chancellor, Gordon Brown, had seen how they worked in elsewhere and was particularly keen on them as a way of assisting poorer people back into work, with a "safety net" to assist the low paid. They were introduced to replace family credit, which was a significantly less generous in-work benefit.

Tax credits have played a huge role in reducing child poverty, from 26% in 1997 to 18% in 2010. The Institute of Fiscal Studies (IFS) has estimated that if tax credits had not been introduced and the previous system of family credit retained, child poverty would have risen to 31%. A less restrictive "claw back" of benefit provided incentives for people to work more and earn more. Additionally, payments for childcare were at the heart of the tax credits system, encouraging single parents to join the labour force.

George Osborne is committed to cutting the welfare bill. REUTERS/Phil Noble

Why the changes?

All this doesn't not come cheap. Payments have almost doubled since they were introduced, rising from £16.4 billion in 2003-04 to £29.2 billion in 2011-12 and they are estimated to exceed £30 billion this year. The cuts are part of a wider plan to make £12 billion in budget savings from the welfare bill.

Thus, a saving of around £4.5 billion for the next financial year was proposed and several methods to reduce costs put forward, including a sharpening of the "taper" (or claw back) by which tax credits are reduced when one's earnings exceed the threshold. This could have resulted in an effective tax rate of 93% in some (albeit extreme) circumstances

In addition, the income threshold for full tax credits was to be dramatically reduced from earnings of £6,420 a year to £3,050 a year for working tax credits and from £16,105 to £12,125 for child tax credits. Some commentators have expressed surprise at Osborne's decision to apply the cuts universally and not just for new claimants, as one would naturally object more to having something taken away compared to never having it in the first place.

Who is affected?

The IFS estimated that around 3m people would be worse off every year by about £1,000 as a result of the cuts. Typically, these would be people in lower income brackets.

The government tried to allay fears by pointing out that the cuts would not take effect immediately and that increased economic activity would improve wages anyway. Plus, the introduction of a new National Living Wage is geared toward reducing the necessity of tax credits - the idea being that employers pay higher wages, reducing the need for government welfare. The IFS points out, however, that the National Living Wage would only go part of the way to meeting the shortfall caused by a reduction in tax credits.

Popular opinion turned against the decision to cut tax credits.

Finally, tax allowances themselves are to be raised, including a new marriage allowance, and some people will be taken out of the tax net altogether. But some people may still lose out. The new marriage allowance, which allows a spouse or civil partner who doesn't pay income tax to transfer up to £1,060 of their personal tax-free allowance to their partner, is only worth £212 per annum at the basic rate of tax of 20%. This is scant compensation for what might have been a much larger cut through tax credits. Plus, the marriage allowance is available to civil partners but not people cohabiting.

What replaces tax credits?

The size of the tax credit bill and the complexity of the system are two arguments used for the introduction of a long-heralded system of Universal Credit.

A third argument for Universal Credit is one made by the government, drawing attention to the fact that tax revenue is already collected from all sectors of society, including the poor, and then recycled back to them in a complicated and inefficient system.

The argument is attractive to critics of the bureaucracy of the public sector. But this ignores the fact that seemingly circular transfers happen all the time. For example, public sector workers are remunerated from money paid by the taxpayer and are then subject to taxation both on their earnings and in other ways - such as VAT.

What's next?

George Osborne wants to push through the cuts, but recognises that public sympathy for claimants who would be adversely affected by cuts is running high. The original proposals seem out of touch and contradictory to the message the Conservatives have been trying to tout that they support "hard-working people". Osborne has stated that there will be a review, that he is listening to colleagues on the subject and new measures will be announced in the Autumn Statement on November 25.

The ConversationChristopher Coles, Senior Teaching Scholar in Accounting and Finance, University of Stirling

This article was originally published on The Conversation. Read the original article.

>>>>> Scroll down to view and make comments <<<<<<

Click here for Historical News Post Listing

Make a Comment

Econintersect wants your comments, data and opinion on the articles posted.  As the internet is a "war zone" of trolls, hackers and spammers - Econintersect must balance its defences against ease of commenting.  We have joined with Livefyre to manage our comment streams.

To comment, using Livefyre just click the "Sign In" button at the top-left corner of the comment box below. You can create a commenting account using your favorite social network such as Twitter, Facebook, Google+, LinkedIn or Open ID - or open a Livefyre account using your email address.

You can also comment using Facebook directly using he comment block below.

Econintersect Contributors


Print this page or create a PDF file of this page
Print Friendly and PDF

The growing use of ad blocking software is creating a shortfall in covering our fixed expenses. Please consider a donation to Econintersect to allow continuing output of quality and balanced financial and economic news and analysis.

Take a look at what is going on inside of
Main Home
Analysis Blog
Comments on Feyerabend’s ‘Against Method’, Part III
Taking a Wrench to Healthcare
News Blog
Early Headlines: Asia Srocks Mostly Lower, Energy HY Bonds Surge, Google Fiber Cutback, Shadow Banks Dominate Mortgages, NATO Crowds Russia, Coffee Surges And More
Top 10 American Misconceptions about China (Version 3)
Documentary Of The Week: Job Buffers Are More Efficient Than Unemployment Buffers
Typing Is The New Talking
Outsourcing Viewed As The Top Threat To U.S. Jobs
SOS, Extra Savings Needed For An Adequate Pension
Bob Dylan's Nobel Prize - And What Really Defines Literature
What We Read Today 25 October 2016
Baby Remarkably Survives Being Born With Heart Beating Outside Her Chest
October 2016 Conference Board Consumer Confidence Declines
Richmond Fed Manufacturing Survey Remains In Contraction In October 2016.
October 2016 Chemical Activity Barometer Continues to Signal Improving Economic Growth
Case-Shiller Home Price Index August 2016 Year-over-Year Rate of Growth Marginally Improves
Investing Blog
This Or That? Technical Report 25 October 2016
Opinion Blog
What Triggers Collapse?
The Beer Goggles Stock Market
Precious Metals Blog
Inflation Surging As Platinum Signals Stock Market Decline
Live Markets
25Oct2016 Market Close: US Stock Market Indexes Closed Down Fractionally, Investors Remain Concerned With Friday's Fed Rate Change, Crude And US Dollar Down, Gold Up
Amazon Books & More

.... and keep up with economic news using our dynamic economic newspapers with the largest international coverage on the internet
Asia / Pacific
Middle East / Africa
USA Government

Crowdfunding ....



Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day


Asia / Pacific
Middle East / Africa
USA Government

RSS Feeds / Social Media

Combined Econintersect Feed

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution



  Top Economics Site Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2016 Econintersect LLC - all rights reserved