The 10% tax rate and low-income households

The Tax Faculty’s evidence for the Treasury Committee

The saga of the 10% tax rate continues, and on 13 May the Chancellor made a statement to the House of Commons, announcing an increase in the personal allowance in order to compensate those who lost out from the 2008/09 tax rate changes.

The Treasury Committee of the House of Commons had previously announced an enquiry into Budget Measures and Low-Income Households. The Tax Faculty of the ICAEW submitted written evidence to the enquiry, which has now been published as TAXREP 34/08. This includes our comments on the Chancellor’s latest announcement.

More details of our TAXREP are given later in this news item. But in brief:

• We think that increasing the personal allowance is a pragmatic solution for delivering compensation in the current year, but are concerned that those people on the lowest incomes have not been fully compensated.
• The 10% starting rate which has been retained for savings is not simple or easy to calculate, and what is more, those who benefit from it will have to claim their refund. HMRC must take practical steps to make people aware of this and to identify those likely to be affected.
• As a general principle we think anomalies and inequalities in the tax system should be addressed via changes to the tax system, and not via the benefits system. We do not think that any of the mechanisms proposed by the Chancellor is suitable for this purpose – tax credits, Winter Fuel Allowance or National Minimum Wage.
• In the longer term we do recommend that tax credits should be extended to people who need support to get into work but do not currently qualify for credits, and the Government needs to do more to encourage take-up by those who are eligible for credits but do not claim.
• There was no consultation on the changes to the 10% rate or the other measures in the 2007 Budget package. We strongly recommend that when developing new tax policy, and certainly before implementing it, the Government consults with all relevant stakeholders at an early stage.

We explained the changes to the 10% income tax rate and who the winners and losers are in a recent news item. The 10% rate of tax no longer applies to the first band of income, regardless of what sort of income that is; from 6 April 2008 it only applies to savings income which falls within the first £2,320 of taxable income.

The Chancellor’s statement

The Chancellor of the Exchequer, Alistair Darling, had previously said that he would consider how best to help those who had lost out from the 10% rate changes and report back in the Pre-Budget Report. However, faced by public concern and continuing unrest among MPs, he made an announcement on 13 May with proposals for compensation.

The proposals are very straightforward: the personal allowance for 2008/09 will be increased by £600 to £6,035, thus giving an extra £120 to basic rate taxpayers. The position of higher taxpayers is not affected because the threshold for 40% tax is being reduced by £1,200 to £34,600. These changes will be made in the Finance Bill.

The Chancellor’s statement actually says that the higher rate threshold will be reduced by £600, but of course this would not give the right answer in terms of leaving higher rate taxpayers no better or worse off. The embarrassing slip was corrected in an item on the HMRC website.

There is no mention of National Insurance thresholds, and we assume that those have not changed and therefore the personal allowance and NIC primary threshold are no longer aligned, at least for 2008/09.

The Chancellor said this change will mean that 22 million people on low and middle incomes will gain an additional £120 this year – this figure being the estimated average loss from the Budget 2007 ‘package’ which included the changes to the 10% rate. 4.2 million households will receive as much or more than they originally lost, and the remaining 1.1 million households will see their loss at least halved. Some 600,000 people will be taken out of tax altogether.

Increasing the personal allowance has the advantage of being simple, capable of being backdated to April 2008 and relatively easy to deliver quickly. However, it is an expensive measure which will cost £2.7 billion. This is because it is not targeted, and benefits many people who had not lost out from the tax rate changes in the first place.

Also, because the measure is based on the average loss, a large number of people will not be fully compensated, and they will be the taxpayers on the lowest incomes.

In our evidence to the Treasury Committee we gave the example of a person with pension income of £8,000 a year (and no other taxable income) would have paid tax in 2007/08 of £343; with a personal allowance of £5,435 their tax liability for 2008/09 would have been £513 (ie an increase of £170); with the new personal allowance it will be £393. Thus even after the changes announced on 13 May, this person will pay £50 more tax in 2008/09 compared to the year before, due to the loss of the 10% rate on earnings.

Treasury Committee enquiry

The Treasury Committee has published the written evidence it has received so far for its enquiry into Budget Measures and Low-Income Households. It will be taking oral evidence on 21 May from representatives from the voluntary and not-for-profit sector (Citizens Advice, Age Concern, Low Incomes Tax Reform Group, Institute for Fiscal Studies, etc) and on 4 June from the Chancellor and Treasury officials.

The key points the Tax Faculty put to the Treasury Committee in our TAXREP 34/08 are:

1. The 10% starting rate which is retained for savings is not simple or easy for people to understand and calculate. It also presents practical difficulties in that taxpayers who are entitled to a refund (because 10% tax applies to their savings income) will have to make a claim for it. The compensation measures announced by the Chancellor so far will not alter these intrinsic difficulties with the operation of the 10% rate.
2. Therefore, in the interests of simplicity, we do not think that the 10% rate should be retained in this limited way just for savings income. If the Government decides to abolish it, this will create further losers, and careful consideration and consultation is needed before anything is done.
3. For 2008/09 we recommend that HMRC takes practical steps to make people aware of the possibility of claiming back tax if the 10% rate applies and to identify those likely to be affected.
4. There are two aspects to compensating those who have lost out from the changes to the 10% rate: compensation for those on low incomes who are financially disadvantaged by the tax changes in the 2008/09 tax year; and longer-term changes, to ensure that these groups are not disadvantaged in future.
5. As a general principle we think anomalies and inequalities in the tax system should be addressed via changes to the tax system, and not via the benefits system.
6. The tax credits system is not appropriate for delivering one-off compensation for those who have lost out from the changes to the 10% rate.
7. In the longer term, we strongly recommend that tax credits should be extended to people who need support but who do not currently qualify for credits. This would involve changing the age and working hours criteria.
8. We also recommend that the Government does much more to encourage take-up of tax credits by those who are eligible but do not claim, and to find out why people do not claim.
9. We do not think that either the Winter Fuel Allowance mechanism or the National Minimum Wage (NMW) is a suitable route via which to compensate people for anomalies or inequities in the tax system.
10. The burden of an increase in the NMW falls not on the Government but on the employer, who has to pay not just the increased wage but also the associated employer’s NIC. This is likely to be received extremely badly by employers.
11. We can accept the increase in the personal allowance as a pragmatic solution for 2008/09. However, we are concerned that it does not fully compensate those on the lowest incomes. This will have to be addressed in any further proposals for 2008/09 or future years.
12. The Chancellor’s announcement said nothing about NIC. The increase in the personal allowance means that this is no longer aligned with the primary threshold for NIC It seems likely that the change in the higher rate threshold for income tax will also have an impact on the Class 1 NIC upper earnings threshold since the Government’s stated aim is to align the two. We are concerned that this announcement will have far-reaching consequences for the wider tax system which need to be properly analysed and consulted upon.
13. The burden of implementing this proposed change mid year for employees will fall on employers. We are concerned that the cost implications of this should be investigated fully before the change is implemented
14. There was no consultation on the changes to the 10% rate or the other measures in the 2007 Budget ‘package’. We strongly recommend that when developing new tax policy, and certainly before implementing it, the Government consults with all relevant stakeholders at an early stage.

15 May 2008