Select Committee on Treasury Written Evidence

Letter to the Chairman of the Committee from HM Treasury concerning the tax credit system

  During the hearing the Committee asked a number of questions relating to the measures announced in the PBR to improve the operation of the tax credits system.

  On the question of the cost of the tax credits package, the Committee said it would like a detailed written explanation of the cost of the package by the end of the day. The Pre-Budget Report 2005 sets out the Exchequer effects of measures over the next three years. These are -£100 million in 2006-07, +£200 million in 2007-08 and +£50 million in 2008-09.

  As I said during the hearing, it is important to bear in mind that this is a balanced package. Some elements announced involve a cost to the Exchequer because they effectively increase families' tax credit entitlement, or because they involve extra payments to claimants in the short term. Other elements generate a yield. This mainly comes from measures designed to reduce the amount of money paid out to claimants that later turns out to be an overpayment. These measures effectively prevent money going out that we would then have to recover and consequently generate a yield. There appeared to be particular interest in the question of why the increase in the annual income disregard to £25,000 does not have a great impact on the overall costs. There are two main reasons.

  Firstly, as the Paymaster General set out in her statement to the House of 5 December, ongoing overpayments under the current system are expected to come from a number of sources of which income rises from one year to the next is only one. The statement explains that:

    "Analysis of overpayments suggests that they result from a number of factors: income rises from one year to the next; families overestimating the extent to which their income has fallen when they seek extra support during the year; provisional payments made at the start of the tax year, which are based on out-of-date information that is subsequently updated when the award is renewed; and delays in reporting changes in families' personal circumstances to HMRC."

  As a result it is not the case that the increased disregard, combined with other measures, will cause overpayments to disappear. The Paymaster General's statement explained that we expected the package as a whole to reduce overpayments by around a third.

  The second important reason, and I think this is a point I did not get round to covering, is the way in which tax credit's payments score in the public finances, which is on the National Accounts basis. The central point is that the cost of the higher disregard is the foregone recovery of overpayments caused by income rises above the current £2,500 disregard.

  Let me explain this in more detail. There are important timing effects underpinning this cost. The basic principle is that when money is paid out to tax credit claimants, it scores as a cost to the Exchequer. On the other hand, when any overpaid tax credits are recovered, there is a yield. Our baseline forecast included a prudent assumption for ongoing over payments, which were accounted for in full as a cost to the Exchequer.

  I hope the Committee finds this helpful.

7 December 2005

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