House of Commons - Treasury

Select Committee on Treasury Sixth Report

5 Package of reforms announced in PBR

104. The Government announced a number of modifications to the design of the tax credit regime in the Pre-Budget Report 2005 (the PBR), published on 5 December 2005. The Government intends that these modifications will:

… ensure that the system strikes the right balance between providing a stable award and maintaining the ability to respond to changes. The package includes a number of measures to increase the flexibility of the tax credit system and involves new responsibilities for claimants to tell HMRC about changes in their circumstances promptly … the flexibility to respond to falls in income and changes in circumstances will be maintained.[164]

105. Key changes to the design of the tax credits regime included:

increasing the disregard for increases in income between one tax year and the next ten-fold, from £2,500 to £25,000 (from April 2006);
applying automatic limits on the amount of overpaid tax credits ("excess payments") HMRC recovers from claimants where awards are adjusted in-year, following a reported change (from November 2006); and
in the case of claimants who report a fall in income during the year, continuing to adjust their tax credits payments for the rest of the year to reflect their new income level but assessing whether they are entitled to a one-off payment for the earlier part of the year at the end of the year, rather than at the point at which they report the fall in income (from April 2007).[165]

106. Key changes to claimants' obligations included:

shortening the deadline for the return of end-of-year information, from the end of September to the end of August (in 2006);
increasing the types of change in circumstances which it is mandatory to report to HMRC (from November 2006); and
shortening the time within which claimants are required to report changes of circumstances to HMRC, from three months to one month (from April 2007).[166]

107. Alongside the publication of the PBR, the Paymaster General made a written statement to the House providing more information about the package of reforms. In that statement, she said that, once the reforms had been implemented, they would provide "greater certainty for claimants, particularly those on lower incomes, while maintaining flexibility to respond to falls in income and changes in circumstances" and would give "claimants clear responsibilities to report changes promptly and more regularly".[167] HM Treasury officials appearing before this Committee at the time of the PBR described the reforms as:

a package … of rights and responsibilities in that the Government is giving people a more generous treatment both in terms of in-year repayments and threshold payments, but in return they are expecting, assisted by HMRC, more responsibility [to be taken by claimants].[168]

108. The Paymaster General also commented on the likely effects of the package on the level of overpayments:

Without the changes announced today, initial estimates suggest that subsequent years' overpayments would be of broadly the same level as in 2003-04. When fully implemented, it is anticipated that today's changes will reduce the value of overpayments by around one-third.[169]

Costing the package of reforms

109. The Government has estimated the costs and yields of the package of reforms as follows. These figures are estimates of the net effect of the package, against a baseline forecast gross expenditure figure. HMRC officials told us that this gross expenditure figure does not include any assumptions about losses or write-offs.[170]Table 3: Estimated costs and yields of PBR package of reforms

Year Cost/yield to the Exchequer (£ million)

2006-07 -£100

2007-08 +£200

2008-09 +£50

2009-10 -£50

2010-11 -£150

Net cost -£50

Source: Treasury Committee, Third Special Report of 2005-06, The 2005 Pre-Budget Report: Government Response to the Committee's Second Report of Session 2005-06, HC 1013, para 35

110. We have already discussed the question of the cost of the PBR package in our Report on the PBR.[171] In the course of the present inquiry, and during our earlier examination of PBR 2005, we have repeatedly asked the Government to provide us with the costs or yields of each individual measure within the package. The Government has consistently said that it is unable to provide us with this information, because:

the way that tax credits are scored on a National Accounts basis means that there are significant timing effects … there are also complicated interactions between elements of the package … that make the cost of individual elements meaningless. For example, the cost of the disregard in the absence of all the other measures would differ substantially from its cost as part of the package announced. These overlaps in the costs of the various elements of the package make any attempt to assign a cost to any one element arbitrary.[172]

The Paymaster General told us that, for the reasons set out above, the disaggregated costs or yields "cannot be available".[173] HMRC officials have told the Committee of Public Accounts that "what we are undoubtedly talking about is figures that can be measured in a few hundreds of million pounds for each of the components of this package."[174]

111. Subsequent to our hearing with the Paymaster General, Mr Brewer provided us with a letter he had received from HMRC, explaining why HMRC had refused to disclose to him, under the Freedom of Information Act 2001, information about the likely cost of increasing the disregard threshold from £2,500 to £25,000.[175] In the letter, HMRC stated that costings for the PBR package were based on limited information:

At the time policy costings were prepared for the PBR the department had only incomplete and uncertain information on tax credits overpayments since 2003-04. (This remains the case.) … Of course the published data are not as up-to-date or comprehensive as one might wish. But nor are the (taxpayer-disclosive) [that is, confidential] data available internally, given all the IT difficulties there have been.[176]

HMRC then explained that using such information "involved a substantial degree of judgement":

No explicit measures of statistical quality and integrity would be possible. Moreover a significant amount of additional modelling was needed to produce a costing. This required a range of assumptions of a policy-related nature about the administration of the existing tax credit regime and the changes to the regime under consideration for the PBR package … It was not, for instance, possible in the work for the PBR to track a representative sample of cases on a continuous basis through time to identify and quantify precisely why overpayments of tax credits were occurring. The costings for the PBR package had to use partial data and required the exercise of substantial skill and judgement. If need be, there are agreed procedures within HMRC for getting 'senior sign off' of complex or controversial costings.[177]

LIKELY REVENUE COSTS ASSOCIATED WITH REFORMS

112. The decision to increase the disregard threshold from £2,500 to £25,000 will, on the face of it, register as an increased cost to the Exchequer. The Chancellor of the Exchequer has told the House that he expects the increase to "cover 95% of all income rises during a year."[178] HMRC expects that about 600,000 families "will benefit from the increase in the disregard", based on data from the first two years of the regime's operation.[179] The NAO told us that HMRC has estimated that, in 2003-04, the final entitlement to tax credits would have been £800 million lower without the £2,500 disregard.[180] Despite this evident cost, the Government expects the reform package to be broadly revenue neutral. Mr Brewer suggested to us that this apparent anomaly indicated that the Government expected to save money as a consequence of writing off fewer overpayments:

Of course, if they were collecting all their overpayments now, these measures would not save them any money; but because they are writing off more overpayments than they thought they would have to, then it will save them money.[181]

Mr Brewer described the increase in the disregard as the "key element" in the package, "in the long run", because "it genuinely increases families' entitlement to tax credits", whereas most of the other measures either "just affect cash flow … or they affect the writing-off of overpayments."[182]

LIKELY REVENUE YIELDS ASSOCIATED WITH REFORMS

113. Given that the ten-fold increase in the disregard threshold will be costly, and yet the Government nevertheless expects the package of reforms to be broadly revenue neutral, it must be assumed that the Government expects some or all of the remaining components of the package to represent a saving to the Exchequer. Savings may arise from the tougher reporting requirements due to be introduced under the PBR reforms. One effect of these tougher requirements should be to provide HMRC with a wider range of more up-to-date information than at present, which should in turn enable the regime to operate more efficiently and represent a saving for the Exchequer.

114. Several witnesses raised concerns with us about the possible effect of the tougher reporting requirements. The LITRG described the reduction in the notification period, from the existing three months to one month, as "a big problem and unworkable in many cases".[183] Citizens Advice referred to starting a new relationship or separating from a long-term partner as examples of common changes in circumstances that might not lend themselves to being reported within a month, and emphasised the importance of HMRC getting across to claimants the message that, "in order to get your increase in your tax credit and all of it at the time you need it, you will need to report that change [in circumstance] quite quickly".[184] OPF pointed out that those claimants who qualify for the childcare element of WTC are required to report any change in childcare arrangement that lasts for four consecutive weeks and that, by definition, this is a difficult change of circumstance to report within a month.[185]

115. Claimants who do not report changes in circumstances to HMRC, or who negligently provide information, are liable to significant fines. Claimants can be fined up to £300 if they:

do not tell HMRC about a change in circumstances that results in a tax credits overpayment, or
supply incorrect information about their tax credits claim.[186]

HMRC's guidance for claimants states that claimants may be charged interest if HMRC has overpaid tax credits because of negligence on the part of the claimant. HMRC will also charge interest on any penalties that a claimant is late in paying.[187] Finally, HMRC may charge a penalty of up to £3,000 if a claimant has negligently not taken care to make sure any information sent to HMRC was correct.[188]

116. CPAG expressed concern that, if HMRC was not careful in the way in which it enforced the penalty regime, the changes could foster a "climate of punitiveness as opposed to encouraging people to report appropriately".[189] CPAG felt it was "not credible to start by talking forcefully about fining already people who are in difficult financial circumstances, when plainly their view of the system already is that they do not feel very confident in it".[190] Similarly, Citizens Advice said it would want to watch very carefully whether HMRC moved to clamp down on charging penalties.[191]

117. We discussed with the Paymaster General how HMRC intended to enforce the penalty regime once the new reporting requirements were implemented. She told us that the Department already recognised exceptional circumstances in which failure to meet the three month reporting deadline would not be penalised, and cited bereavement, accident and serious illness as examples of such exceptional circumstances.[192] When we asked if these exceptional circumstances would continue to apply in respect of the one month deadline, the Paymaster General responded:

Yes. I cannot see any reason why that would not carry over. It would be unreasonable not to, would it not?[193]

OUR CONCLUSIONS

118. As we said in our Report on the 2005 Pre-Budget Report, we welcome the fact that the Government is seeking to improve the operation of the tax credits regime by introducing a package of reforms. However, we remain concerned that the Government has said it is unable to provide a breakdown of the costs or yields of each individual measure within the package. We feel greater attention needs to be paid to trying to disaggregate the different costs of the present system, especially those associated with reporting changes of circumstances. We have received evidence which suggests that the costings for the package were based on "incomplete and uncertain" information, the use of which required HMRC to exercise "a substantial degree of judgement" and to make "a range of assumptions of a policy-related nature". Given this, we question how the Government can be confident of its estimates of the overall costs of the package.

119. The Government expects the package of reforms to be broadly revenue neutral, despite the fact that the decision to increase the disregard threshold from £2,500 to £25,000 will be costly. It follows that some or all of the remaining components of the package must be expected to reduce expenditure or yield revenue. Officials told us that the baseline figure against which the cost of the package has been estimated did not include any assumptions about losses or write-offs, suggesting that any revenue yielded does not arise from revised predictions of the amount of overpayments which HMRC expects to write off.

120. We infer from this that the Government expects the reduction in expenditure or yield in revenue from the introduction of tougher reporting requirements for claimants to be significant. These tougher requirements should enable HMRC to operate the tax credits regime more efficiently, thus representing a saving for the Government. However, another effect may be that more tax credits claimants fail to meet the tougher requirements, and thus incur a fine—another potential source of increased revenue for the Government. Claimants who do not report changes in circumstances to HMRC, or who negligently provide information, are liable to significant fines. We recommend that the Government clarify whether, as a result of the implementation of the PBR package of reforms, it expects to receive increased revenue from fines payable by tax credits claimants and, if so, by how much it expects revenue to increase. We seek an assurance from the Government that it will enforce the penalty regime proportionately, taking into account the circumstances in which an individual claimant finds him- or herself. We recommend that the Government undertake and publish a review of the operation of the system of fines after the first 18 months of operation.

Assessing the PBR reforms

a) Effect of increased disregard on claimants

121. We discussed with witnesses the likely effects of the ten-fold increase in the disregard threshold from £2,500 to £25,000. The Government set out the benefits of a £2,500 disregard in its April 2002 paper setting out proposals for tax credits, The Child and Working Tax Credits: The Modernisation of Britain's Tax and Benefit System:

Why a £2,500 disregard?

[…] Increasing the size of the disregard would further reduce the numbers of those who might need to have their awards reassessed. But a larger disregard increases the cost of the new tax credits and reduces the effective targeting of resources.

Analysis of the British Household Panel Survey (BHPS) suggests that around 60 per cent of households in the new tax credits population could be expected to see a rise in income between one year and the next. The chart below shows the distribution of income rises for the new tax credit population drawn from the BHPS. It shows that households tend to experience either relatively small increases in income of £1,000 or £2,000 a year or else much larger increases.[194]

122. Although the increase in the disregard was broadly welcomed by witnesses, several of them raised concerns that such a significant increase in the threshold would have inequitable consequences. As noted above, the Government itself acknowledged, in 2002, that further increasing the disregard would also further reduce the effective targeting of resources. PCS believed that this measure would lead to "unfairness in terms of relative need between claimants with vastly different incomes", although it did not explain precisely how it thought this unfairness would arise.[195] Citizens Advice Northern Ireland (CAB NI) expressed concern that:

… in the first year that your income goes up by that much you are going to continue on the same level of tax credits and then have a lower income in the second year and you are going to have a massive drop. Many of these are low income clients who may have made financial commitments based on the level of tax credits they are receiving and suddenly there will be a drop in their payments in the second year when the income disregard no longer applies and where will that leave them …[196]

123. Ferret Information Systems, a company consulting on the law relating to welfare benefits, has undertaken some analysis of the possible impact of increased disregard threshold. Its analysis is based on a theoretical example of a couple with two children and with one of the adults working more than 30 hours a week, with no disabilities or child care costs, where one of this couple starts work after a long period of unemployment, education or illness and receives the median UK 2005 pay of £22,412. The analysis shows that "the total tax credits payable over the first 2 years, in these circumstances, is substantially higher under the new rules [and] … that the concession is worth considerably more to the better paid than to those on lower incomes."[197]

124. CPAG and OPF pointed out that the increased threshold would help only those people who see an increase in income in the current year compared with the previous year.[198] Both groups expressed concern that people who, in the current tax year, see their income start and finish lower than the previous tax year but nonetheless rise within the year will receive no benefit from the increased threshold.[199] OPF referred to the example of a woman taking maternity leave. Taking such leave could well result in a family's income both decreasing and then increasing in the current tax year, but not increasing to the level it was in the previous tax year.[200] Such an increase would presumably not qualify for the disregard, and the level of tax credits received would decrease.

125. HMRC officials acknowledged that some "discrepancy" would arise, in terms of how the increased disregard affected different claimants, but said it was "far from clear-cut" whether the discrepancy would "match directly to better-off and less well-off families."[201] We asked HMRC whether it intended to warn claimants that, when their income rose, their tax credits were likely to decrease, perhaps significantly, in the following year. Officials responded that, although HMRC was seeking to be "increasingly clear" in its communications with claimants about the implications of the way the regime operated, "whether we should be getting formally into the position of offering what is kind of close to financial advice … is a rather broader and more difficult question."[202]

Our conclusions

126. The existence of the disregard threshold means that those claimants whose income increases will receive the benefit of both their increased income and their unadjusted tax credits entitlement for the remainder of the tax year, before experiencing a drop in income in the following tax year. One effect of the ten-fold increase in the disregard will be that this drop in income may well represent a significant sum of money (depending on the amount of the increase in income). We recommend that HMRC make clear to all claimants who report an increase in income of between £2,500 and £25,000 that, if their other circumstances remain relatively unchanged, their tax credits entitlement in the following tax year is likely to drop, possibly by a significant amount. We do not consider this amounts to HMRC presuming to offer "financial advice" to claimants, as officials suggested: the purpose should be to make clear to claimants that they should not plan their financial arrangements on the basis that they will continue to receive their current level of tax credits payments.

127. We have received evidence that the increase in the threshold will benefit only those claimants who see an increase in income in the current year as compared with the previous year, because the income disregard threshold is applied on the basis of comparison with the previous year's income. Claimants who, in the current tax year, see their income start and finish lower than the previous tax year but nonetheless rise within the year will receive no benefit from the increased threshold. We invite the Government to comment on whether it has considered ways of addressing this anomaly.

POTENTIAL FOR ABUSE OF INCREASED DISREGARD

128. Ferret Information Systems have pointed out that the increased disregard threshold creates a much greater incentive for claimants to arrange to be paid, or to pay themselves, different sums in alternate years—for example, in annual payments of £20,000, £45,000, £20,000, £45,000, £20,000 and so on.[203] Such an alternating pattern would mean that a claimant's entitlement would be calculated on the basis of an annual income of £20,000, while the real average gross income is £32,500:

… Put this together though with changes in pension legislation which remove limits on contributions into pension plans from April 2006 … Instead of reducing gross pay in alternate years, make pension contributions of £25,000. Pension contributions are disregarded from income for tax credit purposes so the effect is [the] same, perhaps even enhanced by other tax considerations.[204]

129. We put this possibility to HMRC officials, who described it as an avoidance scheme.[205] Officials said the Government had "not put formal measures in place" to counter such a scheme, although they would be "reviewing it extremely closely once the new disregard regime is in place."[206] The increase in the disregard of income to £25,000 creates a greater incentive for claimants to seek to substantially increase their tax credit entitlement by arranging for their annual income to fluctuate in alternate years. We recommend that the Government ensure it has adequate procedures in place to detect such abuse of the regime.

164 HM Treasury, Pre-Budget Report 2005, Cm 6701, December 2005, para 5.22 and box 5.2, Back

165 HM Treasury, Pre-Budget Report 2005, ie box 5.2. Back

166 Ibid. Back

167 HC Deb, 5 Dec 2005, col 57WS Back

168 Treasury Committee, Second Report of Session 2005-06, The 2005 Pre-Budget Report, HC 739, Q 227 Back

169 HC Deb, 5 Dec 2005, col 57WS Back

170 Qq 472-76 Back

171 Treasury Committee, The 2005 Pre-Budget Report, para 90ff Back

172 Treasury Committee, Third Special Report of 2005-06, The 2005 Pre-Budget Report: Government Response to the Committee's Second Report of Session 2005-06, HC 1013, p 21-22 Back

173 Q 411 Back

174 Committee of Public Accounts, Inland Revenue Standard Report: New Tax Credits, Q 53 Back

175 Ev 190 Back