House of Commons - Treasury

Select Committee on Treasury Sixth Report

Annex: Background to new tax credits regime

Introduction

1. 'New' tax credits were introduced in April 2003. Two new tax credits were brought in:

the child tax credit, which the Government intended to be "a single, seamless system of support for families with children, paid directly to the main carer in a family"; and
the working tax credit, which the Government intended to pay "through the wage packet to people without children as well as families with children".[351]

The Government intended new tax credits to "tackle child poverty and help to make work pay … to tailor support to families' specific circumstances, and to respond to their changing needs, providing most support when their need is greatest, for example, when they have very young children."[352]

The situation prior to April 2003

b) Evolution of the tax credits scheme

2. The new tax credits are part of a process of reform which started in May 1997, when the Chancellor of the Exchequer, Rt Hon Gordon Brown MP, invited Mr Martin Taylor, the then Chief Executive of Barclays Bank, to set up a taskforce "to advise on the reform of the tax and benefits systems".[353] The taskforce's terms of reference were to "… examine the interaction of the tax and benefits systems so that they can be streamlined and modernised, so as to fulfil our objectives of promoting work incentives, reducing poverty and welfare dependency, and strengthening community and family life."[354] Within these terms of reference, the taskforce decided to concentrate on work incentives.

3. The taskforce's report identified a number of criticisms of the effect of the existing tax and benefit systems on work incentives and the incomes of the low paid. The report discussed the 'unemployment trap' and the 'poverty trap': the former occurs where in-work support is not sufficient to make work worthwhile or provide adequate incomes for the low paid; the latter where the high rate of withdrawal of benefits as income rises deters the low paid from seeking to increase their earnings.[355] The report concluded that the impact of State benefits paid to those in work was "blunted by":

insufficient recognition of the costs of working (in particular, childcare);
reluctance to take up entitlements because of the need to claim and the hassle and stigma involved;
concerns about disruption to income and resulting cash-flow when benefit entitlements were introduced; and
uncertainty about the level of in-work income.[356]

4. In the report, Mr Taylor noted that, at the time the taskforce was set up, "there was much speculation, by the very nature of my remit, that I should be tempted to advise that the tax and benefit systems should be fundamentally merged."[357] He went on to explain why the report did not pursue "the issue of full-blown integration":

For a start, the tax and benefits systems have traditionally had different objectives: the funding of Government expenditure and the relief of need, and although one can be seen as a negative version of the other, this inverse relationship is arguably superficial. Second, although many recipients of in-work benefits also pay income tax, more generally benefit recipients are not taxpayers. As a result of this, the collection and delivery functions, both in human terms and in terms of the technology used by the two systems, vary considerably. Finally, while taxation is paid by individuals, benefit is paid to household groups; both these arrangements are fiercely defended. Some may find this perverse or paradoxical; I think it just shows that the tax and benefit systems reflect the differences in their traditional objectives. I see no reason, however, why both systems cannot contribute to the same objectives, providing the means to improve work incentives and relieve poverty.[358]

5. To achieve the aim of improving work incentives, the taskforce recommended that the existing family credit should be replaced by a tax credit which would "associate the payment in the recipient's mind with the fact of working" and would be likely "to prove more acceptable to society at large."[359] This tax credit should be built on the existing system as this would also "allow the most rapid and least disruptive introduction for the tax credit", rather than attempting to "replicate the very different structures" on which, for example, the United States' Earned Income Tax Credit was based."[360] The taskforce considered that "the establishment of a tax credit system is likely to come in useful in future as a broader delivery mechanism, eventually allowing closer integration between the benefit system and conventional income tax."[361]

THE WORKING FAMILIES' TAX CREDIT

6. As a result of the taskforce's report, the Government introduced the working families' tax credit (WFTC) and the disabled person's tax credit (DPTC) in October 1999, replacing the family credit (FC) and the disability working allowance (DWA).[362] The WFTC built on the structure of the FC, with entitlement based on a 'snapshot' of income and circumstances at the time of the claim and unaffected by changes in circumstance within the 26 week period of the award. The WFTC contained some new features, intended to improve work incentives and to lower marginal tax and benefit withdrawal rates for the families affected. These features included:

a lower withdrawal rate—55%—than that of the FC—70%—and the level at which the tax credit started to be withdrawn was higher;[363]
a new 'childcare tax credit', "designed to make support for childcare through the tax system more generous and more transparent", and replacing the childcare disregard in the FC;[364]
payment through the pay packet, rather than to the main carer, in order to "reinforce the link between receipt of the credit and rewards of work".[365]

7. The Government emphasised that the WFTC was intended to be a "step towards greater integration of the tax and benefit system."[366] Further reform of the tax system followed in April 2001, with the introduction of the children's tax credit. This replaced the married couple's allowance and its related allowances, which were abolished from April 2000. The children's tax credit was intended to target resources "at lower and middle income families, with the credit tapered away from families where there is a higher-rate taxpayer."[367]

April 2003: the new tax credits

a) The child tax credit and working tax credit

8. In Budget 2000, the Government said that it was "determined to go further in improving the transparency and administration of income-related payments through the tax and benefit system", introducing "a more fundamental reform" than what had gone before.[368] In July 2001, the Government published a consultation document which described the primary aims of this next phase of reform as:

separating support for adults in a family from support for children, so as to provide a clearer focus;
making work pay for low-income households, including those without children, through the employment tax credit (now working tax credit);
tackling child poverty and providing financial support for families with children, through the integrated child credit (now child tax credit) and child benefit;
providing a common framework for assessing entitlement to income tax credits, based more closely on the rules and definitions of income on which people's tax bills are based; and
rationalising administration by making one department, the Inland Revenue (now HMRC), responsible for administering all aspects of the Government's financial support for children, as well as income tax credits generally.[369]

9. The details of the next phase of reform were announced in Budget 2002.[370] Two new tax credits were to be introduced: the child tax credit (CTC) and the working tax credit (WTC). The CTC was to be "paid direct to the main carer, usually the mother", which the Government described as "a single, seamless system of support for families with children, payable irrespective of the work status of the adults in the household".[371] The Government intended the CTC to form "a stable and secure income bridge as families move off welfare into work" and to provide "a common framework of assessment so that all families are part of the same inclusive system and poorer families do not feel stigmatised."[372] The Budget announced that, "in recognition of the costs of parenthood borne by both middle and low income families", the CTC would be available to those on annual incomes up to £58,000.[373] The WTC was intended to "tackle poor work incentives and persistent poverty among working people" and to "extend support to low income working people without children aged 25 or over working 30 hours or more a week."[374]

10. Budget 2002 also announced the introduction of a "modern income test", building "on the definition of income [currently] used in the tax system".[375] This new income test was intended to extend the approach taken with middle and high income families to all families. The Government explained that "aligning the income test for new tax credits with the income tax system means that income is looked at across the tax year as a whole" and that it meant "moving away from a system which excluded families with modest savings to one which, instead, takes into account the income from that capital, thus moving from a 'means test' to an 'income test'."[376]

RATIONALE FOR NEW TAX CREDITS

11. The Government considered that the new tax credits would provide "continuity of support for those who are not experiencing significant changes in circumstances or income, with the ability to adjust quickly for those who are facing major changes".[377] This was in comparison to WFTC which was "relatively unresponsive to changing needs … although WFTC awards can now be revisited if the family has a new child, the general rule is that, once an award has been made, it remains fixed for six months regardless of what happens to the family".[378] The Government identified a number of advantages that it believed the new tax credits would have over the existing system, including:

more generous provision than the existing tax credits;
less form-filling, with one renewal process each year, rather than two;
a fairer system, as awards would be based on family income for the whole of the tax year, rather than the short interval around the time an application was made; and
a more responsive system, in that new tax credits could adapt to a family's changing needs and circumstances during the tax year.[379]

Other improvements identified by the Government included better incentives for dual-income couples, better incentives to save, support for children paid directly to the main carer, a streamlined system of payment through the wage packet, more security on the move into work and a reduction in the stigma associated with being on a benefit.[380]

INTERNATIONAL COMPARATORS

12. In arriving at a decision on how the new system should respond to changes in income and circumstance, the Government looked at similar systems in other countries, "such as Canada, which has a relatively simple and unresponsive system, and Australia, which has a very responsive system".[381] These two systems "represented different trade-offs between competing objectives: providing certainty and administrative simplicity; and ensuring fairness, targeting support to needs and providing enough flexibility for families to choose to seek support when they need it".[382] Neither system provided a model which the UK could replicate precisely:

The Canadian model is difficult to translate to the UK: the levels at which it provides support are relatively low, so targeting support to those who need it most is less relevant and it relies on provincial support systems to provide a safety net for falls in income. The Australian model is more generous and more closely targeted to family needs, but its first year of operation has demonstrated the risks, inherent in its approach to responsiveness, of a significant number of end-of-year debts.[383]

DESIGN OF THE NEW TAX CREDITS

13. The Government announced that the UK system would have three categories of change which could affect a tax credit award:

changes in the adults heading a household: for example, if a couple broke up or when people began living together as a couple;

changes in circumstances which determined the tax credits and elements for which claimants were eligible, such as the arrival of a new child or the use of qualifying childcare; and

changes in income between the current and previous year.[384]

Awards would be recalculated to reflect "all falls in annual income" and "rises in annual income of more than £2,500 a year, disregarding the first £2,500 of any rise".[385]

14. The following table sets out the different elements of the CTC and WTC, and the amounts payable for each of those elements in 2006-07.

The principal elements of the child and working tax credits

Element 2006-07 annual amounts

Working Tax Credit

Child Tax Credit

Family element £545

Family element (baby addition) £545

Child element £1,765

Working Tax Credit

Basic element £1,665

Couples and lone parent element £1,640

Element for people working 30 hours a week or more £680

Childcare element of the Working Tax Credit

Maximum eligible cost for one child £175 per week

Maximum eligible cost for two or more children £300 per week

Percentage of eligible costs covered 80%

Income thresholds and withdrawal rates

First income threshold £5,220

First withdrawal rate 37%

Second income threshold £50,000

Second withdrawal rate (per cent) 6.67%

Fist threshold for those entitled to Child Tax Credit only £14,155

Income disregard £25,000

Source: HM Treasury, PN 02, 2005 Pre-Budget Report: Income tax allowances, national insurance contributions, child and working tax credit rates 2006-07 and fuel duties, 5 December 2005

15. In calculating entitlement, HMRC adds together the different elements relevant to a particular family. In particular, families on income support, income-based jobseeker's allowance or with incomes below the first income threshold (£14,155 for families entitled to only CTC, or £5,220 for families entitled to WTC) are entitled to the maximum amount. In addition, families with income above the threshold receive less than the maximum—the award is gradually reduced at the rate of 37 pence for every pound of gross income above the threshold. The family element is then retained until income exceeds the second threshold of £50,000 a year, at which point this element starts to taper off.[386]

16. In 2003-04, the only year for which statistics on finalised annual awards are so far available, approximately 5.7 million families received tax credits. Of these:

approximately 1.4 million were out-of-work families;
of the approximately 4.3 million families in work, 2.09 million were entitled to the family element or less and 2.08 million entitled to more than the family element.[387]

17. Awards of the new tax credits were initially to be set on the basis of current circumstances and the previous tax year's income. The Government stated that, "if circumstances do not change and there are no significant changes in income, the award will run at that level until the end of the tax year … once the system is up and running, awards will be able to run for 12 months at a time unless there is some reason for an adjustment".[388]

LEVELS OF TAKE-UP OF NEW TAX CREDITS

18. According to the Government, there are currently six million families and 10 million children receiving tax credits, including 360,000 families being helped with childcare costs.[389] More working families appear to be receiving financial support for their children than was the case under the previous FC, as illustrated by the following table.Numbers of families benefiting from Child and Working Tax Credit, as compared with Family Credit

Numbers benefiting in 2003-04[390]

Families Children Individuals

Current tax credits 5.9 million 9.9 million 19.4 million

Previous system of Family Credit 0.8 million 1.6 million 2.8 million

Source: evidence received from HMRC, 31 January 2006, Ev 170

19. The Government also states that the CTC and WTC provide more generous support than previously.[391] The table below shows the amount of support that a two-child family on half-male mean earnings (£15,400 a year) would receive.Support provided to two-child family on half-male mean earnings (£15,400 a year)

Award (2006-07 prices)

Child and Working Tax Credit
(as at April 2006)
£82 a week (£4,200 a year)

Working Families' Tax Credit
(as at April 2002)
£53 a week (£2,700 a year)

Family Credit
(as at April 1999)
£18 a week (£900 a year)

Source: evidence received from HMRC, 31 January 2006, Ev 170

20. According to the Paymaster General, take-up rates for tax credits amongst families with children reached an "unprecedented level" in 2003-04. Government figures show take-up of about 80% overall, and 90% "for the poorest families", which compares with 57% in the first year of the FC.[392] The Paymaster General told us that the level of take-up for new tax credits was seven times higher than that of FC, and that "the very poorest can now be receiving up to £107 a week compared with just £20 in 1997".[393] She also told us that, since 1997, the lone parent employment had risen from 46% to 56% and "evidence suggests that tax credits contribute to nearly half of that rise".[394]

ADMINISTRATION OF NEW TAX CREDITS

21. Prior to 18 April 2005 new tax credits were administered by the Inland Revenue. Since it merged with HM Customs and Excise on that date, the resulting Department, HM Revenue and Customs, has been responsible for their administration. In administering tax credits, HMRC has PSA targets for the length of time it takes to make decisions on claims, renewals and changes of circumstance and for the proportion it decides accurately. For example, HMRC estimates that it met these targets in 2004-05 but that it was unlikely to meet two out of three of the targets in 2005-06.[395]HMRC's achievement against the Service Delivery Agreement (SDA) targets supporting Public Service Agreement (PSA) 1: Deliver improvements in the number of individuals and businesses who comply with their obligations and receive their entitlements.

2004-05 target 2004-05 result

All new claims/renewals/changes of circumstances decided within 5 working days of receipt 55% 86.7%

All new claims/renewals/ changes of circumstances decided within 30 working days of receipt 95% 95.9%

All new claims/renewals/ changes of circumstances decided accurately 90% 96.5%

Source: HM Revenue and Customs, Annual Report 2004-05 and Autumn Performance Report 2005, Cm 6691, pp 73-4

22. On 26 May 2005, the Paymaster General made a written ministerial statement to the House, updating Members on the steps that HMRC was taking to address problems that had arisen in the administration of tax credits, which she said had affected "a small proportion of families".[396] In her statement the Paymaster General set out six measures "to improve significantly the tax credits system, with particular regard to how the Department communicates with families about their tax credit award; reducing the risk of errors adding to the number of over-payments; [and] improving procedures for recovering over-payments."[397]

351 HM Treasury and Inland Revenue, The Child and Working Tax Credits: The Modernisation of Britain's Tax and Benefit System, April 2002; available at www.hm-treasury.gov.uk Back

352 Ibid. Back

353 HM Treasury, The Modernisation of Britain's Tax and Benefit System: Number Two; Work Incentives: A Report by Martin Taylor, 17 March 1998, para 1.01 Back

354 Work Incentives: A Report by Martin Taylor, para 1.02 Back

355 Work Incentives: A Report by Martin Taylor, para 3.04 Back

356 Ibid. Back

357 Work Incentives: A Report by Martin Taylor, para 1.10 Back

358 Work Incentives: A Report by Martin Taylor, para 1.11 Back

359 Work Incentives: A Report by Martin Taylor, para 1.22 Back

360 Work Incentives: A Report by Martin Taylor, para 1.23 Back

361 Work Incentives: A Report by Martin Taylor, para 1.22 Back

362 HM Treasury, The Modernisation of Britain's Tax and Benefit System: Number Three; The Working Families Tax Credit and work incentives, 17 March 1998 Back