Memorandum submitted by Mike Truman
1. INTRODUCTION
My name is Mike Truman. I am a Chartered Accountant
and Chartered Tax Adviser. I edit Taxation magazine, published
by LexisNexis Butterworths, which has been the leading weekly
tax magazine for over 75 years. I am, however, writing this submission
in my personal capacity, and nothing in it should be taken as
a view from the magazine or the company. I have kept this submission
focused on a central issue of proposing a new PAYE-style system
for paying tax credits and have not dealt with several "loose
ends" that this creates; if I can help the committee by dealing
with those at a later date I would be more than happy to do so.
2. TAX CREDITS
OR BENEFIT?
Tax credits have their origin in the benefit
system, and the old Family Income Supplement. It is worth questioning
whether much has changed other than the line management of the
people who administer the system. Tax credits are claimed on a
separate form, which applies a different definition of income
and deductions, and which is processed by a different office to
the normal one dealing with the claimant's affairs as a taxpayer.
Moreover, the experience of dealing with HMRC
for those who are both claimants and as taxpayers will be very
different. For employees in particular, the PAYE system is a world-class
current-year highly responsive deduction system, which ensures
that the overwhelming majority of people have more or less the
right amount of tax deducted from their wages during the year,
regardless of fluctuations in income. Most basic rate taxpayer
employees will have no tax return to complete, and have no real
contact with HMRC at all. There may be underlying issues about
whether PAYE does in fact always deduct the right amount of tax,
but in general it is a system which is accepted and which works
efficiently.
By contrast, claimants of tax credits always
have to complete a claim form to start the claims process, may
well have to complete one every year, and frequently do not have
the right amount paid to them, often resulting in overpayments
being clawed back. The raising of the threshold for adjusting
to current year from £2,500 to £25,000 will significantly
reduce this, but is not supportable in the long term, as it gives
the claimant a "heads you lose, tails I win" result—if
income is higher in the current year, the award can be based on
the previous year's low income, but if income is lower in the
current year, the award can be adjusted to reflect this. As an
appendix, I have included an extract from an article I wrote in
the Dec 15 issue of Taxation magazine explaining how a
£15,000 pension payment can leave a couple with over a thousand
pounds MORE in net income over two years as well as the £15,000
pension fund. This particular loophole can (and should) be blocked,
but the underlying lack of incentive to work more than every other
year cannot.
I believe that the answer is a much greater
integration of the tax and tax credits system, with the introduction
of a PAYE type system for making tax credit payments, and moving
the entitlement to tax credits onto a wholly current year basis.
This will involve employers being responsible for paying the credits
(or, in most cases, offsetting them against tax and NI deducted),
but that is an obvious corollary of taking seriously the status
of these payments as tax credits.
The exception to this is the family element
of tax credits. I suspect I will not be the only respondent to
say that this is anomalous and needs to be removed in one way
or another from the tax credit system. My own preference would
simply be to abolish it, and make any necessary adjustment through
child benefit.
3. COUPLES
One of the main problems in trying to adopt
any form of PAYE-style system is the fact that the income taken
into account for tax credits is that of both partners in a couple.
However, the April 2005 tax credit statistics published by HMRC
show that once the population is limited to those claiming more
than the family element, there are only just over 400,000 claimants
where both partners in a couple are working. By contrast there
are close to 900,000 couples where only one partner works, and
nearly the same number again of single workers claiming more than
the family element, so only 18% of this population of claimants
have two earned incomes.
Even in the two-earner couples, whilst the vast
majority of the main earners are full-time (35 hours a week or
more), only about 175,000 of their partners work more than 24
hours a week. In an overwhelming majority of cases, therefore,
there is either only one income, or one main income, that is taken
into account in calculating the tax credit.
4. HOW A
PAYE TAX CREDIT
SYSTEM WOULD
WORK
The structure of the tax credit system is that
a maximum level of credit is first calculated based on personal
circumstances such as the number of children, which is then tapered
away at 37% once income exceeds a threshold. The PAYE system collects
tax by applying a tax rate or rates to the income which exceeds
a threshold of tax-free income. The two systems are therefore
similar, although not completely analogous.
Within the PAYE system, where earnings are the
main source of income, but other income, benefits, or indeed deductions,
have to be taken into account they are "coded out"—taken
off or added to the tax-free threshold income. PAYE also works
out the tax liability on a cumulative basis, so that fluctuations
in income during the year are accumulated to ensure that the right
amount of tax has been deducted at the end of it.
A similar approach could be applied to tax credits
if they were paid by employers and offset against the PAYE they
deducted from salary. A simplified example is set out below as
Example 1, and then taken further in Example 2.
5. EXAMPLE 1:
Assume the income threshold is £13,000,
and that Ms A has a maximum tax credit entitlement of £4,800.
She has a salary of £18,000 a year, and she has £1,000
of other income or benefits that need to be taken into account
for tax credit. She is single for tax credit purposes.
HMRC would have calculated the £4,800 entitlement
from her claim form. They would also note from this the £1,000
of other income, and would deduct this from the income threshold.
They would therefore report to the employer an income threshold
of £12,000 and a maximum entitlement of £4,800.
In the first month of the tax year Ms A would
earn £1,500, and her PAYE would be calculated as usual. A
further calculation would then compare her income to the income
threshold, and calculate her tax credit as follows:
|
| Income in April | 1,500
|
|
| Threshold (1/12 x 12,000) | 1,000
|
| Balance | 500
|
| Taper @ 37% | (185)
|
| Tax credit maximum (4,800 x 1/12) | 400
|
| Tax credit paid in April | 215
|
|
The £215 would be added to Ms A's pay, meaning that
her net pay reflected both the tax to which she was liable and
the tax credit to which she was entitled.
6. EXAMPLE 2:
Suppose that in the following month Ms A's gross pay increases
by £1,200 a year, £100 a month. If the tax credit calculation
is carried out on a cumulative basis, like that for PAYE, this
automatically gets taken into account.
|
| Cumulative income April & May | 3,100
|
|
| Threshold (2/12 x 12,000) | 2,000
|
| Balance | 1,100
|
| Taper @ 37% | (407)
|
| Tax credit maximum (4,800 x 2/12) | 800
|
| Cumulative tax credit due | 393
|
| Less already paid in April | (215)
|
| Tax credit paid in May | 178
|
|
The change to take home pay resulting from the £100
increase in pay during May would be:
|
| Net increase in pay after 22% tax and 11% NI:
| 67 |
| Decrease in tax credit (215-178) | (37)
|
| Net increase in tax free pay | 30
|
|
This, of course, correctly reflects the combined marginal
rate of 70% that affects someone affected by tapering of credits,
and shows that a system such as this would automatically ensure
that the correct amount of tax credits would be paid on a full
current year basis, in exactly the same way as PAYE. It should
be noted that if income had fallen by £100 the same cumulative
process would have ensured that in the same month tax credits
would have increased by £37 to compensate, so that the net
reduction in take home pay would only have been £30. Whilst
the calculations may look complex, they are easy to program into
the computer software which most businesses are now using for
payroll, and which will have to be used when online end of year
PAYE filing becomes mandatory in a few years time.
The practice of "coding out" other income can also
be used to account for the pay received by the lower-earning partner
of a couple. That would have to be estimated, and might give rise
to an underpayment or overpayment at the end of the year, but
the statistics given above show that this would only affect about
18% of working families, and that less than half of these are
working more than 24 hours a week, so the potential for significant
under or overpayments is reduced.
7. EXECUTIVE SUMMARY
The present tax credit administration is not integrated into
the tax system. The recent increase to £25,000 of the income
increase disregard is unworkable in the long-term. A PAYE-style
approach would allow tax credits to be administered on a fully
current year basis, integrated into the tax system, and to be
immediately responsive to changes in income.
December 2005
|
