Select Committee on Public Accounts Twenty-Second Report

1  Overpayments of Tax Credits

1. Child Tax Credit and Working Tax Credit (tax credits) replaced the previous tax credits system in April 2003 as part of the Government's reforms of the tax and benefits system. The new arrangements were designed to help families with children and working people on low incomes. HM Revenue and Customs (the Department) paid some £47 billion of tax credits in the first three years of the scheme and it estimates that an average of 5.3 million families benefited in 2005-06.[5]

2. A tax credit award is provisionally based on a family's income and circumstances from the preceding tax year. The award is finalised after the end of the tax year when actual income and circumstances are known. The final award can differ from the provisional award, for example where incomes increase. A system of annual awards based on circumstances which often change inevitably results in a substantial amount of overpayments.[6]

3. There can be a number of reasons why a claimant is overpaid, but the tax credits computer system does not automatically generate information on the cause of overpayments for each award.[7] Nevertheless, the Department's analysis suggests that overpayments generally result from:[8]

  • rises in income from one year to the next;
  • families overestimating a fall in income when they seek additional support during the year;
  • provisional payments made at the start of the tax year based on out of date information which the system is not designed to change until the award is finalised; and
  • delays by families in reporting changes in personal circumstances to the Department.

4. Actual levels of overpayments have been much higher than the Department envisaged when the scheme was designed. It originally estimated that overpayments would be around £1 billion a year but in practice around £2 billion was overpaid in the first year.[9]

5. The Department seeks to recover overpayments wherever possible. It can only write-off the debt or restrict the rate of recovery if it considers that repayment would cause hardship. It can also write-off overpayments which result from official error or if it finds these are due to organised fraud.

6. In the first three years of the scheme the Department wrote off £557 million of overpayments. At the end of March 2006, a further £3.6 billion was outstanding,[10] of which the Department is unlikely to recover £1.4 billion, making a further write-off inevitable.

Changes announced in the 2005 Pre-Budget Report   

7. The December 2005 Pre-Budget Report announced changes to the tax credits scheme designed to provide greater certainty to claimants, particularly when the family income rises.[11] The package comprised five principal measures intended eventually to reduce overpayments by one third.[12]

8. The most important change raised from £2,500 to £25,000 increases in income which are disregarded when finalising awards. The effect is that from 2006-07 claimants will retain some of the amounts they would have been asked to repay in previous years.

9. The other changes affect the timing of payments and the recovery of overpayments, for example by reducing the build-up of overpayments that need to be subsequently recovered. These changes:

  • place additional responsibilities on claimants to notify the Department promptly of changes in circumstances that affect their awards; with the aim of reducing overpayments caused by awards being based on out of date information;
  • bring forward the deadline by which claimants need to finalise their awards from 30 September to 31 August;
  • further shorten the period in the following year where payments continue to be made to claimants based on out of date information, by bringing the deadline forward from 30 August to 31 July;[13]
  • will increase payments only for the remainder of the year when claimants report a fall in income during the year, with a further payment if appropriate when the award is finalised after the end of the year; and
  • introduce automatic limits on the recovery of overpayments where awards are adjusted in year following a reported change of circumstance, with the aim of encouraging more families to report in-year changes of circumstances.

10. In the 2005 Pre-Budget Report, the Treasury estimated that the overall effect of the package would be a cash cost to the Exchequer of £100 million in 2006-07, followed by net savings of £200 million in 2007-08 and £50 million in 2008-09.[14]

11. We had previously asked about the underlying cost of each of the individual changes, and in particular the change in the disregard given the significance of its effect on the underlying cost of the scheme to the taxpayer. The Treasury chose not to provide an estimate of the cost of the disregard when the changes were announced, and then took almost a further year to do so. Our previous Report[15] requested this information but the Treasury Minute response did not provide it.[16] The Department explained that it had information only for 2003-04 awards at the time of the Pre-Budget Report and that it did not have sufficient confidence in its estimates for them to be released until information on 2004-05 awards was available.[17] But if it was confident enough to increase the disregard it should have been able to give an estimate of the cost when the decision was first announced.

12. The Treasury eventually wrote to the Committee in October 2006 giving further information on the effect of the changes on Exchequer cash flows ('the Exchequer effect'), as shown in Table 1. From April 2006 the increase in the income disregard will result in a fall in cash inflows to the Exchequer, reflecting the foregone recovery of overpayments due to income rises. The cost and the timing of the Exchequer effect depends not only on the size of the overpayments that would have accrued had the higher disregard not been in place, but also on the profile of recovery of these overpayments. It can take HMRC several years to complete the recovery of overpayments. Thus, as Table 1 shows, the full cost of the increase in the income disregard in terms of its effect on the Exchequer can only begin to be seen after a period of time. Table 1: Exchequer Effect of the £25,000 disregard
2006-07 2007-08 2008-09 2009-10 2010-11
Annual cost of Income disregard of £25,000 £50 m£100 m £150 m£250 m £300 m

Source: HM Treasury

13. The Department told us that the full cost of the increase in the income disregard in terms of its effect on the claimants' entitlement would be around £500 million each year.[18] This is greater than the figure disclosed in Table 1 above, because the Department assumes that some of the overpayments that would have accrued in 2006-07 with the lower threshold for the income disregard would have been recovered in 2011-12 and beyond, and in some cases never recovered at all. The Department's figure is consistent with the National Audit Office's analysis, which suggested that increasing the disregard was likely to cost between £400 million to £600 million annually, depending on assumptions about the growth and distribution of income changes across the claimant population.[19]

14. As regards the cost of the other elements of the 2005 Pre-Budget Report package designed to reduce the build up of overpayments, the Department's estimates are imprecise. It estimates that the four elements of the package, described in paragraph 9, which are designed to reduce overpayments could each bring an Exchequer benefit of up to £100 million a year when all the timing effects have worked through. These benefits will be partly offset by the application of automatic limits on in year recovery where awards are adjusted following a reported change. This measure will reduce the rate at which recoveries of overpayments are made, and the Department estimates that this could cost the Exchequer anything up to £100 million a year.

5   C&AG's Report, table 1 Back

6   Q 205 Back

7   Q 9 Back

8   C&AG's Report, para 2.12 Back

9   Q 205 Back

10   HMRC Trust Statement 2005-06, Note 3.3 Back

11   C&AG's Report, para 2.20 Back

12   C&AG's Report, para 2.20. Back

13   This change starts with 2007-08 awards and was announced in the 2006 Pre-Budget Report.  Back

14   C&AG's Report, para 2.21 Back

15   Committee of Public Accounts, Thirty-seventh Report of Session 2005-06, Inland Revenue Standard Report: New Tax Credits, HC 782 Back

16   Treasury Minute on Thirty-fourth and Thirty-sixth to Thirty-ninth Reports on the Committee of Public Accounts 2005-2006, Cm 6863 Back

17   Qq 8, 33 Back

18   Q 5 Back

19   Q 6 Back

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Prepared 9 May 2007