Select Committee on Treasury Written Evidence


Memorandum submitted by the National Audit Office

EXECUTIVE SUMMARY

  (i)  Tax credits are paid on the basis of an annual entitlement. HMRC calculates a provisional award and makes payments using the latest information it holds on claimants. It makes a final assessment after the end of the year when the claimant's actual circumstances are known. The final award often differs from the provisional award, for example because of income changes. Where the claimant's actual income is higher than the provisional income, overpayments arise. (Paragraphs 4-7)

  (ii)  In 2003-04 overpayments were £2.2 billion and in 2004-05 they fell to £1.8 billion. But not all of these overpayments will be recovered. Up to March 2006 HMRC had written off £557 million and it estimates that a further £1.4 billion is unlikely to be recovered. (Paragraphs 10-12)

  (iii)  The December 2005 Pre-Budget Report announced changes which were designed to provide greater certainty to claimants, particularly when families have a rise in income. These changes included increasing from £2,500 to £25,000 income rises which are disregarded when awards are finalised. HMRC estimates that this will increase entitlement by £500 million each year. This figure is consistent with our own analysis, which suggests that increasing the disregard was likely to increase entitlement by between £400 million to £600 million annually. The full impact of these measures in reducing overpayments will become apparent only in 2008 following finalisation of 2006-07 awards. Because it often takes several years to complete the recovery of overpayments, the full cost to the Exchequer in terms of the reduced level of recoveries from increasing the disregard can only be seen over a period of time. HMRC estimates the Exchequer cost will start at £50 million in 2006-07 rising to £300 million in 2010-11. (Paragraphs 13-18)

  (iv)  HMRC aims to maintain a balance between accessibility of the tax credits scheme to claimants and maintaining safeguards against the risk of error and fraud. It seeks to achieve this by identifying those claims it judges present the highest risk and checking them for compliance. These checks are performed before or after claims are paid, depending on its assessment of the risk. In 2005-06 it performed compliance checks against 146,000 claims and identified incorrect payments made of £221 million and prevented incorrect payments of £307 million. HMRC plans to increase the number of claims it checks as part of this compliance work by 20,000. (Paragraphs 19-23)

  (v)  In 2005 organised criminals carried out a serious attack on the tax credits internet system by submitting false claims using stolen identities. As a result HMRC closed the internet system on 2 December 2005 and it accepts that additional controls are needed before it can be re-opened. HMRC needs to ensure that the new system fully complies with established government standards on security. It has reviewed the other channels through which tax credits can be claimed and has introduced new measures to safeguard against fraud. HMRC needs to continue to assess the wider implications of the fraud and how organised criminals might respond to the closure of the tax credits internet system. (Paragraphs 24-25)

  (vi)  HMRC estimated, in July 2006, that in 2003-04 claimant error and fraud resulted in tax credits of £1.06 billion to £1.28 billion (8.8 to 10.6% by value) being paid to claimants to which they were not entitled, and that claimant error resulted in £190 million to £280 million (1.6 to 2.3% by value) not being paid to claimants when they were entitled to them. These are the first full results for the scheme since it was introduced in April 2003. The Department accepts that these levels need to be reduced. There is currently no evidence to suggest they have fallen since 2003-04. Consequently, the Comptroller and Auditor General qualified his opinion on HMRC's 2005-06 Trust Statement account. The Department has not yet set a target for future reductions in error and fraud because it only has one year's results from the first year of the scheme's operation. (Paragraphs 26-27)

INTRODUCTION

  1.  Child and Working Tax Credits (tax credits) were introduced in April 2003 as part of the Government's reforms of the tax and benefits system aimed at relieving child and in-work poverty. They were designed to provide additional financial support to families with children and working people on low incomes in accordance with their circumstances. They replaced the Working Families and the Disabled Person's Tax Credit which were introduced in 1999, and the Children's Tax Credit, introduced in 2001. During 2005-06, HMRC paid £17.3 billion in tax credits.

  2.  In recent years, the Comptroller and Auditor General (C&AG) has reported annually on tax credits as part of his Standard Report on the Accounts of HM Revenue and Customs. The purpose of this Memorandum is to summarise the National Audit Office's (NAO) recent work on tax credits that is relevant to the Committee's follow up inquiry into its report on the Administration of Tax Credits. It primarily draws on the C&AG's 2006 Standard Report, which examined overpayments and claimant error and fraud.

  3.  There have been a number of recent developments on tax credits and the NAO will be considering these for the C&AG's Standard Report for 2007, which is due for publication in July 2007.

OVERPAYMENTS

The design of the tax credits scheme and end of year adjustments

  4.  The amount of tax credits paid by HMRC is based on an annual entitlement. HMRC calculates a provisional award and makes payment using the latest information it holds about the claimant. It makes a final assessment after the end of the year once the claimant's actual income and circumstances are known. The final award can be higher or lower than the provisional award, for example where the final income is different from the provisional income.

  5.  To limit the need for adjustments to the provisional award, HMRC disregards certain rises in the claimant's income over the previous year when it finalises awards. This level was initially set at £2,500 and HMRC estimates that final entitlements to tax credits in 2004-05 would have been around £700 million lower (£800 million in 2003-04) without this disregard. The threshold below which income rises are disregarded will be increased to £25,000 when finalising 2006-07 awards.

  6.  HMRC pays the claimant a lump sum where it calculates that the provisional award resulted in an underpayment. Where the provisional award has resulted in an overpayment, HMRC seeks to recover it from future payments or, if there is no ongoing entitlement, directly from the claimant. An overview of the tax credit process is given in figure 1.

  7.  HMRC's analysis suggests that overpayments and underpayments result from a number of factors:

    —  income rises 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 is subsequently updated when the award is renewed; and

    —  delays by families in reporting changes in personal circumstances to HMRC.

  Underpayments of tax credits primarily arise when claimants do not notify reductions in household income that would increase the award.

OTHER CAUSES OF OVERPAYMENTS

  8.  HMRC experienced problems with the tax credits computer system following its implementation in 2003 and there were unforeseen overpayments due to software errors. HMRC has recovered significantly from these early problems, although by the end of October 2005 there were still 199 known software errors which potentially caused errors in payments. The Department has an ongoing programme of prioritising and correcting the underlying errors.

  9.  Departmental error can also lead to incorrect payments. But HMRC has made significant improvements in processing information accurately since the introduction of tax credits. In 2005-06 it exceeded its target of processing accurately 95% of claims and changes in circumstances. The Department's research indicated that the three main reasons for inaccurate processing were: incorrect amendments to historical records, inputting of incorrect income; and/or inputting of incorrect childcare costs.

LEVELS OF OVERPAYMENTS AND UNDERPAYMENTS

  10.  In 2003-04 overpayments were £2.2 billion and in 2004-05 they fell to £1.8 billion. Overpayments in 2004-05 were £400 million less than for 2003-04 because HMRC had more up to date information on claimants' income during the year. In addition improved performance of the tax credit system has meant that fewer overpayments were caused by processing or software error. Tax credits awards for 2005-06 were not all finalised until the end of January 2007 and HMRC is currently analysing these awards. It will publish information on 2005-06 overpayments in the Spring of 2007, but its initial estimates were that these levels would be similar to those for 2004-05.

2.  Tax Credits Overpayments and Underpayments
2003-042004-05
Net cash paid to claimants in year£13.5 billion £15.8 billion
Families benefiting4.6 million 5.0 million
Overpayments£2.2 billion £1.8 billion
Families affected by overpayments1.9 million 2.0 million
Underpayments£464 million £556 million
Families affected by underpayments0.7 million 0.9 million

Source: HMRC

RECOVERY OF OVERPAYMENTS AND WRITE-OFFS

  11.  HMRC usually seeks immediate repayment of overpayments where the claimant is no longer eligible for an award, although it considers any request to pay by instalments. Where there is on-going entitlement, HMRC recovers overpayments from future tax credit payments. But HMRC restricts recoveries made against the payment of future awards to prevent hardship. HMRC expects complete recovery of overpayments to take several years.

  12.  The Department has to form a view on what further tax credit debt will eventually have to be written off. In 2005-06 HMRC wrote off £397 million (£123 million in 2004-05 and £37 million in 2003-04). In addition, a total provision of £1,370 million has been made in the Trust Statement account for overpayments expected to be written off. An analysis of amounts written-off, provisions and amounts to be recovered is given in figure 3.

3.  Recovery and write-offs of overpayments from 2003-04 and 2004-05
2003-04 £ billion 2004-05 £ billionTotal £ billion
Overpayments2.2 1.8 4.0
Amounts written off by 5 April 2006(0.3) (0.2)(0.4)
Amounts recovered by 5 April 2006(0.8) (0.2)(1.0)
Debt to be recovered at 5 April 20061.2 1.42.6
Provision for doubtful debtsNot applicable Not applicable(0.9)

This table excludes amounts for 2005-06 awards, because overpayments for these awards will not be known until they have been finalised. Figures may not sum due to rounding.

Source: HMRC

CHANGES TO THE TAX CREDITS SCHEME ANNOUNCED IN THE 2005 PRE-BUDGET REPORT

  13.  The 2005 Pre-Budget Report announced important changes to the tax credits scheme designed to provide greater certainty to claimants, particularly when incomes rises. The package comprised five measures intended eventually to reduce the value of overpayments by one third. The success of these measures in reducing overpayments will start to become apparent in the overpayments statistics published in 2008 following finalisation of 2006-07 awards.

  14.  One measure raised from £2,500 to £25,000 increases in income which are disregarded when finalising awards. The effect is that claimants will retain some amounts they would have been asked to repay in previous years.

  15.  The other changes affect the timing of payment 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 HMRC promptly of changes in circumstances that affect their awards;

    —  bring forward the date by which claimants have to finalise their awards;

    —  introduce automatic limits on the recovery of overpayments where awards are adjusted in-year following a reported change in circumstance, with the aim of encouraging more families to report in-year changes of circumstances; and

    —  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.

  16.  At the time of the 2005 Pre-Budget Report, the Treasury estimated that the overall effect of the package would cost £100 million in 2006-07, followed by savings of £200 million in 2007-08 and £50 million in 2008-09.

  17.  In October 2006, the Treasury provided further information on the Exchequer (cash flow) effect of increasing the disregard to £25,000, as shown in Figure 4. From April 2006 the increase in the income disregard will result in a fall in cash inflows to the Exchequer, reflecting the recovery of overpayments due to income rises that will now be forgone. The cost and the timing of the Exchequer effect depends on the size of the overpayments that would have accrued had the higher disregard not been in place and the rate at which overpayments are recovered. Because it often takes several years to complete the recovery of overpayments, the full cost to the Exchequer in terms of the reduced level of recoveries from increasing the disregard can only be seen over a period of time.

4.  Exchequer effect of the £25,000 disregard
2006-07 £ million 2007-08 £ million2008-09 £ million 2009-10 £ million2010-11 £ million
Annual cost of Income disregard of £25,000 50100150 250300

Source: HM Treasury

  18.  To assess the change in entitlement from increasing the income disregard we examined the value of overpayments that would have continued to accrue each year if the higher disregard was not in place. HMRC estimate that this would increase entitlement by around £500 million each year. This figure is consistent with our own analysis, which suggests that increasing the disregard would increase entitlement by £400 million to £600 million annually, depending on assumptions about the growth and distribution of income changes across the claimant population.

CLAIMANT ERROR AND FRAUD

Compliance checks performed on tax credit awards

  19.  HMRC tries to maintain a balance between ensuring the accessibility of the scheme to claimants and maintaining safeguards against the risk of error and fraud. It aims to achieve this by investigating claims which it judges present the highest risk and it checks these before or, in certain cases, after claims are paid. Since the introduction of tax credits HMRC has placed greater emphasis on identifying error and fraud before payments are made as the most effective way to avoid financial loss.

  20.  HMRC makes a number of pre-payment checks, as set out in Figure 5. All new tax credit claims are subject to a series of verification checks and a risk assessment process. These involve:

    —  automatic verification of certain personal data claimants provide to check they are consistent with information that HMRC already holds for them. HMRC's checks will not necessarily stop fraudulent claims involving stolen identities because the personal information provided in the claim is correct and matches the details held by the Department.

    —  automatic risk assessment to identify high-risk cases, such as undeclared income, undeclared partners or fictitious child care costs. HMRC also checks for cases that display features of organised fraud. New claims posing the greatest risk are examined before payment.

  In addition, HMRC checks all payments over a certain value to identify any large payments that could indicate potential fraud.

  21.  HMRC carries out further checks once claims are in payment. It carries out computer based interrogations against all awards in payment to identify those showing characteristics of fraud or non-compliance. It takes action, including withholding payment and undertaking further enquiries, where it considers there is sufficient evidence of risk.

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HMRC'S TARGETS FOR COMPLIANCE CHECKS

  22.  HMRC's performance against its targets for compliance checks on tax credits is shown in figure 6. In 2005-06, HMRC's compliance teams carried out 146,000 pre and post payment checks on the highest risk claims, which identified incorrect payments made of £221 million and prevented incorrect payments of £307 million. During 2005-06 HMRC changed the balance of its pre and post payment checking by increasing the number of checks carried out before the payment of the highest risk claims. In 2005-06, 45% of all claims checked by the compliance unit were checked prior to payment (16% in 2004-05). HMRC plans to increase the number of claims it checks as part of this compliance work by 20,000.

6.  HMRC's direct compliance checks (targets shown in brackets)
2004-052005-06
Volume of Checks
Pre & post payment checks107,789 (101,500) 146,376 (110,000)
Pre payment : post payment ratio16% : 84 % 45% : 55%
Effectiveness of checks
Yield£130 million (HMRC did not set a target for yield in 2004-05) £528 million (1) (£143 million)
Checks resulting in change to award:
  Pre award93%65%
  Post award65%85%
Sanctions
Cases where a penalty was charged1,114 2,241
Total value of penalties£445,645 £887,585
Criminal prosecutions211 289


(1) Yield of £528 million comprises incorrect payments identified that need to be recovered of £222 million and incorrect payments prevented of £307 million.

Source HMRC

  23.  In addition to direct checks by tax credit compliance teams, HMRC may act in other ways to identify fraud and withhold tax credits payments. This can be either as a result of the work of its criminal investigation teams or through other procedures, such as the withholding of payments where the claimant fails to sign the award notice. HMRC estimates that in 2005-06 it intervened in 195,000 cases in total and prevented payments of £447 million, including £409 million for organised fraud. The Department's analysis also shows that, in addition to payments prevented, in advance of its intervention in these cases it had made incorrect payments of £250 million, including £131 million of suspected organised fraud.

THE TAX CREDITS INTERNET SYSTEM AND ORGANISED CRIME

  24.  In 2005 organised criminals carried out a serious attack on the tax credits internet system by submitting false claims using stolen identities. These attacks led HMRC to close the internet system on 2 December 2005. As noted in paragraph 20, HMRC's checks will not necessarily stop fraudulent claims involving stolen identities because the personal information provided in the claim is correct and matches the details held by the Department. The ability to claim tax credits through the internet was particularly appealing to organised criminals as it allowed them to submit multiple claims quickly. HMRC estimates that during 2005-06 some 62,000 fraudulent claims were made through the tax credits internet site using stolen identities, of which 33,000 were successful and passed into payment at a cost of around £55 million. This includes some 13,000 claims made using the identities of DWP and Network Rail staff, of which 7,000 were successful at a cost of around £10 million. HMRC has no evidence that the other attacks were based on the use of information systematically stolen from any one employer.

  25.  HMRC assessed that the tax credits internet site complied with its internal security standards when it was introduced in August 2002. But it has accepted that additional controls need to be built into the system before it can be re-opened to conform to subsequent guidance issued by the Office of the e-Envoy[6]6. Whilst the tax credits internet site required limited verification of the claimant's identity against HMRC's records, claimants did not have to produce documentary evidence to prove their identity and address, such as a passport or bank statement.

OVERALL LEVELS OF CLAIMANT ERROR AND FRAUD

  26.  HMRC measures the overall level of error and fraud by investigating a random sample of awards, although the design of the tax credits scheme affects the speed with which it can complete this work. Under the Tax Credits Act 2002, HMRC cannot commence its investigation into randomly selected awards until they have been finalised. While most awards for 2003-04 were finalised by the end of September 2004, some could not be finalised until the end of January 2005 if taxpayers submitted an initial estimate. HMRC could not therefore start its investigation of some cases until February 2005.

  27.  In June 2006, HMRC completed its testing of 2003-04 awards, based on a sample of some 4,500 random enquiries. As a result of this, HMRC estimates that claimant error and fraud resulted in £1.06 billion to £1.28 billion (8.8 to 10.6% by value) being paid to claimants to which they were not entitled. It also estimates that claimant error resulted in £190 million to £280 million (1.6 to 2.3% by value) not being paid to claimants to which they were entitled. The Comptroller and Auditor General concluded that these levels were unacceptably high and, as there was no evidence to suggest that they would have fallen significantly from 2003-04 to 2005-06, qualified his audit opinion on the Trust Statement account in respect of tax credits.

Annex One

RELEVANT MATERIAL

  C&AG's Standard Report on HM Revenue & Customs (HC 1159, Session 2005-06)

  C&AG's Standard Report on the Inland Revenue 2004-05 (HC 446, Session 2005-06)

  C&AG's Standard Report on the Inland Revenue 2003-04 (HC 1062, Session 2003-04)

  C&AG's Standard Report on the Inland Revenue 2002-03 (HC 1072, Session 2002-03)

March 2007







6   In September 2002, the e-Envoy issued guidance on controls that should be built into systems where government services were provided electronically, "Registration and Authentication: e-Government Strategy Framework Policy and Guidelines." Back


 
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