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Explainer: what are tax credits?

The Conservative government has suffered two defeats in the House of Lords over plans to cut tax credits for 3m households.

Cue a row over the constitutionality of what has taken place and, more importantly, uncertainty over how tax credit reform will take place. But what are tax credits, and how will cutting them affect people? Here’s a break down of what’s at stake.

First off, the term “tax credits” is a misnomer. It does not mean tax relief, because you don’t have to pay tax in the first place to get tax credits. Rather, they are a benefit that is administered by HM Revenue and Customs. Having HMRC doing this not only removes the stigma of “the social” from claimants but is also highly convenient for administration, as knowledge of a person’s annual employment details and income is needed to accurately work out tax credit entitlement.

There are two main types of tax credits:

  1. Working tax credit for people on low incomes, which includes separate elements for circumstances such as disability and payments for childcare.
  2. Child tax credit, which can be claimed by all UK residents with children.

Entitlement to credits reduces and even ceases as claimants’ earnings increase – and the claims mechanism is rather complex. Claimants receive their payments based on their income in the previous tax year (April 6 to the following April 5), so overpayments and underpayments are not uncommon, leading to some people having difficult experiences with HMRC

Tax credits are not new, nor are they confined to the UK, with similar systems in place in Canada and Ireland. They were introduced in the UK by the Labour government in 2003. The then chancellor, Gordon Brown, had seen how they worked in elsewhere and was particularly keen on them as a way of assisting poorer people back into work, with a “safety net” to assist the low paid. They were introduced to replace family credit, which was a significantly less generous in-work benefit.

Tax credits have played a huge role in reducing child poverty, from 26% in 1997 to 18% in 2010. The Institute of Fiscal Studies (IFS) has estimated that if tax credits had not been introduced and the previous system of family credit retained, child poverty would have risen to 31%. A less restrictive “claw back” of benefit provided incentives for people to work more and earn more. Additionally, payments for childcare were at the heart of the tax credits system, encouraging single parents to join the labour force.

George Osborne is committed to cutting the welfare bill. REUTERS/Phil Noble

Why the changes?

All this doesn’t not come cheap. Payments have almost doubled since they were introduced, rising from £16.4 billion in 2003-04 to £29.2 billion in 2011-12 and they are estimated to exceed £30 billion this year. The cuts are part of a wider plan to make £12 billion in budget savings from the welfare bill.

Thus, a saving of around £4.5 billion for the next financial year was proposed and several methods to reduce costs put forward, including a sharpening of the “taper” (or claw back) by which tax credits are reduced when one’s earnings exceed the threshold. This could have resulted in an effective tax rate of 93% in some (albeit extreme) circumstances

In addition, the income threshold for full tax credits was to be dramatically reduced from earnings of £6,420 a year to £3,050 a year for working tax credits and from £16,105 to £12,125 for child tax credits. Some commentators have expressed surprise at Osborne’s decision to apply the cuts universally and not just for new claimants, as one would naturally object more to having something taken away compared to never having it in the first place.

Who is affected?

The IFS estimated that around 3m people would be worse off every year by about £1,000 as a result of the cuts. Typically, these would be people in lower income brackets.

The government tried to allay fears by pointing out that the cuts would not take effect immediately and that increased economic activity would improve wages anyway. Plus, the introduction of a new National Living Wage is geared toward reducing the necessity of tax credits – the idea being that employers pay higher wages, reducing the need for government welfare. The IFS points out, however, that the National Living Wage would only go part of the way to meeting the shortfall caused by a reduction in tax credits.

Popular opinion turned against the decision to cut tax credits.

Finally, tax allowances themselves are to be raised, including a new marriage allowance, and some people will be taken out of the tax net altogether. But some people may still lose out. The new marriage allowance, which allows a spouse or civil partner who doesn’t pay income tax to transfer up to £1,060 of their personal tax-free allowance to their partner, is only worth £212 per annum at the basic rate of tax of 20%. This is scant compensation for what might have been a much larger cut through tax credits. Plus, the marriage allowance is available to civil partners but not people cohabiting.

What replaces tax credits?

The size of the tax credit bill and the complexity of the system are two arguments used for the introduction of a long-heralded system of Universal Credit.

A third argument for Universal Credit is one made by the government, drawing attention to the fact that tax revenue is already collected from all sectors of society, including the poor, and then recycled back to them in a complicated and inefficient system.

The argument is attractive to critics of the bureaucracy of the public sector. But this ignores the fact that seemingly circular transfers happen all the time. For example, public sector workers are remunerated from money paid by the taxpayer and are then subject to taxation both on their earnings and in other ways – such as VAT.

What’s next?

George Osborne wants to push through the cuts, but recognises that public sympathy for claimants who would be adversely affected by cuts is running high. The original proposals seem out of touch and contradictory to the message the Conservatives have been trying to tout that they support “hard-working people”. Osborne has stated that there will be a review, that he is listening to colleagues on the subject and new measures will be announced in the Autumn Statement on November 25.

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