Sunday, October 25, 2015
A fine mess: How Osborne can dig himself out of his tax credit hole
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

George Osborne, it seems, is on a three-year cycle. Much of the time he gets a pretty good press, given that he has presided over some unpopular policies, and he has had the last laugh over his austerity critics.

Every three years, however, something goes badly wrong. Three years ago it was his “omnishambles” budget, which combined the brave move of cutting Labour’s 50% top rate of tax to 45% with some unwise tinkering with the tax privileges of Cornish pasties and caravan owners.

Now it is his “toxic” cuts to tax credits, which are in danger of joining a long list of policies which look elegant and logical on a Whitehall computer screen are disastrous when implemented. They include Gordon Brown’s abolition of the 10p tax band, the bedroom tax and Osborne’s own child benefit cuts, which penalised higher-paid single-earner families, while letting two-earner couples with high household incomes off the hook. Some are even drawing comparisons with the poll tax, the policy which more than any other brought down Margaret Thatcher.

The chancellor, political to his fingertips, will be aware of all these precedents. But when he presented his summer budget in July, his second in the space of four months, he was perhaps still in the first flush of excitement after the Tories unexpected majority in the May election. As in the early months after the 2010 election, when he was in the first flush of excitement of becoming chancellor, things were done that on reflection might have been done differently.

Let me start, however, with praising Osborne on tax credits. Having inherited a system that was becoming ruinously expensive, and which benefited nine in 10 families with children in 2010, the reforms the chancellor steered through in the last parliament, largely without fuss, went a long way towards putting things right.

The proportion of families with children receiving tax credits has been reduced to six in 10 and the tax credit bill, rather than rising to £37.8bn this year and £40bn in 2016-17 in cash terms, has been stabilised at around £29.5bn, before the summer budget changes kick in. Spending on tax credits has been cut in real terms, and cut dramatically compared with unchanged policy, with the minimum of fuss.

The other essential point to make is that, despite savings such as these, there is a long way to go on the deficit and debt. The September public borrowing figures were “good”, in that they were lower than the markets expected, but the government still spent £9.4bn more than it brought in on taxation. Borrowing so far this year is £7.5bn lower than last year but analysts still think it touch and go whether the official forecast of £69.5bn will be met. Public sector net debt has risen by £70.5bn in the past year.

The question is why Osborne’s latest push on tax credits, which will reduce the number of eligible families with children from six to five in 10 and produce additional saving of less than half what has been saved so far, has caused so much trouble.

The answer is that the tax credit cuts these will usher in from April are large, and people on low incomes hard. So a single-earner household with two children on £6,420 (the old threshold for withdrawing tax credit) will see their tax credits drop from £10,885 to £9,651, a drop of £1,234, or more than 7% of their combined income from earnings and tax credits. Somebody earning the new national living wage, which for a full-timer on 35 hours a week will be £13,100 a year from April, will lose £1,701, cutting their combined income by 8%. A household on roughly double those earnings, £26,530, will lose all their tax credits, currently £2,640 a year.

Given the nightmare complexity of the tax credits system, these things are never straightforward. Osborne, like many before him, may find that what he saves in one part of the welfare system costs him elsewhere. Press down hard in one place and up something pops elsewhere. Paul Ashton, an independent economist, has a plausible example of a single mother getting back much of what she loses in tax credits from higher housing and council tax benefits. It is quite likely that some of those worried most about the cuts to tax credits are not the biggest losers, or even losers at all.

Even so, there are big losers, and they are among the “hard-working families” the Tories want to encourage, and they happen suddenly. So if this threatens to be Osborne’s poll tax moment, how can he escape it?

The first option is to phase in the changes. A 7% or 8% drop in income is a big hit; 1.5% to 2% annually spread over four years is more manageable. People’s circumstances change (admittedly something the tax credits system is not great at dealing with), but with the cuts spread people would have a better chance of working their way through them. This process would be helped by rising wages, notwithstanding the Institute for Fiscal Studies’ (IFS) point that the national living wage will not on its own come close to compensating for the cuts.

The second option is to keep the overall tax credit cuts but push them up the income scale, as suggested by Frank Field, the former Labour welfare reform minister. Under his proposals, which he claims would save as much as Osborne intends, nobody would lose anything on earnings below £13,100, all the losses being above that level.

Field is always worth listening to but his alternative reform would impose unacceptably high marginal rates of tax and benefit withdrawal. David Phillips of the IFS calculates that they would mean a 97% effective marginal rate on earnings above £13,100, once the loss of tax credits, income tax and national insurance are taken into account. If households are on housing and council tax benefit, that marginal rate rises to 99%.

There may be a third way. I would suggest a combination of phasing in the changes and Field’s suggestion of shifting the burden of the cuts to higher income families, but with a crucial addition. This crucial addition would be using higher taxes to reduce the amount that credits have to be cut.

What taxes? It is a pity that the new £1m inheritance tax threshold on family homes passed to children has been announced and is being implemented. That will cost nearly £1bn a year by 2020 and, apart from buying the Tories a few votes in the election, is hard to justify.

Also increasingly hard to justify, however, is the obsession with increasing the personal tax allowance; the amount that people can earn before paying income tax. Raising it to £11,000 next year in the July budget was at a cost of more than £1bn a year, a tax cut that has long ceased to be of benefit to the very lowest paid.

Most obvious of all, at a time of low inflation and low petrol and diesel prices is to push up fuel duty. The chancellor’s “fair fuel stabiliser” four years ago ruled out duty increases when oil prices were above $75 a barrel. They are currently under $50. A 2.5p increase in duties would raise over £1bn and take some of the rough edges off the tax credit changes. It would be unpopular. But not as unpopular as the raw changes in tax credits Osborne seems determined to inflict.