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Don Draper considers how the UK tax regime can unfairly penalise families, with effective tax rates approaching 80%.

Introduction

The time has come to look again at the way we tax families. Independent taxation was a necessary reform. Working wives had their own tax allowances, but until 1990 a married woman’s income was treated as that of her husband. This relic of the Victorian age  had to go. But the way this was done has resulted in some families bearing a disproportionate share of taxation, one-earner families paying up to twice as much tax as two-earner families, a quarter of all families facing a 76% marginal rate, and the less well-off paying more tax than the better-off!

How well off people are doesn’t just depend on income. It depends also on the size of the family. A household of two adults and two children will need a higher income than a single person living alone to be as well off as the single person.  When family size is taken into account, the Institute of Fiscal Studies tell us that a one-earner couple with two children on £35,000 will be in the poorest 40% of the population even when tax credits and child benefit are taken into account. A single person on £35,000 will be in the top 20%, yet their income tax bills are the same.

Child Benefit and Tax Credits

All families, of course, currently get child benefit and the majority also get tax credits. But for many families tax credits and child benefit do not compensate for the fact that the system of independent taxation disregards the family. Moreover, from January 2013 families with a parent earning over £50,000 will have to give up their child benefit or take a tax charge. Although this has been defended by George Osborne on the basis that it will apply only to families in the top 15% of the income distribution, it will in fact apply to some families who are in the least well-off half of the population. Very few families in the top 15% will be affected.

Effect on Tax Rates

This is not the only problem families face. A quarter of all families have an effective marginal tax rate of 73% or more. Income tax may only be 20% but national insurance contributions account for another 12%. If a family receives  tax credits – and most ordinary families do – and gets extra income, credits are cut and that accounts for another 41%. Add it all up and you get to 73%. In the current tax year a one-earner family with three children on an income below £37,492 will be paying 73% on any additional income earned.  A family with four children will be paying 73% on incomes below £43,838. In many cases the 73% tax rate reaches even higher up the income scale, as these figures do not take account of pension payments. Pension payments not only reduce taxable income, they also reduce income for tax credit purposes. When pension contributions are taken into account the 73% could apply to families earning £45,000. Not all families will be paying tax at 73%, but two million will be – that is around one in four families.*

Universal Credit

Things aren’t about to get better any time soon. Next year, when the Universal Credit starts to replace tax credits, the marginal rate will rise even more and when this happens families will keep less than 24p from every extra pound earned. People worry about the disincentive effect which a 50% marginal tax rate has on those with very high incomes. What do we suppose is the disincentive effect on the 2 million families who next year will be paying 76%? With effective tax rates as high as this, families can have little hope of ever improving their family finances.

Effect on Employers

Employers also are caught in this tax trap. If the employee’s marginal rate is 76%, there is little incentive for an employer to pay more. The cost to the employer of increasing a wage by £100 is £113.80 when the employer’s national insurance contributions are added. But when next year the marginal rate for many families rises to 76.2% the employee will get less than £24. The Treasury however will be £90 better off!  This is an Alice in Wonderland world!

Independent Taxation and Family Welfare

A solution has to be found. This problem cannot be left to fester for another five years whilst the nation’s finances are sorted out. No other major country has marginal rates of tax as high as that which applies to many ordinary families.  The problem is independent taxation. The UK income tax system is unusual in that it takes no account of the family unit. Most other systems do.
 
The tax system we have today is mainly the creation of two people – Margaret Thatcher and Gordon Brown. It was Margaret Thatcher who gave us independent taxation. It was Gordon Brown who completed it by abolishing the Married Couples' Allowance and the Additional Personal Allowance which single parents could claim, and who introduced tax credits geared to income. A tax system which ignored the family had to be balanced with welfare payments and these had to be means tested. Nigel Lawson, Margaret Thatcher’s Chancellor of the Exchequer at the time, has made it clear that it was never his intention that independent taxation should have penalised ordinary families, but this is what has happened.

Possible Solutions

The answer is to redesign the income tax system so that it does take account of the family. If this is done, fewer families will need tax credits. Fewer families would then face near confiscatory marginal rates. Employers would have some incentive to pay employees a living wage.  As a cursory study of other countries shows, there is more than one way of doing this. Nigel Lawson recognised back in the ‘80s that a system of transferable allowances is one obvious way of reducing the tax burden on those families who have been most disadvantaged by the present system. Others may prefer some form of joint assessment or income splitting. 

The case for transferable allowances has been made mainly on marriage grounds. The debate about marriage has resulted in nearly everyone losing sight of the fact that the main beneficiaries would be those families who have been most disadvantaged by independent taxation. Raising the tax threshold for all taxpayers is not the answer – most of the benefit of this goes to those who are already in the top half of the income distribution. Most of the benefit of a transferable allowance would go to families in the bottom half of the income distribution.

Conclusion

There is never a good time to make a change to the tax system.  But a system which leaves less well off people paying more than better off people, and which leaves families paying far more than their fair share and facing a 76% marginal rate has to be remodelled. These problems are so great that reform cannot be postponed any longer.

*These figures take no account of the so-called "passported" benefits of which the most important is that of free school meals. Someone who suddenly loses free school meals because his or her income rises by a few pounds, especially if there are two or three children, can be very much worse off by as much as £1,000 or more.