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Increasing tax personal allowances has featured in Liberal Democrat/Conservative coalition talks. But because of complex tax/benefit interfaces, LITRG warns that such a change is not straightforward in its impact.

A simple change?

The most straightforward tax change to help people on low incomes is to increase personal tax allowances, but even such a change has wider ramifications. This is because any change to the basic personal allowance (currently £6,475 or £124.52 per week) can have different knock-on effects depending on the individual’s income level and their consequent entitlement to benefits.

Increasing the personal allowance

How much the personal tax allowance might be increased by is not a matter for LITRG, but an understanding of what this does to the financial position of someone on a low income is certainly within our remit. For the sake of illustration we will consider the effects of increasing the personal allowance by £1,000.

Non-taxpayers

The very poorest individuals in the UK are not affected at all by an increase in the personal allowance of £1,000. For example, those on Jobseeker’s Allowance alone will not benefit. However, raising the threshold could provide an incentive to take on work because the disincentive of paying tax would be reduced when calculating how much better off a person would be in moving off benefits into work.

The lowest income taxpayers

Currently, it takes someone earning the adult rate of national minimum wage only 21.5 hours per week to start paying tax. It has always seemed perverse to us that people who are by one government definition “in poverty” should be required to pay tax. An increase of £1,000 to the personal allowance increases the tax-free hours that can be worked to just under 25.

It would take an increase in the personal allowance of over £2,500 to eliminate a tax liability for national minimum wage workers working 30 hours a week (the number of hours in a week that many working tax credit only claimants are required to work to become entitled).

An increase of £1,000 in the personal allowance would solve one of the most incongruous problems for low income women pensioners. A single woman who is 61 and has received a state pension of £6,750 as her only income becomes entitled to a tax-free Pension Credit top up in 2010/11 of a further £145 a year. Yet at the same time HMRC require her to complete a Self Assessment return to pay tax of £55 a year on her state pension.

Having paid tax of £55 to HMRC the pensioner is then caught in a bureaucratic circle, having to approach the Department for Work and Pensions for a refund of that £55 in extra Pension Credit.

Those with slightly higher incomes

When we consider those with slightly higher incomes we can illustrate the interactions between the tax and the means-tested benefit systems.

The case of Joe

Joe is 30 and single. He works a 35-hour week and earns £10,556 each year. He pays annual rent of £6,240 for a one-bedroom flat and council tax of £810. He also pays income tax of £816.

However, he is able to claim:

1. Working tax credit of £1,102
2. Housing benefit of £2,491

An increase in the personal tax allowance of £1,000 gives Joe a reduction of £200 in his tax liability. However, paying less tax reduces his entitlement to Housing benefit by £130, so his overall benefit (and cost to government) from the policy change is only £70.

Were Joe’s personal tax allowance to be increased to £10,000 his tax liability would drop from £816 to £111 saving him £705 in tax but reducing his entitlement to Housing benefit by around £462 so leaving him only £243 better off.

The case of Suzanne

Suzanne is a single mother who works over 16 hours a week at just above the adult rate of the national minimum wage. Each year she earns £7,475 and at current rates will pay tax of £200. She has similar accommodation to Joe in the last example and is entitled to:

1. Working tax and child tax credit of £6,253
2. Child benefit of £1,058
3. Housing benefit of £3,747
4. Council tax benefit of £43

An increase in the personal allowance of £1,000 reduces her tax liability by £200 but at the same time reduces her other benefits by around £170 so leaving her better off by only £30.

People further up the income scale

As income levels rise and entitlements to means-tested benefits drop away, then the reduction in tax liabilities from an increase in personal allowances is more significant. It’s worth £200 for every £1000 of increase for a basic rate taxpayer and £400 for a 40% taxpayer – unless there is an adjustment to the starting point of the 40% tax band as happened in 2008.

However, increasing the basic personal allowance for working age people causes a dilemma as to what to do when it comes to the special regime of higher age-related tax allowances which come into play at age 65. Are those to be increased by the same amount as the increase in the basic personal allowance? It seems inevitable that something like this would have to take place.

It is, of course, possible to benefit only those on lower incomes by give increased tax allowances to everyone and then claw them back from people with incomes over a certain level. This is what already happens with higher age-related tax allowances where income exceeds a certain threshold (currently £22,900). This contains the cost of the measure, albeit at the expense of simplicity.

Allowances for marriage

The Conservatives were committed to recognising marriage and civil partnerships in the tax system. If adjustments were being made to personal allowances then it might be the right time to consider whether to include the potential for transferring allowances between couples who are married or in a civil partnership. But this would add even greater complexity.

The only allowances which are currently transferable are the married couple’s allowance (entitlement to which is confined to those born before 6 April 1935) and the blind person’s allowance.

Any such changes would need to consider the knock-on effects into the world of means-tested benefits.

National insurance

National insurance is a tax in all but name. At one time the starting points for income tax and NICs were aligned but they diverged again in 2008 and people now start paying NICs before they start paying income tax (this can, of course, help in securing entitlement to contributory benefits).

In the Conservative Manifesto there are proposals for raising the thresholds from 2011 as part of a certain amount of recasting of NICs. As with income tax, such changes have knock-on effects but the main point is that any discussion of raising the income tax personal allowance should also make it clear whether the NIC threshold is to be similarly impacted upon. Usually it isn’t.

Conclusion

All tax and national insurance changes are best considered at leisure when the full implications can be assessed. Sweeping assertions as to who is better off and by how much can cause trouble, as was found in the 10% tax rate furore. Ostensibly straightforward changes have complex interactions. It is necessary to have a clear idea of who will benefit from changes if the costs are to be contained and the help is to reach the target audience.