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Tax Credits

Volume 447: debated on Monday 5 June 2006

National statistics published on 31 May show continued growth in the number of tax credit recipients:

The total number of families benefiting rose to 5.9 million in 2004-05 (a 3.5 per cent. increase compared to 2003-04);

some 305,000 families benefited from the childcare element (a 14 per cent. increase compared to 2003-04);

some 79,000 families benefited from the disabled worker element (a 23 per cent. increase compared to 2003-04); and

end-year adjustments leading to an overpayment have fallen by a fifth—from £2.2 billion in 2003-04 to £1.8 billion in 2004-05.

The statistics record levels of end-year adjustments. They were preceded by the Comptroller and Auditor General’s standard report on the accounts of the Inland Revenue 2004-05; by HMRC officials’ evidence to the Public Accounts Committee on 19 April; by the Paymaster General’s remarks in the House on 11 May 2006; and by correspondence dated 25 May 2006 between the Paymaster General and the Chairmen of the Public Accounts and Treasury Select Committees which all reported the view that end-year adjustments would be at a level similar to that in 2003-04.

End-year adjustments are an integral part of a flexible system that responds to families’ circumstances as they change. Payments are based on household incomes which can of course change during the course of the year. Payments are therefore subject to adjustment during the course of the year and, if necessary, at the end of the year once these changes in incomes are known. National Statistics show that end-year adjustments leading to an overpayment have fallen by a fifth—from £2.2 billion in 2003-04 to £1.8 billion in 2004-05. Improved performance of the tax credits system has meant that fewer overpayments are caused by IT or administrative error. This is demonstrated by the improvements made to accuracy in processing and calculating awards, which rose from 78.6 per cent. in 2003-04 to 96.5 per cent. in 2004-05.

HMRC expects to recover the majority of the money overpaid, except where there has been a mistake by HMRC and it is not reasonable to expect the claimant to have noticed the error. Since the introduction of tax credits there have been clear procedures in place to ensure that recovery of overpayments does not create hardship. These include reduced recovery rates for those on low incomes, and, for those who are no longer receiving an award, 12-month instalment plans are available with longer repayment periods where necessary. On top of this HMRC considers the case for making additional payments to those who claim hardship as a result of recovery.

The national statistics released on 31 May relate to a previous year, 2004-05, and so do not show the impact of measures announced at the time of the 2005 pre-Budget report to give greater certainty to families while maintaining flexibility to respond to changing circumstances. Once these come fully into effect the level of end-year adjustments are expected to fall by a further third in future years.

The tax credits system has delivered three key achievements: it has improved incentives to work, reduced the tax burden on low to middle income families and helped to dramatically reduce child poverty.

Tax credits play a major role in moving people into work and helping people move up the employment ladder, ensuring that work pays over welfare. Tax credits and economic stability have helped to increase the number of people in work by over 2 million since spring 1997, and since 1997 long-term unemployment has reduced by 450,000. From October 2006:

A couple with two children, moving into full-time work on the national minimum wage will be £41 per week better off compared with the £34 per week gain to work in 1997;

a lone parent with two children, moving into full-time work on the national minimum wage will be £76 per week better off compared with the £54 per week gain to work in 1997; and

a single person without children, moving into full-time work on the national minimum wage will be £58 per week better off compared with the £39 per week gain to work in 1997.

Tax credits have also been central to reducing the tax burden on low to middle income families. The latest OECD study shows a large fall in the tax burden for families as a result of tax credits. The tax burden on a single earner couple with two children earning £21,000 has fallen from 17.3 per cent. of gross earnings in 1997 to 9.8 per cent. in 2004. This is the lowest rate of any G7 country.

In the UK, a single earner family with two children can now earn just under two-thirds of the average wage before they start to pay any net tax, that is, pay more in tax than they receive in financial support from the government. Tax credits have helped ensure that since 1997 the number of families with children paying no net tax has risen from under 2.5 million in 1997-98 to over 3 million in 2006-07.

The tax credits system has also played a key role in tackling child poverty. Since 1996-97, 700,000 children have been lifted out of relative poverty, compared to a doubling of child poverty in the previous 20 years. Tax credits have also helped to halve the number of children in absolute poverty. There are now over 1.8 million fewer children on absolute low income compared to 1996-97 on a before-housing-costs basis.

Tax credits today provide support to 20 million people including 6.0 million families and 10.1 million children. Take-up of tax credits is substantially higher than in any previous system of income-related financial support for in-work families, with low-income families most likely to take up their entitlement. In the first year of tax credits 93 per cent. of families on incomes below £10,000 claimed their entitlement to Child Tax Credit; this compares to 50 per cent. in the early years of Family Income Supplement, 57 per cent. for Family Credit and 62-65 per cent for Working Families Tax Credit.

Building on the experience of the first two years of the new tax credits system, the Government have introduced a series of administrative enhancements and policy developments to improve the operation of the tax credits system.

A detailed programme of administrative improvements was announced in the Paymaster General’s statement to the House on 26 May 2005. This included measures to improve HMRC’s communication with families about their tax credit awards, reduce the risk of errors adding to overpayments, and improve the procedures for recovering overpayments.

Specific measures have also been taken to improve the service received by tax credit customers. From April 2006, award notices have included a clearer summary of what will be paid and, for the first time, an explanation of how this has been calculated. The guidance notes sent to customers with their award notices have been improved making it easier for recipients to check whether information is correct. HMRC’s code of practice on overpayments has been revised on the “reasonable belief” test when deciding whether to write off an overpayment.

As set out in the Paymaster General’s statement to the House on 5 December, analysis of the available data on end-year adjustments, or overpayments, suggests that they are caused by a number of factors. As a result, the Government announced the following key policy changes:

First, to address the impact of the annual income rises that have led to the need for adjustment, the Government announced an increase in the tax credits disregard from £2,500 to £25,000.

Secondly, families sometimes overestimate the extent to which their income has fallen when they seek extra support during the year. To address this, when claimants report a fall in income during the year, their tax credits payments will be adjusted for the rest of the year to reflect their new income level, but will not include a one-off payment for the earlier part of the year. At the end of the year, their award will be finalised when their actual income is known. If they have been underpaid, a further payment will be made in the ordinary way.

Thirdly, HMRC will continue to make provisional payments at the start of the tax year based on information from the previous year until claimants submit renewal information. But to reduce the scale of subsequent updating, the renewal window will be reduced to five months.

Fourthly, there are sometimes delays in reporting changes in families' personal circumstances to HMRC. The Government therefore announced greater responsibilities on claimants to report changes of circumstances, to ensure that delays in reporting do not lead to the need for subsequent adjustments. In addition, the notification period will be shortened.

Fifthly, to reduce the impact of adjustments on family circumstances, automatic limits on the amount by which tax credit payments can be reduced to recover a tax credit overpayment will be introduced.

These policy changes are designed to minimise the need for adjustments while maintaining the flexibility to respond to reductions in income and changes in circumstances.

Eliminating the need for adjustments would require a move to a fixed system where eligibility was based on the previous year’s income and circumstances, and where, as a result, flexibility would be diminished. This flexibility to respond to changing circumstances is important in today’s modern labour market where in any year three million people change jobs. Each year at least 200,000 men and women who move into new or better jobs see their family income rise by more than £10,000.