Why not everyone gains from a higher personal allowance

There’s intense speculation that the chancellor will once again raise the income tax personal allowance in his budget today, writes Channel 4 News Economics Producer Neil Macdonald. It’s a policy that both members of the coalition have been keen to take credit for. But it’s hugely expensive and has some strange distributional consequences, so it’s a policy worth exploring in more detail.

Here’s how it works. Everyone gets a chunk of money they can earn before they start paying income tax at the basic rate of 20 per cent. From April, this allowance will be £10,000 a year. If George Osborne raises this allowance to £10,500 – as the pre-budget commentary suggests – then someone can earn an extra £500 without paying income tax – which means they get to keep 20 per cent of £500 – or £100 a year. Not a king’s ransom, but a bit of relief for hard-pressed families.

Of course, raising the personal allowance costs the exchequer money because it’s not bringing in tax revenues that it otherwise would have done. And the coalition has been raising the allowance since it came to power four years ago, when it was just £6,475. In total, this government has given away £10.7bn in tax revenues forgone. That’s a huge sum. To put it in context, a cut of 1p in the basic rate of income tax would cost the Treasury just £3.8bn.

No benefit?

One justification for this very expensive policy is that it helps the low paid. But ironically this is becoming less and less true over time. Clearly, there’s no benefit to someone earning £8,000 a year if you raise the personal allowance from £10,000 to £10,500 because they are already paying no income tax. The Institute for Fiscal Studies says that one in six workers is already in this situation – their income is too low to benefit from changes in the personal allowance.

The Institute for Fiscal Studies says the income of one in six workers is too low to benefit from changes in the personal allowance.

At the same time, earners quite a long way up the income scale do benefit. For example, if the allowance is increased by £500 in the budget, then someone earning £12,000 a year will be £100 better off. But so will someone on £25,000 or £30,000. In fact, all taxpayers benefit up to the point where the 40 per cent tax rate kicks in – that’s at £41,865 in the next financial year.

This is the reason why the policy is so expensive – it involves giving a tax cut to the broad swathe of UK taxpayers, more than 26 million people. But it does produce the strange result that a policy to help the low paid would give nothing to someone earning £9,000 a year but does give something to someone earning £40,000 a year. While £40,000 a year isn’t necessarily rich, it’s debatable whether they fall into the “low and middle income” category the policy is meant to target.

Focusing on the poor

That problem is compounded by the fact that everyone has their own individual personal allowance. So a household with two earners bringing in – for example – £80,000 a year would also gain something.

Cutting the personal allowance is a very expensive way of helping the poorest earners because its not really targeted at them. Put another way, if there is a £10bn pot of cash in the Treasury, wouldn’t it make sense to concentrate it much more directly on people with low incomes?

There is a broader philosophical issue: is it correct for a growing section of the population to pay no income tax?

But it’s debatable whether there is such a pot of cash when the UK is still running a record deficit on the public finances. That deficit has meant the coalition has had to raise other taxes, so arguably the change in personal allowances has simply given back to people what was taken away by other measures. For example, the rise in VAT generated over £12bn a year for the Treasury – very nearly the cost of the rise in personal allowances.

The coalition could argue that the tax cuts delivered by raising the personal allowance have been paid for by extra cuts in public spending. But to the extent that these extra cuts have been to the welfare budget, this might exacerbate the distributional impact of the rise in personal allowances – because, unsurprisingly, welfare payments tend to go to people on low incomes.

Philosophical point

These questions of who gains and who loses will become more important in the next parliament if the Lib Dems are part of another coalition and try to push the personal allowance up further – £12,500 has been talked about as an aspiration. The IFS calculates this would take 2.9 million people out of income tax altogether but at a cost of £12bn.

There’s a broader philosophical point to consider as well: is it correct for a growing section of the population to pay no income tax? Clearly almost everyone contributes something to the public coffers, through VAT or national insurance or a raft of duties. But we know that 1 per cent of taxpayers are already paying 28 per cent of all income tax, while the changes in personal allowance mean 17 per cent of the population pay no income tax at all.

Does that imbalance – which is likely to grow in future years – encourage a view for some that they are paying too much towards public services, while others feel that public services essentially come with no costs attached?