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Raising the income tax threshold is not the best way to improve the lives of the worst off

Posted by Vicki 26 January 2012 : Lib Dem , financial inclusion ,

Today's blog post is written by Runnymede's head of policy, Omar Khan

There’s been a lot of coverage today of Nick Clegg’s focus on raising the personal threshold of income tax. Given that black and minority ethnic people are disproroprtionately likely to be living in poverty we thought it would be worth considering how this proposed change promotes fairness. While questions remain regarding how the Government can pay for this measure, the wider question of how the tax and benefits system promotes (or undermines) fairness is less well understood. In part this is due to the technical (i.e. boring!) nature of the discussion, though each of the three parties may also have political reasons not to explain the tax and benefits system better.

Put simply, the payment of benefits does much more work in promoting fairness in the UK than the collection of taxes. For example, 49% of the income of the lowest quintile in the UK derives from cash benefits, compared to only 2% for the upper quintile. Overall, benefits are by far the major source of improving fairness in the UK.

Direct taxation generally is somewhat progressive, and in the case of income tax (the target of the government’s proposed policy change), the poorest fifth only pay 3.1% of their income in direct tax, compared to 17.4% for the richest fifth. This suggests that income tax is much less unfair that Nick Clegg’s speech implies.

Given that direct tax accounts for only 3.1% of the incomes of the poorest, there is therefore relatively little money to gain for this group in raising the tax threshold; conversely, the poorest fifth paid 8.7% of their income in VAT, and this was before the rise to 20%. Put another way, the poorest fifth in the UK are probably paying 3 times as much in VAT as they are in income tax. In a way, this point is being ignored as the three main parties focus on the so-called ‘squeezed middle’, and not the poorest. But the second quintile also pays more in VAT than in direct tax, and even the third quintile pays more in indirect taxes than in direct income tax.

There are (at least) three policy implications. Perhaps counterintuitively, the international evidence suggests that progressivity (or fairness) in benefits is a better measure of and way to increase fairness overall. The US has one of the most progressive tax systems in the world, but because the benefits system is so narrow, the overall effect is less fair than in the UK and elsewhere in Europe. In the current context in the UK, this is why the cuts are likely to harm the poorest: given that they get 49% of their income in benefits, but pay only 3.1% in income tax, cuts to the former can only minimally be counteracted by cuts in income tax, i.e. raising the income tax threshold.

Secondly, there may be a case for greater focus on the fairness of indirect taxes, e.g. VAT, a point that the Labour opposition, but also some Conservatives and Liberal Democrats, have been quick to highlight. Finally, given that the provision of benefits is the key factor in promoting fairness, perhaps we should ignore fairness in the collection of taxes, and instead ensure that they are collected efficiently and at little cost. Taxing people on low incomes equally or even more than those on upper incomes may seem unfair, but if the resultant revenue is more accurately provided to those at the bottom, the result is increased fairness. No political party has been forthcoming on this point, perhaps because they do not wish to highlight how much lower income people rely on benefits, and how little the richest get from much of the welfare state; or perhaps because this implies that a shrinking state (on which all parties agree) will inevitably result in reduced fairness.

But if we want to have an honest discussion on ‘fairness’, or indeed try to promote it, we must understand the evidence and promote those policies that actually improve the lives of the worst off, among whom a disproportionate share are black and minority ethnic people. Raising the income tax threshold is not a particularly efficient way to do this, whatever the political and electoral merits of such a policy.