Tax credits are not best way to help low paid

Would tax credits help the low paid? Tax credits, where all taxpayers get the same cash amount as a reduction on their tax bills, are now being advanced as necessary to focus income tax relief on the low paid. This is a myth: the low paid can be helped just as easily without moving from the current structure to tax credits.

Nor does moving to tax credits guarantee that tax cuts will be targeted on the low paid - particularly if the measure is accompanied by a cut in the top rate of tax.

We must not lose sight of some basic facts:

Many low paid workers pay no tax at all - they will not benefit from further tax cuts or from the introduction of tax credits.

A system of tax credits contains no more potential for targeting the lower paid than the present tax-free allowance system.

If tax credits replaced personal allowances, a cut in the top rate of tax would not be needed to compensate top rate taxpayers.

It is simple to construct a system of tax credits which has exactly the same effect as the system of personal allowances. To do so, just replace allowances with a tax credit equal to the value of the allowance at the standard rate; and widen the standard rate band so that the income at which the top rate of tax becomes payable - the top rate tax threshold - is unchanged.

There is no need to cut the top rate of tax to compensate top rate taxpayers - the widening of the standard rate band achieves precisely the necessary compensation for the fact that they no longer have a tax-free allowance valued at their marginal rate. A cut in the top rate of tax could not achieve this precise compensation - the very rich would gain most, while other top rate taxpayers could lose out.

Further confusion over the impact of a move to tax credits arises when we come to consider special allowances such as the PAYE allowance, widowed and lone parent's allowances. Some would see a move to tax credits as an opportunity to target these reliefs towards low- and middle-income earners, and accept that this means less relief for top rate taxpayers. If this is the intention, standard-rating the reliefs - in the same way as mortgage interest relief - would do the job just as easily.

Others see the potential losses for top rate taxpayers from converting these reliefs to tax credits as a problem, and look for a means of compensating them. There is no exact compensation mechanism for these potential losses. But if this is the major concern, it is not clear why a move to tax credits is being contemplated at all.

It is true that under the present system an increase in tax-free allowances would have a greater cash value for a top rate taxpayer than a standard rate taxpayer. The cash value of an increased tax credit would, by contrast, be the same for all taxpayers (with an existing tax liability greater than the increase in credits). But it would be possible to achieve the same effect under the current system.

The "trick" would be to increase tax-free allowances, but offset this increase with a narrowing of the standard rate band, so as to leave the top rate tax threshold unchanged: all taxpayers would gain from this change.

It may be easier for a Minister for Finance to "sell" a package based on increased tax credits than one based on an increased tax-free allowance and narrower standard rate band. But at a technical level each system can achieve the same results: tax credits do not in themselves increase the potential to achieve the desired distribution of taxes.

It is widely agreed that any cuts in income tax should now be targeted towards the lower paid. This would improve the financial incentive to work facing the unemployed, and help to share the fruits of growth more equitably. The introduction of tax credits would not substantially alter the options available to the Minister for Finance on Budget day. But the confusion surrounding the topic may muddy the waters when the strategy required is actually very simple.

Targeting tax cuts on the low paid requires a steady focus on increasing personal allowances or increased tax credits.

In either case, a reduction in the top rate of tax would not be justified, as resources which could otherwise be devoted to assisting low- and middle-income earners would then flow to top earners.

Tim Callan is a Research Professor at The Economic and Social Research Institute.