Budget may overhaul tax system

The Department of Finance is considering a radical overhaul of the current tax system in the forthcoming Budget, which would introduce the widespread use of tax credits for the first time. These credits would replace many of the existing income tax allowances and would be designed to give significant relief to the low paid.

Although a form of credits is currently in use for some reliefs, extending it to personal and PRSI allowances is seen as a way of distributing tax relief more equitably. This is because the current method of tax relief benefits workers on the top 46 per cent rate of tax more than those on the standard 24 per cent rate.

The Minister for Finance, Mr McCreevy, was trenchantly criticised following last year's Budget for cutting the top rate of tax, as well as capital gains tax, which were seen as giving the greatest gains to those at the upper end of the income scale. It is understood that his Department is now actively considering bringing in tax credits as a way of avoiding similar criticism this year and of spreading the benefits of tax relief more widely.

The introduction of such a system would involve taxpayers all getting the same cash amount as a reduction on their tax bill. This compares to the current allowances system, where the deduction is made from taxable income, meaning that those paying tax at the higher rate benefit more.

As it is a measure giving the greatest benefit to lower rate taxpayers, introducing credits could allow Mr McCreevy to justify other measures helping higher earners - such as further cuts in the top rate of tax. The two income tax rates must be cut to deliver on commitments in the Programme for Government.

Tax credits have already been used for both mortgage interest and VHI relief, both of which are now allowable only at the standard rate of income tax.

Who would win or lose under a credit system would depend on the extent that bands, allowances and tax rates were adjusted. The problem is that simply to introduce credits at the same level as the existing allowances would significantly increase the tax burden on everyone who pays the higher rate, unless allowances and bands were increased or the top rate of tax significantly cut.

One option would be simply to double the present level of the current personal tax allowance and introduce it as a tax credit. This would leave higher-rate taxpayers in exactly the same position but would dramatically alter the situation of a standard rate taxpayer, who would be able to earn substantially more before being liable for tax. However, this would prove very costly for the Exchequer.

At the other end of the scale the top rate of tax could be cut to make up the shortfall. Some combination of both measures is most likely.

The move is also likely to meet with the approval of the social partners who have been calling for allowances and bands to be widened. Yesterday, the main public services trade union, IMPACT, called for a doubling of the allowances to be converted into a credit.