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2 July 2020updated 26 Jul 2021 11:27am

Why the government should end punitive Universal Credit tax rates

The best way to support the economy is to ease the eye-watering tax burden faced by low earners.

By Alfie Stirling

In March the UK moved through parallel political universes. At the Budget, the government’s welfare response to coronavirus amounted to little more than removing the three-day wait for sick pay. Fast forward a few days, and the Chancellor had committed to two wage-subsidy schemes that would go on to pay the salaries of almost a third of all UK workers

July is likely to mark a return to political reality with the Chancellor’s “summer economic update” next week. Through his rhetorical flourishes, the Prime Minister has sought to conjure comparison with Franklin D Roosevelt’s New Deal, but the substance tells a very different story. Even if it were all new money – rather than a modest reprofiling of existing spending – the £5bn infrastructure package is seven times smaller than the increase in annual public investment following the 2008 recession, and 200 times smaller than the original 1930s New Deal

The real mood music in advance of next week has been clear: sweeping deregulation and, above all, significant tax cuts in areas such as national insurance contributions (NICs) and VAT. 

There are many reasons to believe the UK economy is not about to “bounce back” of its own accord. Restrictions on travel and social distancing will disrupt services such as hospitality and tourism for months to come. Meanwhile, much of the savings accumulated during lockdown are concentrated among those least likely to increase their spending in a hurry. This includes those with large savings in advance of the crisis, or those above an age where there may be continued nervousness about hitting the shops or travelling for leisure, or both

Perhaps even more so than during previous economic recoveries, further support must now be highly targeted on specific sectors, low earners and the creation of additional work. But to say that the trailed tax cuts are a poor match for these objectives would be an understatement.

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Since the lowest-paid jobs already attract few or no NICs (employee or employer), cutting rates indiscriminately simply transfers public funds to almost every part of the economy, except where they are needed most. Further cuts would create what economists call large “deadweight loss”, with little redeeming upside. 

Cutting VAT is arguably even worse. Many of the basic essential items in highest demand from struggling families are already VAT zero-rated, and many retailers are either set to offer large discounts, or else currently have such tight margins they won’t be able to pass on a price cut at all. Trailing an ineffective VAT cut in advance also risks the worst of all worlds: consumers holding back spending today in anticipation of lower prices tomorrow, with the twist that tomorrow either disappoints or never comes.

Direct public investment in job creation, and targeted rent holidays for distressed households and firms, are likely to yield far greater benefits, and at a far lower economic cost. Reforming the job retention scheme into more targeted, sector-specific support, while rebuilding the rest of the UK’s safety net to provide a genuine “minimum income guarantee” will also be vital.

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That doesn’t mean tax cuts should be ignored altogether though, but they do need to be far smarter. The very highest marginal tax rates are experienced by those on in-work benefits. Even before earning the equivalent of £9,500 per year, which is required to start paying NICs, many employees on Universal Credit keep just 37p of every additional £1 they earn, as withdrawn benefits create an “effective marginal tax rate” of 63 per cent. This rises to at least 75 per cent after further taxes kick in, compared to just 32 per cent for those paying NICs and income tax on middle incomes – or a maximum combined rate of just 47 per cent for income above £150,000 per year.

Addressing the eye-watering tax rates experienced precisely where increased hours, earnings and spending is needed most, should be an uncontroversial goal that both left and right can endorse. Crucially, there are already ways of achieving this quickly and efficiently.

The ​“taper” in Universal Credit sets the rate at which benefits get withdrawn for every additional £1 in earnings from work, and the so-called “work allowances” give a threshold for earned income, above which the taper is applied. Simple changes to these rates and thresholds could dramatically lower effective tax rates for the poorest people in work. Because these policies are extremely well targeted on those that most need them, the costs to the government start in the hundreds of millions, not the billions required for meaningful changes to NICs and VAT.  

For a Chancellor prepared to travel through political space-time as recently as March, ignoring calls for expensive and ineffective tax cuts in favour of targeted support where it is needed most, should be a simple task. We’ll soon see. 

Alfie Stirling is head of economics at the New Economics Foundation