To cut income tax – a progressive tax – at the same time as increasing VAT – a regressive tax – is always going to hit the poorest hardest.
Our Guest writers are Howard Reed, of Landman Economics and Tim Horton, Research Director of the Fabian Society
A few months ago we published an analysis of why the Liberal Democrat election manifesto commitment to spend £17 billion raising the income tax personal allowance was not a particularly progressive policy. Contrary to how it has been presented (as something “especially to help those on low incomes”), the measure does nothing to help the millions of families in the UK whose incomes aren’t high enough to pay income tax, and most of the giveaway goes to people further up the income distribution.
That Lib Dem manifesto commitment has now become the coalition government’s aspiration, and George Osborne started to move towards it today with a £1,000 increase in the income tax allowance.
The government is lowering the point at which people start to pay higher rate income tax so that taxpayers currently on the higher rate will not benefit from the policy. But, even so, as green line in the graph below shows, the distributional impact favours middle-income households rather than poorer ones (that is, middle-income households gain a lot more as a proportion of their overall income than poorer ones).
While the income tax cut is estimated to cost about £3.7 billion by the fiscal year 2012-13, it is overshadowed by an increase in VAT from 17.5% to 20%, scheduled for January 2011, which will raise around £13 billion.
VAT is a regressive tax – those on lower incomes pay a larger proportion of their income in tax than those on higher incomes. This is in large part because household expenditure takes up a larger proportion of income for lower-income households than for higher-income ones.
Incredibly, some of the briefing around the budget today suggested that the coalition saw the income tax cut as some kind of compensation for the VAT rise. But, as the graph above shows, that isn’t the case at all.
The blue line shows the combined impact of the income tax cut and the VAT rise using one standard method of calculating the distributional impact of VAT. (Basically, the distributional impacts of VAT are harder to estimate because this depends on the relationship between income and expenditure for each household. This technique uses spending figures and income figures from the UK Expenditure and Food Survey (EFS) and work out the distributional effects of the VAT increase as if it were a reduction in disposable income using EFS income deciles.)
The graph shows that the poorest deciles lose far more from the VAT rise than they will gain from the income tax cut. The graph also shows the impact is extremely regressive across the income distribution, with low-income groups losing out far more proportionately than middle- and higher-income groups.
And some groups will be especially badly hit by the VAT increase – especially those that don’t earn enough to pay income tax: pensioners, the unemployed and parents in low-paid part-time work.
The IFS has suggested that VAT is not as regressive as this, and instead that the impact is proportional to incomes. (This would mean that the impact of VAT is flat across the incomes deciles.) So the red line in the graph above shows the combined impact of the income tax cut and VAT rise using the IFS’ approach. As can be seen, the result is less regressive than before, but still regressive nonetheless. The reality is probably somewhere in between the two approaches.
Whichever one you use, however, it still undermines the coalition’s claim to be creating a fairer tax system. To cut income tax – a progressive tax – at the same time as increasing VAT – a regressive tax – is always going to hit the poorest hardest.
Elsewhere, the budget announced a further range of changes to the tax credits and benefits systems. Some of these, such as higher child payments for the Child Tax Credit, and increases in the Pension Credit, are progressive. But they are not generous enough to completely overturn the regressiveness of the tax package as a whole.
One further aspect of the budget will further exacerbate this regressiveneess over time: the announcement that benefits are to be indexed by the Consumer Price Index (CPI) rather than the Retail Prices Index (CPI). This is regressive in the short run, because the CPI is currently around 1.7 percentage points lower than the RPI. This amounts to a real-terms benefit cut in future years by stealth. The fiscal projections in the budget assume that the government will save almost £6 billion by 2014-15 through uprating by CPI instead of RPI. If this is an accurate estimate, the regressive effects of the uprating change will continue over the whole of this parliament.
Far from being ‘unavoidable’, all these policy changes are discretionary choices. A government committed to fairness could have done so much better.
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