Article by Keith Deacon, formerly Head of Operations, Inland Revenue, published in the June 2001 of Tax Adviser KEY POINTS
- Increased recent prominence of the concept of ‘tax credits’: where is it leading?
- Chancellor making full use of them: protecting the environment, encouraging investment and helping individuals into work and children out of poverty.
- But withdrawing dividend tax credits hits the non-taxpayer and adds to ‘stealth taxes’.
- Integrating tax and benefits systems second time round: looking back nearly 30 years to an aborted system and what became of it.
- Chancellor to consult on new tax credits: Inland Revenue must improve on the unsatisfactory 1999 system.
- What price tax simplicity if Chancellor is bent on ‘social re-engineering’?
In the ranking lists of current Government ‘buzzwords’, ‘Tax Credit’ should soon be heading for the top spot, for this term has had considerable exposure over the past two years. Its withdrawal as a means of tax relief was to many an unwelcome part of the Government’s reform of company taxation, although most would support its recent introduction as a vehicle for tax relief for business expenditure on measures beneficial to society. More significantly, tax credits are playing a key role in bringing the direct tax and social security benefits systems closer together. This will have major consequences for taxpayers and non-taxpayers alike as well as for the customer databases, systems, procedures and forms of the Inland Revenue and the Department of Social Security – as well as, dare one say, for their attitudes to their ‘customers’. So what is the underlying concept, and how interested should we be in where all this is leading? This article takes stock before the next likely developments already foreshadowed in the 2000 Budget.
What are ‘tax credits’?
Tax credits are widely used by governments. In essence, a tax credit is a deduction from, or a set-off against, the amount of the tax bill, rather than a deduction from taxable income before the charge to tax. Furthermore, governments may award tax-free amounts in the form of a credit, perhaps as an investment credit to encourage investment in business assets, and usually to be determined as a percentage of the cost of the asset. Or tax credits can be an alternative method of awarding tax relief by reference to, and in respect of, the personal circumstances of the individual.
Tax credits are most commonly ‘non-refundable’ (or ‘wastable’). That is to say, the set-off is limited to the amount of the tax liability (arising on the source in double taxation relief). Sometimes, they are ‘refundable’ so that the excess over the tax liability (if any) can be paid or refunded to the individual or business.
Tax credits as business incentives
Gordon Brown broke new ground in his 1999 Budget by announcing the introduction from April 2000 of tax credits for the costs of research and development. These are potentially ‘refundable’ and provide 150 per cent relief on sums invested in research and development: on a CT rate of 30 per cent, relief at an effective rate of 45 per cent. Where taxable profits are insufficient to absorb the relief, the tax credit can be converted to immediate cash. He has followed up this move with current proposals for accelerated tax credits for 150 per cent of the costs incurred by companies after Royal Assent, of cleaning up contaminated land acquired for use in the business; here, too – the credits can be encashed. Out for consultation are similar tax credits for an extra payment to encourage the development and distribution of vaccines and drugs to combat ‘killer diseases’.
These flexible tax credits are clearly targeted on social and environmental activities of which Government approves as well as being mindful of businesses’ cash-flow problems. Even as the controversial climate change levy seeks to deter activities of which Government disapproves.
Tax credits and those ‘stealth taxes’
Before 6 April 1999, shareholders had been receiving dividends, on which the company had paid advance corporation tax (ACT), with attached tax credits that satisfied further tax liability on the dividends for the individual except that for higher-rate taxpayers. Shareholders not liable to income tax on their taxable income could claim payment of the tax credit, thus converting it to a ‘refundable’ tax credit.
These rules changed from 6 April 1999. The stated objective of the Government’s reform was to encourage companies to re-invest profits in the business instead of distributing them through extra dividends. Payment of ACT was ended and the calculation of claimable tax credit amended. Crucially for some, these changes also transformed what had been a helpful ‘refundable’ tax credit into a disappointing ‘non-refundable’ one. For everyone, the tax credit was reduced to one-ninth of the dividend received, or ten per cent of the grossed-up dividend. As before, individuals liable only at the basic rate of income tax were not required to pay more income tax on the dividend. And for those liable at the higher rate, a special rate was set at 32.5 per cent. So none of these shareholders was worse off overall. Only the non-taxpayer received no help, and confused advice from treasury ministers to re-invest their savings previously held in shares into ISAs served only to rub in the proverbial salt, as did assurances that the economy would benefit from greater business investment.
The rationale might have been better defended to non-taxpayers on the grounds that the Government was continuing to provide tax relief for those shareholders liable to income tax on the dividend but not for those who are not. But, along with the 75 pence per week pension increase, it is doubtful whether Gordon Brown will be allowed to forget his seemingly hard-hearted decision. Ironically, the sharpness of the perceived injustice may have been blunted somewhat by the sheer complexity of the tax position. Many people simply could not understand how and why they had lost money in this way – even those who read those financial columnists who gamely struggled to demonstrate just what the Chancellor had done. The injustice seemed all the greater for that.
A reduced relief for investment vehicles and charities is being phased out but, for pension funds, the impact of withdrawal was such as to advance the measure to the head of the roll call of alleged ‘stealth taxes’. It has provoked considerable debate in political and financial circles – but not, perhaps surprisingly, the degree of public outrage that some campaigners might have hoped for. This could be because the charge was seen to be on the fund and not on the individual subscriber; moreover, it would not have an immediate effect on pensions still some years from payment. Misguidedly, no doubt, but understandably, this seemed to cushion the impact to a sufficient extent for the move to work politically (maximum feathers and minimum hissing!).
A reliable decision on whether in the longer run this stratagem has actually turned out to have assisted or damaged investment in British business will require an historical perspective greater than that allowed by the timing of this article. At present, the issue is clouded by conflicting opinions from OECD, IFS and HM Treasury on the interpretation of data on investment levels in the UK.
Integrating tax and benefits
The introduction of the means-tested Working Families’ Tax Credit (WFTC) and the Disabled Person’s Tax Credit (DPTC) from 5 October 1999 looks increasingly like the resurgence of the Tax Credit as a tool for both taxation and what might be described as ‘social re-engineering’. The hurried and incomplete transplanting of the former social security benefits (Family Credit and Disability Working Allowance) into the direct taxation world was an inconspicuous start to what could become a major integration of tax and benefits systems.
I say ‘resurgence’ advisedly: consider this Government statement:
‘The Budget Speech in March contained proposals for a new tax-credit system. This radical new approach – in which this country is leading the world – would bring together large parts of the personal taxation and social security systems. It is a development of great importance and one which we believe will be widely welcomed.’
No, not 1999 or even 2001 but 1972 and the opening words of a Conservative Government Green Paper, Cmnd. 5116 ‘Proposals for a Tax-Credit System’.
It is worth noting, nearly 30 years on, some of the stated objectives from 1972 – ambitious, close to creating a negative income tax scheme but not, of course, tested by actual implementation (I declare an interest as having been involved in its planning):
- Tax credits to replace the main income tax personal allowances and the Family Allowance (now Child Benefit).
- No means testing.
- A more readily comprehensible system.
- Inclusion also of main National Insurance beneficiaries.
- Administrative costs savings, including ‘many thousands of civil service jobs’.
- The abolition of secondary income tax personal allowances.
- Income tax relief at source by deduction on payment.
- The deduction of tax from bank and building society interest received.
Although the scheme itself was aborted following the General Election in 1974, the last three proposals were subsequently introduced (subject to the retention to date of the Blind Person’s Allowance). The reformatting of deductions for the main personal allowances into what were in effect cash-quoted tax credits followed the decision in 1991 to limit the Married Couple’s Allowance to basic rate only. Once on the same tax relief footing as MIRAS, MCA followed the familiar countdown to abolition for most, to be replaced – after a year’s gap remunerative only for the Exchequer – by the Children’s Tax Credit for many, but not all. Those couples where neither partner was 65 before 6 April 2000 and whose dependent children have now grown up, find themselves funding them again.
The 1999 tax credits conspicuously do not measure up on the middle four points. Intriguingly, means testing, in particular, seems now a major factor in the tax credits system, reversing historical party political ideologies.
The next step
Assuming he is still Chancellor, the consultation paper foreshadowed by Gordon Brown should take the resurgence a further step forward. The promised second generation of tax credits is likely to be the Employment Tax Credit (ETC) for helping those (including disabled people) without children into low paid work; and the Integrated Child Credit bringing together the child elements of the WFTC/DPTC (rooted in social security legislation) and the newly introduced Children’s Tax Credit (based on income tax principles distorted by flawed means testing). These will be the working age tax credits administered by the Inland Revenue and will need to fit together consistently with the Pension Credit (non-tax) to be administered by the DSS.
To accomplish all this, the Inland Revenue must overcome the operational obstacles that prevented a more user-friendly system and a fully successful take-up for WFTC/DPTC: a failure to integrate with income tax rules and procedures; antiquated and incompatible IT systems; and over-complicated forms (Williamson & Deacon, Tax Adviser, March 2000).
Crucially, a policy decision will be needed on the unit of assessment: ‘individual’ (independent taxation/Inland Revenue) or ‘family’ (aggregation/DSS). This will also raise the continuing relevance of the McClements Equivalence Scale for determining weightings of benefits for different size households to achieve a similar level of welfare. This is disapplied for WFTC to the detriment of single-earner families.
The consultation might also help decide whether the integration of tax and benefits is a long-term strategic aim or merely an ad hoc measure to implement a perceived policy of ‘social re-engineering’: encouraging people back to work, lifting two million children out of poverty and cleaning up the planet. And just how interested the Chancellor and his departments really are in a simpler and more transparent tax system.
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