Treasury Committee - Experts warn of ‘extraordinary distortions’ caused by tax cliff edges

Members of the committee were joined by members of the Work and Pensions Committee for the hearing.

Worst cliff edges

The Chair of the committee, Harriett Baldwin (Con) began the session by asking the panel what they believe are the worst cliff edges in the UK benefit and tax system.

Morgan Wild, Head of Policy at Citizens Advice, replied by saying that one issue that many currently face is about “the cliff edges for cost of living payments”. Providing an example, he highlighted that individuals who are currently claiming universal credit legally have no award in a month, which is the eligibility month for cost of living payments. As a result, they do not receive an award.

Helen Miller, Deputy Director at the Institute for Fiscal Studies, drew the committee's attention to the distinction between cliff edges and parts of the tax system that merely increase the marginal tax rate, stating that cliff edges are harmful because “not only do you pay more but you are worse off” when an individual earns a bit more. She provided a number of examples of cliff edges, such as losing access to childcare subsidies, and VAT thresholds, and agreed with Wild that losing access to the cost of living payments scheme is also one of the very sharp cliff edges.

Tom Clougherty, Head of Tax at the Centre for Policy Studies, said that while he sympathises with people on very low incomes, he believes the worst example of cliff edges in the tax and benefit system could be childcare subsidies. He highlighted that a family with full time childcare for two children in London are better off earning below £100,000 than £150,000 annually. “An extraordinary distortion” he felt it could have been easily avoided.

Fran Bennett, Associate Fellow, Department of Social Policy and Intervention at The University of Oxford, agreed with other panel members’ comments and added one more issue she felt strongly about: the high-income child benefit charge. She said: “If people have children, they have lower taxable capacity, and we should help them with that at the time that they have children”.

Deven Ghelani, Director at Policy in Practice, raised two points with the committee. Firstly, the issue of cliff edges surrounding cost of living payments, which could potentially increase due to people not taking up support that would ensure access to more benefits. Secondly, a technical cliff edge, similar to sanctions, which arises from the costs associated with moving into work, such as hygiene, clothing, and transportation. Ghelani suggested that if more people accessed universal credit, it could help mitigate these cliff edges.

Pension contributions

Rushanara Ali (Lab) asked the panel whether they agree with the abolition of the lifetime pension allowance. Clougherty agreed with the Chancellor that removing the allowance helps work incentives, in particular around highly paid senior NHS staff. “The lifetime allowance was just a bad way of controlling pension contributions and their fiscal cost”, he added.

Ali noted that the Resolution Foundation thinks scrapping the allowance will enable people to retire even earlier. Miller acknowledged that “people might reach their savings goals earlier and therefore retire earlier. At the margin, they have a stronger incentive to save, but there are offsetting effects”. She said that the principle behind the lifetime cap causes issues as individuals may not be able to manage exactly how much they have in their pensions pots once investment returns are considered. She said that if the implementation of the policy is only for the “labour supply effects” then it is not a right way to do it.

Ali asked if there should be some conditionality on rich people. Miller replied that the government could cap the tax benefits. While a cap has been implemented on the 25 per cent lump sum, it is restricted to the current lifetime allowance, meaning that one cannot receive more than 25 per cent of that amount. However, other tax benefits, such as the large national insurance benefits, which are often exempted on both entry and exit, and the complete exemption of pensions from inheritance tax, are still in effect. She pointed out that there are several ways the government could target wealthy pensioners, but she believed the most simple way is “to move to a cap on contributions rather than the total pot.”

Then Ali asked her final question from Miller regarding pension taxation, to which she responded that the current issue with the tax free 25 per cent lump sum is that it “benefits higher-rate taxpayers in retirement” while providing no advantage to non-taxpayers – this is problematic. To address this, the system could be reformed in a way that maintains the status quo for basic rate taxpayers, decreases benefits for higher-rate taxpayers, and increases benefits for non-taxpayers.

VAT thresholds

Douglas Chapman (SNP) asked whether there was “any evidence to suggest that the current £85,000 tax threshold in terms of VAT is a disincentive for business growth”. Clougherty said there was. He advised that according to the chart of corporations by turnover, there are many companies which are just under the threshold.

Miller agreed. “While that is an issue per se because there might be people who would have earned a little bit more, the bigger and much more important point that this bunching teaches us is not just that there are some people who have not grown in order to overcome it, but that the VAT system is distortionary.”  She continued that the big problem with VAT is compliance costs, which stop businesses being willing to get into the VAT system.

Highlighting that the UK has the highest threshold of all the OECD counties, Chapman asked what the best way to incentivise business to grow and “make that leap over the barrier beyond £85,000” is. Miller argued that if the compliance costs within the VAT system are reduced, crossing the threshold would be easier as there would not be a huge fee to complying. If you set a higher threshold for VAT, then fewer businesses will need to comply with the VAT system. This represents a significant trade-off to consider.

Miller informed the committee that the UK has more zero rates and exemptions than most other counties and the VAT system is very complex when compared with everywhere else. “The simpler your system, the easier it is to say, ‘We will put it down to more businesses’ because it is not as complex”, she said.

Chapman raised his concern that with inflation and more companies being caught in the VAT net, the threshold should be adjusted and not remain in place until 2026 as announced by the Chancellor. Clougherty, believing that there is a political calculation at play, said while the Treasury knows the threshold is higher than it should be, reducing it would be politically toxic. Instead, they are “going to fix it in nominal terms”, which will cause it to decrease in real terms.

Asked about potential solutions to the VAT threshold problem in the UK, Clougherty suggested that the government should simplify VAT, having a lower main rate applied to more things, and making compliance and reporting as simple as possible. He cited New Zealand's goods and services tax as a model for simplicity. Clougherty continued that, in the long term, businesses of a certain size should be able to stay out of the VAT net by linking a more internationally standard threshold to inflation, which could be achieved by reforming and simplifying the VAT system.

High income child benefit charge and other high marginal tax rates

Dame Angela Eagle (Lab) asked what the largest marginal tax rate in the benefits system was. Miller said that it might not be the highest, but if you have three children, the removal of child benefit between £50,000 and £60,000 gets you a marginal rate of towards 70%. Because the start and finish points of the taper have been frozen, more people are being brought into this system. Meanwhile, child benefit is going up in nominal terms, “which means that, in order to reduce child benefit across that range, you have higher and higher marginal rates. We are not there yet, but, if you continue in that system, you could easily get to marginal rates of above 100%, because you are moving the marginal rates down and compressing the range over which it is drawn in real terms.”

Ghelani noted that the standard withdrawal rate for people in work on universal credit gets up to 70% once you are above the income tax and national insurance threshold. That is the marginal rate that people on UC face generally. Additionally, there are around 300,000 higher rate taxpayers on universal credit: “It does not take much if you rent in a high-cost area and have one or two children.” When you factor in universal credit withdrawal, you are above 100% with the high-income child benefit charge at the same time, he said. 

Anthony Browne (Con) asked how steep a marginal rate has to be to be a cliff. Miller said a cliff edge is where you have a jump in your average tax rate: “A high marginal rate might mean you lose 90%, but you are still better off. A cliff edge is where, no, you are worse off.” She gave the removal of tax-free childcare as an example: “[I]f you are a parent with a couple of children, you can be better off earning £99,000 than all the way up to £130,000. You could take a pay rise anywhere between £99,000 and £130,000 and not just have a higher tax rate but be worse off. That is inexcusable.”

Browne asked about the behavioural impact of high marginal rates. Miller gave the example of company owner-managers: “We have very clear evidence, using HMRC tax records, saying that a lot of them do save large amounts of their money in a company rather than taking it out in salary in the year.” Asked whether the ‘Laffer curve’ applies, she said that, “if we increased the additional rate of income tax, the current expectation based on HMRC estimates is that it would not raise very much money. That is because of the design of the system. We are near peak Laffer curve if we keep the design of our system the same. If we moved to a system where there was greater alignment in taxes between labour and capital gains, we could raise more.”

Ghelani made the argument increasing the headline rate of tax would improve labour supply. “That is because the decisions people make relate to cliff edges and not nearly as much to marginal rates. At £50,000, I am going to lose my child benefit. I want to work three days a week instead of four or five. At £100,000, I am going to lose all of my childcare. My personal tax allowance is going to be withdrawn… Because of these cliff edges, you are introducing a decision point that, in a normal progressive taxation system, should not exist. If you increased the additional rate of tax by 5p or the higher rate of tax by 1p or 2p, you could pay for and remove all of these distortions.”

Clougherty said the withdrawal of the personal allowance at £100,000 is “a particularly nasty policy because those people in the £100,000 to £125,000 bracket are not the internationally mobile super‑rich. You can get away with taxing them at much higher marginal rates and still raise a lot of money in a way that you could not do if it was just raising the additional rate of tax to 60%.” He noted that when Alistair Darling announced that the personal allowance would be withdrawn, we had “a relatively low personal allowance. It affected a relatively small number of people.” But getting rid of it now would cost about £5.5 billion. “Everyone would say, “Why are you targeting a £5.5 billion tax cut at people earning over £100,000?”” Clougherty observed.

Other issues

Harriett Baldwin asked the panel whether they agreed that the Treasury should be abolishing the OTS. Morgan Wild said “yes, because that is not the problem”. Deven Ghelani had no view on this, while the rest of the panel said “no”.

Sir Stephen Timms, chair of the Work and Pensions Committee, and Baldwin asked about the effectiveness of, and eligibility for, free school meals.

Clougherty told the MPs that the logic of universal credit is “that everything should be rolled into a cash payment, which is withdrawn at a simple and predictable rate… More and more things would be rolled into it, and you would get that greater simplification and get rid of the cliff edges.”

Miller suggested that one option, at the point of a current cliff edge, if that is when you want to start removing an entitlement such as free school meals, is to give parents a cash payment at that point equivalent and then taper that away.

Work and Pensions Committee member, and former tax adviser, Nigel Mills asked how effective universal credit was at ‘making work pay’. Wild said universal credit “has a lot of fans among our advisers, particularly compared to aspects of the legacy system”. It works pretty well if you are the normal case that it is designed for, though there is uncertainty from the volatility of payments, he added.

Miller said there is evidence that part-time work does not have the same kind of long-run payoffs as full-time work. You can do things that make work pay more, she continued. “You could increase work allowances or reduce the taper, so you get more if you go into work and you get to keep more. One effect that that has is to move further up the income distribution.”

Andrea Leadsom asked about support for childcare: “If I am working and I am earning, let us say, £100,000 a year, and I have a child and I want to raise that child, is it right that I should be supported by the state to be able to do so?”

Clougherty thought it “weird that we do not count the economic value of a parent staying home and looking after their children, while we do count someone being paid to provide the same service. We have skewed the playing field. It is not level because the Government are funding free childcare in many cases, but we are not allowing transferable tax allowances. We tax solely on an individual basis. That is problematic.”

Miller called it a ‘thorny issue’. She said how you design a childcare system depends on what you are trying to do with it. You might be thinking about labour supply choices, or child education and welfare, or helping people who have higher costs, or all three. “The problem with our system at the moment is that it jumbles all of those things up. It does some bits in some cases and not in others,” she explained.

The hearing also discussed one-off cost of living support payments, benefit sanctions, the impact of student loans on effective tax rates and support for those with disabilities or who are otherwise inactive.

You can read the full transcript of the session here.