An anti-poverty Scotland budget - Are income tax cuts on lower earnings progressive?

Summary:

• Income tax increases proposed in Scotland necessary and welcome
• Income tax cuts on lower earnings not a good way of helping the poorest households or reducing poverty
• Instead of any future extension of the proposed 19p Starter Rate, the Scottish Parliament should prioritise reform and investment in social security payments as the best way to boost low incomes
• One immediate option would be recompensing families for the financial loss caused by the Two-child limit (which includes the infamous ‘rape clause’) and Benefit Cap in Scotland at a cost of £120m per year, potentially bringing 10,000 children and 5,000 adults out of poverty in Scotland
• Any investment in local authority budgets before final budget could be invested in topping up benefits through local authority funds. This could bring a triple impact:
  • Protecting local authority budgets in real-terms
  • Significantly reducing child poverty in Scotland, effectively ending the impact of the benefit cap and two-child limit on families
  • Reducing pressures on local authority and voluntary sector services and budgets

Introduction

The Scottish Government has proposed significant reforms to Scotland’s income tax system, using the Scottish Parliament’s new powers to add two new income tax bands and using powers to change income tax rates. In doing so the Scottish Government has set itself four tests. This includes whether the income tax changes:

1. protect funding for public services
2. protect the poorest from paying higher levels of tax
3. are progressive and reduce inequality, and
4. support the economy.

The Scottish Government deserves a lot of credit for using its tax powers in a significant way, and for raising funds to help to reduce cuts to spending in Scotland. They will bring in an estimated £164m per year and will see 55% of income tax payers in Scotland pay less than in the rest of the UK. IPPR Scotland has described the proposals to increase taxes as necessary and welcome as they will reduce public spending cuts in Scotland, at least for one year.

However, we wanted to look in detail at the Scottish Government’s third test – are the tax changes progressive and do they reduce inequality? In particular, we wanted to look at the effects and costs of introducing the Scottish Government’s proposed new 19p ‘Starter Rate’ on all earnings up to £13,850 and more generally the idea of using income tax cuts on lower earnings to help the poorest households.

The Scottish Government’s recent Child Poverty (Scotland) Act 2017 sets a clear direction for government policy setting targets for reducing relative poverty levels in Scotland over the coming years. Therefore, while the focus on inequality within the income tax paying population is interesting, we wanted to look at the effects of tax policy on the poorest households more generally (whether in-work or out of work and whether income taxpayers or not) and in particular on poverty rates in Scotland.

In doing so, we’ve used our extensive microsimulation tax and benefit model to consider the costs and impacts on poverty of the new Starter Rate, together with opposition party proposals from the last election to introduce a more extensive Starter Rate of 18p on earnings up to £19,000. We’ve compared these to the costs and impacts on poverty in Scotland of equivalent reforms to the benefits system. In addition, we look at the potential interaction between tax cuts on lower earnings and the UK Government’s Universal Credit system.

Section 1 – the costs and effects of cutting tax on lower earnings

To consider the impact of cutting income tax on lower earnings we looked at the two remaining ‘live’ proposals for income tax cuts for lower earners in Scotland.

Firstly, we looked at the Scottish Government’s proposal for a new Starter Rate of 19p on earnings up to £13,850. This would be set at 1p less than the current Basic Rate, reducing tax on earnings at this level. Secondly, we looked at the Scottish Greens’ proposal at the last Holyrood election for a more significant tax cut on lower earnings. This would see a Starter Rate of 18p on earnings up to £19,000, a 2p tax cut on lower earnings. Both proposals were part of broader tax policies that would see increases in tax on higher earnings, however we wanted to isolate the effects of the tax cut on lower earnings alone, and consider its costs and effects on the poorest households in Scotland.

The table below outlines the costs of these proposals to cut taxes on lower earnings in isolation from wider income tax proposals, and their effects on relative poverty.

Table 1- Cost and effect on poverty of proposals to cut taxes on lower earnings for 2018/19

*Rounded to the nearest 5000

Note: Poverty threshold recalculated following policy intervention to include distributional effects of the policy

We found that the cost of the Scottish Government’s proposed 19p Starter Rate would be around £50m in isolation from the other elements of its proposed tax changes. This compared to the cost of £300m for the more extensive 18p Starter Rate proposed by the Scottish Greens at the last election (again in isolation from other elements of the Scottish Greens’ proposed tax changes). In terms of poverty rates, we found that the proposals saw a small reduction against a static poverty line. However, cutting taxes on lower earnings through these two proposals had no effect on relative poverty rates in Scotland, one of the key Scottish Government poverty measures, (and in fact a more extensive Starter Rate could marginally increase relative poverty rates in Scotland by increasing median incomes and bringing greater numbers of people under the poverty line).

This shows that cutting taxes on lower earnings is not a good way to tackle poverty, a clear priority of parties across the Scottish Parliament, and indeed a more extensive Starter Rate, beyond that proposed by the Scottish Government, may in itself be counterproductive to meeting Scotland’s new poverty targets.

Section 2 – the costs and effects of benefit reform

We wanted to look at the costs and effects of investing in benefits reform in Scotland instead of using funding to cut taxes on lower earnings. In doing so we looked at two reforms that could be implemented in the coming year using existing local authority powers, or through use of newly devolved social security powers to the Scottish Parliament. Equally, we wanted to look at reforms that were comparable (or lower) in cost than the proposals for tax cuts on lower earnings. In doing so we decided to concentrate on the costs and effects on poverty of two reforms: fully mitigating the Two-child Limit (which includes the infamous “Rape Clause”) and the Benefit Cap in Scotland.

The Two-child Limit applies to Tax Credits and Universal Credit claimants, meaning they can only receive financial help for up to two children. The change applies to children born after April 2017. The Benefit Cap applies to a household’s total benefit entitlement across most working-age benefits, capping a household’s income from the benefits system at no more than £20,000 per year (outside of London), with a lower cap for single adults with no children.

The reason we focused on these two reforms were that they could be achieved through existing local authority powers, they are comparable in cost to the tax proposals in Section 1, but also effectively removing the impact of the cap and the limit are important to ensuring that any other further or future investment in social security in Scotland (whether in increasing Child Benefit, Universal Credit, or creating whole new benefits) has the maximum impact on poverty rates and can reach those households most likely to be in poverty.

The table below shows the cost and effects on poverty of effectively ending the impact of the Benefit Cap and Two-child Limit in Scotland assuming full-roll out of Universal Credit (to future-proof the cost estimate).

Table 2 – Cost and effect on poverty of ending the Benefit Cap and Two-child Limit in Scotland, 2018/19

*Rounded to the nearest 5000

Note: Poverty threshold recalculated following policy intervention to include distributional effects of the policy

We found that fully mitigating the Benefit Cap and Two-child Limit would cost around £120m per year. Unlike tax cuts on lower earnings, effectively ending these policies would have a positive effect on poverty rates, and could lift up to 10,000 children and 5,000 adults out of poverty in Scotland (for 2018/19, assuming full implementation of the Two-child Limit).

This shows that investing in social security in Scotland is likely to be a much better way of helping the poorest households and tackling poverty, compared with cutting taxes on lower earnings. Furthermore, this could be done this coming year through investment in local authority discretionary or Welfare Funds. Investing further funds to end the impact of the Two-child Limit and/or Benefit Cap, could have a triple impact of protecting local authority budgets, significantly reducing poverty rates, and reducing pressure on local services (both government and voluntary sector).

There is a further reason why cuts to income tax on lower earnings is not an effective way of increasing income for the lowest income households. Once Universal Credit is fully rolled out (currently planned to be end of 2018 by UK Government for new claimants and by 2022 for all claimants), and for those areas in Scotland that already have the Universal Credit, income increases through tax cuts for those claiming Universal Credit, may well be clawed back through the Universal Credit system. For those low income households in receipt of Universal Credit that would benefit from the proposed Starter Rate, the Universal Credit system will clawback 63p of every £1 benefit. This is because Universal Credit entitlement is calculated using net income, after taxes and some other costs. Therefore, if a low income household were to see an increase in net income due to a tax cut on lower earnings, their Universal Credit entitlement would be reduced accordingly. Investing in social security in Scotland is unlikely to have the same effect, meaning the investment will go to those intended to receive it, without risk of clawback from the Universal Credit system.

A tax cut on lower earnings is not a policy well suited to benefiting low income households in general, as many households in poverty will not be in work, or earning enough to pay income tax. Indeed, a number of second earners in high income households may benefit from the Starter Rate. However, this is even more the case given the design of the UK Universal Credit which will see any benefit from the Starter Rate that does actually go to low income households, clawed back at 63p in the £1 from those in receipt of Universal Credit. It may be possible for the Scottish Government to reclaim this funding, or indeed to negotiate with the UK Government not to take it at source, employing the ‘no detriment’ principle agreed through the latest wave of devolution. However, this remains to be seen and is unlikely to happen in time for any tax changes in April.

Conclusion

The Scottish Government’s proposals to increase taxes are necessary and welcome. However, cuts in income tax for lower earnings are not well targeted to help the poorest households. They will not benefit the very poorest households, and at the same time will benefit a number of high income households (through second earners). For those low income households that do benefit, the Universal Credit system will clawback 63p of every £1 of a tax cut. The ‘no detriment’ principle agreed between the UK and Scottish governments may mean this can be reclaimed by the Scottish Government, or prevented from being taken at source, but this remains to be seen, and certainly is unlikely by April 2018.

Furthermore, we find that going further with income tax cuts on lower earnings, beyond what the Scottish Government has proposed, has no impact on reducing poverty (and may actually marginally increase levels of relative poverty in Scotland, boosting median incomes and, with that, bringing greater numbers of people under the poverty line). So while the new Starter Rate has the welcome advantage of allowing the Scottish Government to increase tax revenue overall while also cutting taxes for 55% of income taxpayers in Scotland compared to the rest of the UK, going further than what is proposed, whether this year or in the future, could begin to increase relative poverty rates rather than reduce them and would make it harder for the Scottish Government to meet its targets on reducing poverty rates in Scotland.

From our analysis, a far greater impact on poverty would come from investing in the social security system in Scotland. Fully mitigating the financial impact for families of the Two-child Limit and the Benefit Cap in Scotland would cost up to £120m in 2018/19, and would bring up to 10,000 children and 5,000 adults in Scotland out of poverty. This could be done this year using local authority welfare funds or discretionary payments, and in time through the Scottish Parliament’s new benefits powers.

Opposition parties in Scotland have focused much of their attention on the local authority budget cuts proposed in the draft budget. These amount to real-terms cuts of £185m in revenue funds, or £135m if you include specific grants that local authorities can access. If further funds are found for local authorities between now and the final budget in March, then providing these to local authorities to effectively end the impact of the Two-child Limit and Benefit cap could provide a triple impact:

1. Protecting local authority budgets in real-terms
2. Bringing 10,000 children and 5,000 adults out of poverty, ending the Benefit Cap and Two-child Limit and
3. Reducing pressure on local authority and voluntary sector services and budgets.

Acknowledgements

The content and opinions expressed in this research are those of the author alone. IPPR Scotland would like to thank CPAG in Scotland, One Parent Families Scotland and SCVO for their support, for their advice and for their financial contribution towards making this analysis possible.