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Personal Tax Allowance: How an Increase Widens Inequality

This week, the Liberal Democrats pledged to increase the personal tax allowance to £12,500 - a move they said "simply a question of fairness." But is raising the personal tax allowance actually fair? We re-publish this blog by Tim Stacey, Senior Policy and Research Advisor at the Equality Trust on the general principle of raising the personal tax allowance. The blog was published a month before the Liberal Democrats made the announcement.

A tax cut that helps high income households more than it helps low income households will not help solve inequality. It seems odd that this needs to be said, but judging from newspaper articles and think tank reports from the last week not everyone has grasped this basic truth.

As analysis after analysis has shown, increasing the personal tax allowance does not help families on the lowest incomes at all and helps those on higher incomes more than those in the bottom half. And yet it seems that barely a week goes by without someone claiming the personal tax allowance as today’s great policy panacea, a policy apparently laser targeted at reducing inequality

An article in the Sunday Times yesterday suggested there may be further increases in the personal allowance beyond what has already been announced. This is justified by saying that it will take those on low incomes “out of tax altogether”. The problem with this is that it’s utter rubbish. Income tax is not the main tax that people on low incomes face. For low income households VAT and Council Tax (even after taking into account council tax support) are bigger taxes than income tax.

In fact raising the income tax threshold doesn’t even mean that households on low incomes will have no other tax deducted from their pay check, as they will still be paying National Insurance Contributions. Even the most audacious flight of fancy would struggle to conclude these people have been ‘taken out of tax’. In fact as our report from last year suggested, the poorest 10% would still be paying a greater proportion of their income in tax than those with incomes in the top 10%.

The reality is that a personal allowance increase to £12,500 would give £18 a year to households in the bottom 10% and £203 to households in the top 10%. Given this simple analysis, it’s difficult to square a Policy Exchange report which worries about the future effects of technology on inequality with its recommendation to increase the personal allowance even further. Their report suggests creating “a living income” by removing all tax from the minimum wage. However, the report fails to discuss the regressive effects of these tax changes which overall benefit the better off more than those on low incomes. It really shouldn’t need to be said again, but you cannot tackle inequality by cutting taxes for those on high incomes by more than those on low incomes.

The one argument for these sorts of tax cuts that may still viable is that they increase the incentive for people on low incomes to work more hours. At present, those on the lowest incomes face the highest effective tax rates. Even under Universal Credit people on low incomes face withdrawal rates of up to 76%. These high tax rates can deter people on low incomes from working more hours. However, there are more cost efficient ways of improving incentives than raising the personal allowance. Reducing the withdrawal rate of Universal Credit or increasing the amount that a household can earn before benefits are withdrawn would both be far cheaper and could do more for incentives to work than raising the personal allowance.

Proposals that will effectively reduce inequality will focus on how people on low incomes can see these incomes increased. They are unlikely to give a tax cut to the richest 10%.

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