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Raising the personal income tax allowance is pro-poor, despite the protestations

    After Nick Clegg argued for raising the income tax personal allowance a few weeks ago, a range of voices cropped up, once again, to argue that this was somehow a regressive measure. This mainly stems from some analysis done by Howard Reed of Landman Economics last year, in which he shows that in decile terms the poorest households will gain least from the measure to raise the PA to £10,000, as shown by the graph below:

    Howard Reed chart

    Presumably, this is because many in the very poorest households are likely to have nobody earning above the threshold, or if they do, not significantly above to benefit greatly benefit. Likewise, those in the next few thresholds are less likely to have two earners who earn above the threshold. And there is some interaction whereby increasing the personal allowance is offset by losing a proportion of housing benefit.

    It is worth noting at this point that it is pretty obvious this was always intended as a tax cut for the working. The very poorest households have their incomes topped up by benefit payments. But what this sort of static analysis does not capture is the incentive effect that raising the personal allowance has on those out of work to move into work. As our analysis of effective marginal tax rates last year showed, the current complexity of the benefit system means that some of the poorest people face a 98% marginal deduction rate when moving into work – the only long-term means of alleviating themselves from poverty. Income tax cuts through raising the personal allowance will clearly lower the point at which it much more economically rewarding to be in work.

    Furthermore, it seems absurd to have a minimum wage – sold as a minimum basis for income – and then to tax those earning less than it.

    But the reason Howard Reed’s analysis really falls down is because it gets tied up by the very ‘fairness’ definitions used by those who believe in redistributive policies.

    Let’s take a simple example: the raising of the main rate of VAT from 17.5% to 20% last year. At the time, we heard a lot about this being a regressive measure, and I’d tend to agree. This is because the rate rise would have a much larger proportional effect on poorer households than richer ones. Since a greater proportion of a poorer households income is used for consumption, the tax rise would hit them relatively harder. Nevertheless, it is clear that a richer household will still pay a much larger overall absolute amount in VAT, because they buy much more stuff.

    Now take the chart above. In absolute terms, it shows the richest households gaining more per week than the poorest households –£17 compared to £5. But it’s obvious to anyone looking at it that as a proportion of income, the £5 for the poorest household is more than the £17 for the richest household. That is, according to our progressive/regressive metric often used, the policy is progressive. As the IFS said after the March 2011 Budget when examining all changes to taxes and benefits:

    • The main winners from these reforms are non-working lone parents and low- to middle-income households without children. The main factors offsetting the other reforms for these two groups are the increases in the child element of the Child Tax Credit and in the income tax personal allowance respectively.
    • The reforms introduced in January 2011 and those to be introduced in April 2011 will slightly weaken the incentive to work at all, on average. However, those on low to middle earnings without children will see their work incentives strengthen because of the increase in the income tax personal allowance.

    Reed would, and has, of course argued that the policy is badly targeted as an individual policy to help the poor – a point taken from another IFS report. The problem here is that this takes the depressing, and entirely discredited, view that the only way of really helping the poor fairly is for state benefit payments to top up their incomes. Most in the real world realise that welfare on this scale simply doesn’t work.

    By reducing the marginal cost of moving into work for the poorest and by giving those earning just above the current personal allowance a large proportional gain, Nick Clegg continues to be right in stating that raising the personal allowance really does help the poor. The fact that it gives other income tax payers more of their own income to keep at the same time is a happy side effect.

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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