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The Chancellor must address the Child Benefit cliff-edge effect to 'make work pay'

    The Chancellor George Osborne has, so far, been reluctant to adapt his planned change to Child Benefit for higher rate taxpayers. Households with one earner whose gross income just exceeds the £42,375 threshold will lose the benefit (£1056 for one child per year and then an additional £697 per child thereafter). Households with two earners, whose gross incomes might exceed £84,000, will retain the benefit – leading to many commentators labelling the changes as unfair.

    As others have noted, this unfairness mainly arises because most of our tax system is based around taxing individuals rather than households, or families. The Chancellor therefore might argue that he is being consistent with the tax system. But if the principle underpinning child benefit is that the state should support children, then there’s an argument to suggest this should occur at all levels of income.

    Regardless, less of the coverage so far has been on the effects of the so-called ‘cliff-edge’. The Chancellor has decided to withdraw the benefit completely for those earning above the gross income associated with higher rate taxpayers, rather than means-testing or tapering away. For families with one earner earning just below the higher rate threshold, this means that obtaining a pay rise of £1 to take them into the higher rate threshold might lead to a £1055 fall in net income. Likewise, there will be families with one higher rate taxpayer just inside the threshold who would be better off taking a pay cut or working less.

    Analysis by the IFS in their Green Budget showed that there were around 200,000 families in which the gross income of the adult with the higher income was just below the higher rate threshold, and could find themselves refusing moderate pay rises to avoid the Child Benefit loss and lower net income.

    Furthermore, the charts below show net income against gross income for a range of family scenarios just inside the higher rate threshold.

    • The change would mean families with one child with one higher rate earner earning more than £42,735 are £1056 worse off as a result of the change. Any of these families earning between £42,735 and £44,555 would be made worse off as a result of the change than they would be if they then earned less than the higher rate threshold.

    One child

    • The introduction of the child benefit change mean families with two children with one higher rate earner earning more than £42,735 are £1752 worse off as a result of the change. Any of these families earning between £42,735 and £45,746 would be made worse off as a result of the change than they would be if they earned less than the higher rate threshold.

    Two children

    • Families with three children with one higher rate earner earning more than are £2449 worse off as a result of the change. Any of these families earning between £42,735 and £46,958 would be made worse off as a result of the change than they would be if they earned less.

    Three children

    With families with four children the situation is even worse – with those having to earn above £48,159 before they’d be better off after the change than earning below the household.

    The IFS estimates that this will affect 170,000 families in total. That’s 170,000 families whose primary earner has every incentive to re-arrange his/her tax liabilities or work less because he/she would now be better off below the higher rate tax threshold.

    Furthermore, there will be many families for whom the cost of having a salary cut in terms of foregone net income would be much lower. The IFS again give the example of a two-child household with one earner above the higher rate threshold earning £50,000 who could take a 20% salary cut to £40,000 but only be £4,320 worse off in terms of net income due to the reinstatement of child benefit.

    It’s clear therefore that the Child Benefit change, as proposed, does little to meet the Government’s principle of always making work pay. This looks a bad policy which is being sold on an appealing mantra of the erosion of universal benefits for high earners. In reality, the cliff-edge will mean perverse effective marginal rate rates being introduced to this group of families, at a time when Iain Duncan Smith is desperate to overturn the same problem lower down the income scale.

    It’s also worth noting that these cliff-edge effects will NOT be solved by the proposed increasing of the threshold to £50,000 gross income. All that these would do is shift the perverse incentives further up the income scale.

    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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