Do the poorest really pay the most in tax?

Authors: Stuart Adam and Mike Brewer


The Liberal Democrats have, once again, claimed that the poor pay more of their income in tax than the rich, and that this gap has got larger under Labour. But, by ignoring the fact that the poor get most of this income from the state in benefit and tax credit payments, and by overstating the extent to which indirect taxes are paid by the poor, this comparison is meaningless at best and misleading at worst.

The underlying figures come from the Office for National Statistics, and are not in dispute. As the Liberal Democrats say, in 2007-08, the poorest fifth of households had a gross annual income of £11,105 on average, and paid £4,302 a year in tax, a ratio of 38.7%. Meanwhile, at the other end of the scale, the richest fifth of households had an average gross annual income of £74,247, and paid £25,926 in tax, on average, a ratio of 34.9%. (See Table 1 of this article).

The first key point to note is that benefits and tax credits account for £6,453 of the £11,105 average gross income of the poorest fifth of households. Their original income – in other words, private income from sources such as earnings, private pensions and investments, but not that from benefits and tax credits – was an average of £4,651. So the poorest fifth of households were clearly net beneficiaries from the tax and benefit system, to the tune of £2,151 a year, on average. At the other end of the scale, the richest fifth of households received £1,666 a year in income from the state, and so they are net contributors to the Government’s coffers, to the tune of £24,259 a year, on average.

If we define “net taxes” as “taxes paid less benefits received”, then the net tax rate of the poorest fifth is -46% of their original income (or -32% of their after-tax income), with the negative number reflecting that they are net beneficiaries. At the other end, the richest fifth have a net tax rate of +33% of their original income (or +50% of their after-tax income). These figures show what one would expect: the tax and benefit system as a whole takes money from the rich, and gives it to the poor.

The combined impact of the tax and benefit system on the distribution of income seems much more enlightening than the impact of the tax system alone when talking about fairness. The Liberal Democrats’ analysis does highlight, though, that benefits and tax credits do more to reduce income inequality in the UK than the tax system.

A second difficulty with the numbers relates to the way in which indirect taxes are treated, and this affects whether they appear to be regressive or not. People who are interviewed in the sort of surveys which underpin this analysis, and who report a low current income, tend to spend a lot relative to their current income, and therefore pay a lot of indirect tax relative to their current income. But this arises because the figures are a snapshot view of indirect taxes paid in a given period as a percentage of income in the same period. In reality, much low income is temporary, and people borrow and save to smooth out their living standards; over a lifetime, individuals cannot spend more than their income. As acknowledged by the ONS (see footnote 35 here), we get a different impression of the impact of indirect taxes by ranking people by their level of spending. That shows, for example, that VAT is progressive as a percentage of spending, since zero- and reduced-rated goods (such as food, children’s clothes and domestic fuel) are necessities that are bought disproportionately by the poor. IFS researchers have written more about this issue here, although it must be noted that the ONS analysis suggests VAT is regressive even as a percentage of spending.

What about the Liberal Democrats’ second claim: that the tax system has got less redistributive over time? Following the definition we introduce above, net tax rates on the poorest fifth have gone up since 1997-98, and those on the richest fifth have fallen very slightly (the 1997-98 figures which underpin this calculation are available in Table B here. But the poorest fifth have seen their own private income rise faster than the richest fifth (masking the opposite trend at the very extremes of the income distribution), so this may not be a particularly enlightening comparison: net tax rates should rise as incomes rise under a progressive tax and benefit system.

A more definitive answer is provided by analysis of the impact of Labour’s tax and benefit reforms on the distribution of income, which have been strongly progressive, with the poorest households gaining, on average, and the richest households losing, on average (but with the precise amounts depending on what one considers to be a “change”). It is also clear that these changes acted to dampen down what would otherwise have been a large rise in inequality.

Even on the Liberal Democrats’ peculiar definition, a natural follow-up is to wonder whether the tax system would get any less regressive over time under their policies? IFS researchers will provide a fuller assessment of that after their manifesto has been published. It is reasonably clear that the reforms to capital gains tax and the new mansions tax should increase the tax burden on the rich, but it is less clear that the proposal to increase the income tax personal allowance to £10,000 will help many of the poorest households, as the poorest fifth of households will contain those with incomes too low to pay income tax. (In any given year, one third of adults do not pay income tax and one quarter of adults live in a family where no-one pays income tax). The largest beneficiaries of the higher personal allowance will be families with two earners (where both earn less than £100,000).


Osborne must find reverse gear to drive the UK economy towards recovery

The Faustian pact the coalition made with the Bank of England and the markets has not worked. It’s time to end austerity and use fiscal policy to revive Britain

Faustian pacts are not a good idea. On assuming office in 2010 the coalition entered into a pact with the Bank of England and the financial markets which ranks as one of the most ill-conceived ventures in economic policy by any British government since the second world war.

It was to be deficit reduction – indeed the elimination of the so-called “structural” deficit – by 2015, in return for supportive monetary (including exchange rate) policy from the Bank of England and the enthusiastic backing of the financial markets. The sine qua non as the criterion for success of this policy and pact was to be a marked improvement in the pace of economic recovery.

The chancellor, George Osborne, made a bad start by raising VAT – a £12bn blow to consumer spending, with additional multiplier effects. The economy the incoming government inherited was recovering, albeit slowly. But the combination of the perverse increase in taxation (knocking almost 1% off gross domestic product per annum), and the impact of the austerity programme was sufficient to stop the recovery in its tracks.

This added to the deflationary impact of higher import prices arising from the massive – but necessary – devaluation of the pound in which the Treasury and the Bank of England had acquiesced. Then there have been all the other depressing influences on real incomes of which the governor, Sir Mervyn King, recently complained.

I should emphasise that paradoxically, an increase in energy prices can be inflationary in that it affects the general price level and deflationary in that, via the impact on real incomes, it has a depressing effect on spending power and therefore economic activity. Thus the monetary policy committee can be criticised by purists for not hitting the official inflation target of 2%, yet praised for not taking its brief too literally, and aggravating the depression.

For depression it is: in common with the redoubtable Jonathan Portes of the National Institute of Economic and Social Affairs I have regarded the term depression appropriate to a situation where output continues to remain well below its previous peak, let alone the 15% or so by which it is below what the historical trend would indicate.

In a paper which I recommend to all (“How to Restore Growth and Cut the Deficit, The Policy Consequences of Revived Keynesianism, Lombard Street Research“) the economist Christopher Smallwood reminds us of Keynes’s definition of depression: “a chronic condition of subnormal activity without any marked tendency either towards recovery or towards complete collapse”.

Although things are pretty bad, we have certainly avoided complete collapse – so far! The role of Gordon Brown and others in “saving the world” in 2008-09 was vital in preventing disaster then. Central bankers since had either read or heard about Liaquat Ahamed’s book Lords of Finance about how their predecessors got it so wrong in the 1920s and 1930s. Through quantitative easing – open market operations to offset a private sector credit crunch by easing monetary conditions – the central banks have stopped the rot.

Quantitative easing was urged way back by Keynes in order to lower interest rates. But it was when monetary policy was ineffective – like “pushing on a string” – that Keynes advocated what have come to be known as “Keynesian” policies – the use of fiscal policy (government spending) – to revive activity.

Unfortunately, under the Faustian pact we have witnessed a double whammy: fiscal policy being used to reduce government spending when the economy is already depressed. And a monetary policy that has been pushing on a string.

As Smallwood points out, the Treasury and Bank drew the wrong conclusion from the apparent success of the combination of fiscal contraction and monetary expansion in the 1980s and 1990s. “In both cases, the contractionary impact of tax rises and spending cuts was counterbalanced by substantial falls in interest rates, and of the sterling exchange rate at a time when our export markets were growing,” he writes. Exports and investment took up the slack left by budgetary cuts.

This time there was not much further for interest rates to fall. Indeed, banks were widening their margins and many borrowers did not feel the intended effects. For some, interest rates actually rose. Moreover, despite the more competitive pound, the sluggishness of our main markets prevented an export boom.

George Osborne cannot bear to admit he has been wrong, blames the Bank, and produces a Canadian ex machina in the shape of Mark Carney. And so far from pleasing the financial markets with this austerity programme, he finds they are more concerned about lack of growth, or continuing depression. Indeed the markets showed signs of incipient panic when they learned last week that King himself wanted more quantitative easing at the last meeting of the MPC.

Now, following recent work on the operation of “fiscal multipliers” in the US, Smallwood argues that a switch to a policy of fiscal expansion is the only way out. The multiplier was a discovery of the economist Richard Kahn’s, which Keynes adopted. Normally economists think of additional public spending or tax cuts having “multiplier” effects, as the person or institution in receipt of extra funds spends them in a way that boosts the incomes and spending of others. Similarly, higher investment produces what economists call “accelerator effects”.

But at present we have very damaging negative multiplier effects, in which budget cuts lead to obvious hardship, to further reductions in people’s ready cash and consequent social problems.

Smallwood argues convincingly that fiscal policy needs, selectively, to be put into reverse. “A properly designed fiscal stimulus could restore growth, at the same time generating powerful tax flow-backs from (a) national income (multiplier effects); (b) higher private investment (accelerator effects); and (c) improved long-term growth potential as a result of increased investment.”

There is a huge range of potential infrastructure projects out there. They can pay for themselves. The only way out of this mess is a complete reversal of fiscal policy. It would be seriously ironic if the financial markets ended up punishing this country for the unintended consequences of a Faustian pact that was meant to please them. The ratings agencies have already started.

Osborne’s fiscal policies risks stalling recovery

The new Chancellor of the Exchequer, George Osborne, received a letter from the Governor of the Bank of England Mervyn King today, explaining the latest rise in inflation. Official figures from the Office for National Statistics (ONS) show consumer price inflation increased to 3.7 per cent in April, while retail price inflation rose to 5.3 per cent, its highest rate since July 1991. Consumer price inflation has now been 1 percentage point or more above its target rate of 2 per cent for four consecutive months.


The Governor was able to point to some special factors that have boosted inflation in the UK, including the increase in the standard rate of VAT from 15 per cent to 17.5 per cent in January, record petrol prices and the lingering effects of sterling’s 25 per cent depreciation in 2007-08 (though the last should have just about worked through the system by now).

He also reiterated the Bank’s view, expressed in last week’s Inflation Report, that inflation will fall sharply in the second half of the year. But it is an uncomfortable fact that prices in the UK have been increasing far more rapidly than the Bank, or indeed most other forecasters, expected.

This is important for three reasons.

First, the Chancellor’s plans to make savings of £6 billion in public spending in the current financial year are predicated on the assumption that monetary policy can remain extremely loose well into 2011. If the Monetary Policy Committee thinks inflation expectations are increasing, as a result of high recorded inflation, they may have to rethink the timing of the first moves to reduce quantitative easing or increase interest rates.

If so, the economy could face a simultaneous monetary and fiscal policy squeeze at a time when the recovery remains very fragile.

Second, wage inflation is very low, so high price inflation means real wages are contracting. Unless households are prepared to save less or borrow more – and the Conservatives believe that the opposite is desirable – consumer spending will grow very little, and could contract, in coming quarters.

As a consequence, the economic recovery could fail to pick up momentum and may be at risk of stalling.

Third, Mr Osborne may be contemplating an increase in VAT and/or in other indirect taxes in his ‘emergency Budget’ on June 22. To do so while inflation is already at uncomfortably high levels would be to increase the risk of weaker growth in the short-term and of higher inflation expectations in the medium-term.

Not a good first move as Chancellor.

It is, perhaps, natural for a new Government to want to be seen to be putting its own stamp on economic policy as soon as possible – but the economic situation in the UK is very delicate and argues for extreme caution in coming months; the less that is in the emergency Budget, the better.

Left Foot Forward

How regressive is VAT?

Tim Horton told the Jeremy Vine show – in a discussion with Ruth Lea in which she proposed 50% on luxury yachts from the right – used a very good concise summary of how to get across the point that VAT hits the poorest hardest.
The richest 10% pay one in every 25 pounds of their income in VAT; the poorest 10% pay one in every seven pounds as VAT.

This is “The effects of taxes and benefits on household income” from the Office for National Statistics. (PDF file)

If you look at table 14 (appendix 1), which shows the income, taxes and benefit for all household decile groups. The figures are for 2007-08.

You can see that the bottom decile have an average gross income of £8820, and pay out £1240 in VAT – that is one pound in seven.

You can see that the top decile have an average gross income of £92936, and pay out £3688 in VAT – that is one pound in every twenty-five.

Gross income is the conventional way to look at what is the appropriate tax mix.

If we were to instead take disposable income (after direct taxes have been levied), the poorest 10% are in fact paying a higher proportion (one pound in six) in VAT – an even more striking impact – while the richest 10% are paying one in nineteen pounds. That again shows how the impact of VAT is very regressive.

VAT rises are regressive

The other concern is the impact of VAT increases on poverty and inequality. Compared to raising direct taxes like income tax, increases in indirect taxes like VAT have a much bigger impact on people with low incomes. As the Office for National Statistics has pointed out, direct taxes are progressive; they “contribute to a reduction in inequality”. Indirect taxes, on the other hand:

“Have the opposite effect to direct taxes taking a higher proportion of income from those with lower incomes, that is, they are regressive.”

If we divide the country by income into quintiles (fifths), income tax accounts for 3.2 per cent of the income of the poorest quintile, but 18.4 per cent of the income of the richest. VAT, on the other hand, accounts for 10.8 per cent of the income of the poorest quintile but just 4.5 per cent of the income of the richest.

If there are no measures to balance this impact, an increase in VAT will make inequality worse. It will also deepen poverty – VAT accounts for over 7 per cent of the spending of people in the bottom quintile, with no other source of income than benefits they will have few alternatives to cutting already low levels of spending when prices rise.

The most worrying thing of all is that there has been no mention in any news story of an increase in benefits and tax credits to protect the poorest. The last Conservative government actually froze benefits when it was trying to cut public spending and Robert Chote has warned that the coalition agreement:

Leaves open the option of tougher action to cut social security spending.”

Both parties in the coalition government claimed to be pro-poor in the election. The Liberal Democrats have made this claim longer and more convincingly than the Conservatives, so I suppose the onus of responding to this criticism lies most heavily on them. Will they promise not to cut or freeze benefit rates? And will they commit to increasing benefits and tax credits to compensate for any increase in VAT?