Negative Income Tax For Dummies

Personal Allowances

The UK income tax system ostensibly gives all income tax payers an identical allowance which exempts the first slice of an individual’s market income from income tax. This exemption is known as the personal allowance and is set by parliament each year. For the current year it stands at £11,500.

Basic Rate (20%) Tax Payers

The personal allowance typically reduces the amount of income tax a basic rate tax payer must pay on their market income by £2,300 pa. However, if a basic rate tax payer’s market income is below £11,500 p.a. they do not receive the full benefit of the annual personal allowance. This is arguably a weakness with the UK’s current income tax arrangements.

Example

Susan earns £10,000 p.a. Her tax-free personal allowance is £11,500 p.a. This means she currently pays no income tax and her disposable income (ignoring her National Insurance Contribution) is £10,000.

Comment

If Susan had no personal allowance she would have paid income tax of £2,000 (£10,000 x 20%).  The personal allowance has saved Susan £2,000. Had Susan earned £11,500 in the year she would have saved £2,300 in income tax. Because she had only £10,000 of income to offset against her personal allowance of £11,500 Susan has £1,500 of unused personal allowance remaining. In the UK personal allowances can not be carried forward to be utilised in following years. Nor can personal allowances normally be transferred  to someone else or be traded –  it’s a case of use or lose.   

Is there a better way of administering income tax whereby surplus personal allowances would not be wasted if they remain unused at the end of a tax year? An answer to this question is “Yes, negative income tax”.

Negative Income Tax

Giving a taxpayer an annual personal allowance of £11,500  costs the government up to £2,300 in lost tax revenue. In Susan’s case, because her market income is below £11,500, the cost to the government of Susan’s personal allowance is £2,000 in lost tax.

Negative income tax departs from the current income tax system by paying out the value of the personal allowance (the tax shield) in cash to each and every qualifying citizen. To  help fund this apparent largesse, income tax would be collected and calculated without reference to personal allowances.

In Susan’s case, income tax of £2,000 would be deducted by her employer and remitted to HMRC. Susan’s net pay from her employer would therefore be £8,000.  Susan, along with all qualifying citizens, would receive from HMRC an annual amount equal to the value of her tax shield (£11,500 x 20%)  The following table summarises:

Tables

At the year end Susan’s income is £300 higher than her gross market income. This £300  is the value of her surplus personal allowance (£1,500 x 20%). So effectively Susan has been allowed to claim back the value of her unused personal allowance as a “refund” from HMRC. 

Cost

In Susan’s case, HMRC has paid out to Susan £300 more than she has paid to HMRC. So HMRC has a deficit while Susan has a surplus. So how will HMRC fund its deficit? 

Firstly, because Susan is on a low income there is a probability that she is on a means tested benefit, such as the dreaded Universal Credit, to augment her low market income. The benefits agency (DWP) may reassess Susan’s financial circumstances and adjust her award to take account of Susan;s additional source of non-market income. So the government may claw back all or part of Susan’s increased income to eliminate its deficit at HMRC.

Secondly, although Susan has a surplus with HMRC, many taxpayers will have a deficit. It is only qualifying citizens with market incomes below £11,500 who will be receiving more from HMRC than they pay in income tax.  Many taxpayers will be paying income tax far in excess of the £2,300 they will be receiving each year from HMRC. Deficits and surpluses would offset  each other

Purposes of Negative Income Tax

Firstly, to make the income tax system fairer. Currently, those with a market income of above £100,000 do not receive a personal allowance. Introducing a non-means tested negative income tax would enable policy makers to restore the tax shield to high income recipients. 

Secondly, to provide an enhancement to low incomes,  albeit a modest one.

Thirdly, to give every qualifying citizen a guaranteed, obligation-free income, although a small one. It should help individuals to better absorb and weather the shocks that humans are heir to, including those shocks administered by DWP.

Unlike Universal Basic Income (UBI), the purpose of NIT is not to replace contingent benefits, although some means’tested benefits may be reduced as a consequence of NIT’s introduction.

Qualifying Criteria

Every natural person of working age AND registered to vote in UK elections should qualify, irrespective of income. Qualifying individuals would include job seekers, students, disability benefit claimants, employees, self-employed persons, stay-at-home parents, rough sleepers, and prisoners (subject to voting rights). People of state pension age would be excluded.

Summary and Conclusions

The aims of the particular NIT scheme discussed are modest. The scheme is specific to the UK’s income tax system. The scheme provides an opportunity to equalise treatment of different income groups in respect of the operation of personal allowances, otherwise referred to as a tax shield. The parameters of the proposed scheme, that is the NIT rate and the size of the personal allowance, are under the control of the UK parliament and can be altered to suit. The scheme shares features of Basic Income, eg, it is obligation-free, it is not means tested, its coverage is universal (subject to fraud safeguards), and it supports active enfranchisement of disengaged voters. It also provides a small cushion against  loss of income and failure of the social security system. Although modest, the benefits would be real and in excess of its costs. 

Appendix 

The impact of Negative Income Tax on higher and additional rate taxpayers

Higher Rate (40%) Taxpayers

 

Example

Stephen has an annual market income of £80,000

Stephen 1

Stephen 2

Stephen would pay £2,300 more under this particular NIT scheme than he does under the current income tax system. This is because HMRC is paying out at 20% x £11,500 while the lost personal allowance brings in 40% x £11,500 to HMRC.  HMRC is in surplus.

 

Additional Rate (45%) Tax Payers

For annual incomes above £150,000 the income tax rate rises to 45% and no personal allowance is available. 

Example

Frances has an annual market income of £170,000

Frances 1

 Frances 2

Frances would pay £2,300 less under this particular NIT scheme. This is because in the current income tax regime taxpayers with market incomes above £100,000 have had their personal allowances completely withdrawn. The receipt of NIT of £2,300 from HMRC consequently would reduce tax payable in cases such as this. 

Image

Basic Income and Welfare

Background

A recent Guardian piece by Declan Gaffney asserts that a Universal Basic Income could not replace the UK’s social security (or welfare) system. The piece can be read here:

http://www.theguardian.com/commentisfree/2015/dec/10/finland-universal-basic-income-ubi-social-security

A basic income that replaced the UK’s social security system would need to be so generous that it would disincentivise the jobless from looking for work. Hence a punitive social security system that relies on sanctions is necessary because otherwise the jobless will not look for work. In short, such a Basic Income would make life too comfortable for the lazy and workshy.

Well perhaps this is true. given Declan’s assumption of a universal and unconditional basic income intended to replace the social security system. Such a basic income would need to be very generous and might well have the effect that Declan fears. A valid  inference of Declan’s fine piece is that Basic Income is a nice idea but infeasible; so let’s keep means tested and contingent benefits. and rely on Universal Credit to provide the right balance between carrot and stick.

Should the idea of Basic Income be abandoned?

Given Declan’s point, that UBI could not, or should not, replace the social security system, is Basic Income simply a nice but impracticable idea?

I agree that it would be too expensive for basic income to replace all social security, at least in the UK’s circumstances. UK housing costs, for example, are far too high and would need to fall massively before a Basic Income could be anywhere near sufficient to cover housing costs. Until such time as the high cost of housing in the UK  is addressed, a system of means tested benefits for housing costs will be needed.

Similarly, the social security system also provides contingent benefits, that is benefits which compensate for disability, unemployment, old age, and child rearing. It would not make sense for a uniform basic income to be set at a level  which covers contingent costs  of minorities – it would be far too expensive. In any case, the National Insurance Fund insures against some of these contingencies via contributions.

So Declan says (and others say) that the current social security system accommodates the variegated needs of the population and that a basic income is unnecessary and inadequate. However, I do not believe Declan’s argument is dispositive.  A modest basic income scheme, that is, one which does not seek to replace all social security benefits, is a practical  and worthwhile option.

Proposal for a modest basic income

A hat tip to Mike Gist (@mgist) who suggested that I calculate the net tax liability at different income levels before and after introduction of a basic income. I have done this analysis for the tax year 2015/2016, assuming an annual personal allowance of £10,600, which, to help fund the scheme, would be scrapped. So post tax income after implementation of basic income and after scrappage of the personal allowance is being compared with post tax income before scrappage of personal allowance. Tax credits have been excluded from the analysis.

The analysis shows that no one, whatever their income level would be left worse off if annual basic income were to be set at £4,240. Below is a graph of the results.

  1. The graph shows that for market incomes of below £45k (approx) tax payers would be better off post tax after abolition of annual personal allowance under basic income of £4,240 p.a.
  2. For incomes between £45k approx and £100k, there is no gain or loss. For incomes over £100k there is a gain which stabilises at £4,240 when income reaches £120k approx.
  3. The gain for incomes over £100k arises because personal allowances are currently restricted or non-existent at this level. Scrapping the annual personal allowance as per the scheme thus causes all income levels to be treated equally with respect to personal allowances.

Basic income simulation

Other points

  1. The analysis shows that the cost of even this modest scheme will exceed the current (pre-scheme) income tax take. To establish the cost of the scheme it is necessary to know how many people will gain how much for all income groups.
  2. A basic income set at £4,240 is sufficient to replace Job Seekers’ Allowance for the unemployed, and Working Tax Credits for those in work. Hence the aggregate spend on JSA and WTC can be deducted from the additional cost calculated in point 1.
  3. The basic income would replace working tax credits without the cliff edges and complexity that the existing system contains.
  4. The graph’s U shape is caused by the kinks in the current income tax schedule, and not by the properties of the basic income scheme itself. The withdrawal rate is a constant 20%. There is thus a strong incentive for workers at lower pay rates to increase their market earnings.
  5. The scheme has been formulated with the same parameters as are used in the existing income tax regime. That is the bands and rates (20%, 40%, and 45%) on which income tax is charged are identical as those which are in current use.
  6. Some of the annual gains of £4,240 accruing to 45% tax payers (those earning more than £150k p.a.), could, if a government had a mind to, be taxed away by raising the rate to 50%.
  7. The scheme should be acceptable to the electorate since there are no losers.

Summary and conclusions

An ambitious basic income scheme, that is, one that seeks to replace all social security benefits, is probably incontrovertibly infeasible.

However, because an ambitious scheme may be infeasible this is not necessarily a good ground for rejecting the concept of Basic Income completely. A modest scheme may be both feasible and worthwhile.

A modest scheme, as outlined above, could replace Job Seekers’ Allowance and Working Tax Credits. Withdrawal rates would be at the basic rate of income tax of 20%.

A need for other social security benefits would continue. Incentives to work could be improved by addressing housing costs which are currently so high that without Housing Benefit support it does not pay people to work.

Replacing Job Seekers’ Allowance and Working Tax Credits with an unconditional basic income removes the threat of starvation (which JSA sanctions represent) as an instrument of government policy.  Starving people is wrong and most people would agree that starvation should not be used by governments as a weapon against civilian populations.

Acknowledgements

@mgist for his suggestion that inspired the analysis

@cjfdillow for his comprehensive descriptions of how basic income works.

All errors are mine.

Appendix:

Calculation of post-tax income 

Appendix Basic Income calculations.png

 

 

 

 

Beware the ideas of IDS

Introduction

I am a proponent of Negative Income Tax (NIT). I am because it can deliver social security via a basic income, because it is simple and cheap to administer, and because it is libertarian.

In this piece, I try to set out why implementing NIT in Britain does not require any radical surgery to the existing income tax system. I also point out that the disincentive effects of NIT are comparatively low. I suggest that the sanctions regime currently in vogue would be inappropriate under a fully developed NIT. I also briefly explain why the cost of implementing NIT, at least at first, is likely to be close to zero.

What is NIT?

It’s a very simple idea. For those individuals whose incomes fall below the personal allowance, the tax authority, instead of charging income tax, makes a reverse payment to top up the individual’s income. One of its original architects, Milton Friedman, thought the payment should be universal,  unconditional and be made without moral judgement. His idea was to replace complex and judgemental social security systems. The logic of income tax automatically and progressively claws back negative income tax payments when an individual’s income exceeds their personal allowance.

How would IDS and his followers view NIT?

Despite the libertarian origins of NIT, the IDS school of thought would seek to bring NIT, were it to be implemented in Britain, within the currently fashionable sanctions regime.  IDS  has already expressed his intention to bring in-work benefits within the sanctions regime. It is hence reasonable to suppose that IDS would wish a NIT system to be conditional and to include it in his beloved sanctions regime too. It is pretty clear from the high level of  coercion embodied in Universal Credit that IDS does not share the libertarian values of NIT.

How would a negative income tax look in Britain?

Surprisingly perhaps, it would look similar to the current income tax system in Britain – most people would notice no change to their income tax charge and to their net pay. Income tax, whether through deductions at source or through end of year self-assessment would operate as now,  without change to method or amount. Only individuals with incomes below the personal allowance would notice any difference.

Only a comparatively simple tweak to HMRC’s software would be needed to implement NIT. NIT would be simple, cheap and low risk to implement. Because radical surgery to the existing system would not be needed, a government should not find practical objections to NIT implementation.

So how would NIT differ from the current income tax system?

At the moment, the first £10,600 of an individual’s annual income is tax free – individuals pay income tax only on their annual income in excess of £10,600. The starting rate of tax for incomes above the £10,600 threshold is 20%. For the purpose of this explanation it is not necessary to consider the higher income tax rates (40% and 45%) as these are unaffected by NIT. In fact, NIT will make no difference to the income tax charge for anyone whose income exceeds £10,600, whether their marginal income tax rate is 20%, 40%, or 45%. Only those whose income is below £10,600 will be affected by NIT.

Example:

Freda’s annual income is £8,000.

Her tax charge under the current system is 20% x (£8,000 – £10,600) = – £520, which, because it is negative, means HMRC will not seek to collect income tax from Freda. So Freda pays no income tax and her post-tax income is £8,000.

In contrast, under NIT the negative result of -£520 produced by her tax computation  would trigger a payment to Freda of £520 from HMRC. Her post tax income would hence be £8,520 (£8,000 + £520). In effect, Freda’s wage is being topped up by the state through the tax system.

NB. 20% x (£8,000 – £10,600) can be written as 20% x £8,000 – 20% x £10,600

So why not stick to tax credits currently operated by HMRC?

The NIT calculation is very simple and should logically be preferred to the complex strictures and administrative expense of the tax credit schemes currently operated by HMRC. A further point is that IDS’s intention is to bring in-work tax credits into the benefits sanction regime via Universal Credit.  This will add further complication to an already over-complicated system.. An NIT could ease the burden on Universal Credit, which is already creaking under the weight of its own complexity. The implementation proposed here is modest and cautious. Over time, increasing confidence would hopefully impel a government to implement NIT comprehensively, perhaps with a view of complete replacement of other social security benefits.

Would a negative income tax have disincentive effects?

IDS et al hold that low income earners are discouraged from increasing their earned incomes because they are in receipt of tax credits and other means tested benefits. Increased use of sanctions (the withdrawal of benefits) has been IDS’s chosen method of countering these putative disincentive effects.  NIT would be perceived by IDS to have disincentive effects given the evidence. IDS et al would thus argue that receipt of NIT should be conditional and subject to sanctions should a recipient be perceived as “free-riding” on the revered tax-payer. IDS is not a libertarian.

The withdrawal rate, (the amount by which the state top-up is reduced for each additional £ of income) is  equal to the 20% starting rate of tax. This is far lower than the 65% withdrawal rate aimed for by Universal Credit. The NIT implementation proposed here thus compares favourably to IDS’s Universal Credit.. This suggests that sanctions should not be necessary to “motivate” NIT recipients to increase their incomes

How much would NIT cost?

Confining NIT (at least to start with) to recipients of market incomes and to pensioners then the answer is not much. This is because their benefits and tax credits would be reduced by the amount equal to the NIT payments received by them. NIT would be payable only where market incomes and pensions fall below £10,600, so many people would not be NIT recipients, The total social security bill and tax take would be identical as between the current arrangements and NIT.

So why implement NIT then?

A modest and cautious implementation has been recommended here so that the costs and risks of failure are low. Over time, more benefits of NIT can be captured. These benefits include

  1. reduced administration costs;
  2. better incentives;
  3. increased flexibility;
  4. a basic income;
  5. simplicity;
  6. reduced benefit costs;
  7. a more constructive role for DWP;  and
  8. less state coercion

Using the tax system to deliver a living wage

In a previous post, I proposed a formula for calculating income tax that would provide for a  negative income tax. I did so because I believe a negative income tax system would be simpler, fairer, more humane, technically more feasible , and cheaper to develop than the current Universal Credit project being rolled out by Her Majesty’s government. A negative income tax would be administered by HMRC and have at its core the following formula for calculating income tax:

T(n) = m∑Y(n) – c∑H(n) – ∑T(n-1)

where

m is the single marginal tax rate;

c is the hourly value of the tax shield

∑Y(n) is the cumulative market income received by the end of period n

∑H(n) is the cumulative hours worked by the end of period n

∑T(n-1) is the cumulative income tax paid by the start of period n.

Comments

The proposed tax system has a single marginal tax rate. The choice of this rate is a political as well as a technical decision (i.e., achieving the desired behavioural effects) An individual’s hourly tax-free pay is given by the grossed-up tax shield (c / m).

In this post, I want to show how a negative income tax system can deliver what many describe as a “living wage”. The figure of £10 / hour has been mooted as a living wage. I shall hence assume this figure for the living wage  in my illustration.

Prologue

In this post, I will incorporate the UK’s national minimum wage (NMW), currently £6.50 per hour, into the model.

I will also use a marginal tax rate of 40%, a tax rate which is both comparable to and competitive with existing UK income tax rates (20%, 40%, and 45%). Hence m has been set to 40% or 0.4 in my illustrations.

I will assume a working week of 35 hours and an individual’s weekly hours will be capped at this level.

I will also show how the model can be used to generate a basic income. I will briefly set out my views on whether a basic income should be conditional or unconditional.

Calculating the tax shield

In this section, I will show how negative income tax can transform the minimum wage of £6.50 / hour into a living wage of £10.00 / hour.  To achieve this, the value of the tax shield (c) must be calculated with reference to the minimum wage and to the living wage of £10.00. The value of the tax shield (c) must be set so that the hourly negative tax payment makes up the difference of £3.50 

Ignoring the summations in the above f ormula (they are not necessary here), we have

T = m x (£6.50) – c = – £3.50

T= 0.4 x £6.50 – c = – £3.50

c = £6.10

The tax formula that transforms the hourly national minimum wage of £6.50 to an hourly living wage of £10 will thus be

T(n) = 0.4 x ∑Y(n) – £6.10 x ∑H(n) – ∑T(n-1)

or on a week 1 basis, the hourly tax charge will be:

T = 0.4 x £6.50 – £6.10

= – £3.50 (negative,  as required)

Illustration

Lenny earns the adult minimum wage. He works 35 hours per week. His pay slip will show:

Market income (35 hours x £6.50/hour)                                       £227.50

Negative income tax  (35 hours x £3.50)                                     £122.50

Take home pay (35 hours x £10 hour)                                         £350.00

 

Lenny now receives £10 per hour.

Incentives

The hourly post-tax income of someone whose market income is £10 would be transformed to £12.10.

T= 0.4 x (£10.00) – £6.10 = – £2.10 (negative)

Hence that individual would take home £10 – (- £2.10) = £12.10 for every hour worked at or below the 35 hour weekly cap on hours. So although the “differentials” between market incomes have narrowed the higher paid worker still receives more per hour than the minimum wage worker.

Tax free allowance

The break-even hourly income with an hourly tax shield of £6.10 and a marginal tax rate of 40% is £15.25. This means a worker with an hourly income of £15.25 will neither pay income tax nor receive a tax payment. This is equivalent to an annual tax free allowance of £27,755 (compared to the current allowance of £10,000 p.a.). Individuals with a a market income of above £15.25 per hour or £27,755 per annum would pay income tax of 40% on the excess.

Basic income

The parameters used in the formula produce an amount 0f £6.10 per hour for those who have no market income. This could be taken to be a basic income payable to anyone whose market income is zero.

T = 0.4 x £0.00 / hour – £6.10 / hour

= – £6.10 per hour (negative)

The issue is whether this fortunate by-product of negative income tax should be conditional or unconditional.

Unconditional basic income

An unconditional basic income would credit every citizen with 35 hours. The basic income would thus be received by every citizen of working age.  The basic income would amount to £213.50 (35 hours x £6.10 per hour).

Hourly income with unconditional basic income and living wage of £10/hour

Hourly income with unconditional basic income and living wage of £10/hour

Conditional basic income

A conditional basic income would credit some groups with 35 hours a week but not others. For example, the disabled, the infirm, and those with caring responsibilities could be credited.  This would automatically trigger a payment at HMRC of £213.50 to individuals falling in these groups. The unemployed would be credited with hours only to the extent of their hourly contributions to society via voluntary work and / or participation in counter hysteresis activities (such as internships, work placements, or work programmes).

Hourly income with a conditional basic income and a living wage of £10/hour

Hourly income with a conditional basic income and a living wage of £10/hour

Conditional or unconditional basic income?

My main concern is that every UK citizen should have access to honest and adequate income. For disadvantaged groups, income accessability, particularly with increased benefit conditionality, can often be an issue.

Provided plentiful opportunities for voluntary work and / or opportunities to engage in counter hysteresis activities are made available to physically and mentally capable individuals without a market income then basic income should be conditional along the lines described above. A reasonably generous income of £213.50 per week would accrue to such individuals if their engagement in these activities was for 35 hours a week. Lesser contributions would be rewarded proportionately.

Summary of the model

Basic income = £6.10 /hour. May be conditional or unconditional. Could replace unemployment benefit.

Minimum wage (statutory)  = £6.50 / hour.

Living wage (assumed) = £10.00 /hour.

Break-even wage = £15.25 /hour.

Marginal tax rate = 40%

Maximum hours of credit = 35

Some final points

The withdrawal rate for someone transiting from unemployment to minimum wage work is about 43% (0.4 x £6.50 / £6.10). This is substantially better than the proposed withdrawal rate of 65% planned for Universal Credit.

However, the withdrawal rate rises as the starting hourly wage rate rises. At a starting rate of £15.25 per hour the withdrawal rate is 100%. It is unlikely that such a high withdrawal rate would be a disincentive to accept work at this wage rate.

It seems likely that a negative income tax designed with the parameters outlined in this post would lead to a lower overall income tax take for the government. Some of this might  be due to a lower marginal tax rate of 40% for top earners compared to their current 45% and because the tax free allowance is more generous than the current £10,000 annual allowance. For this reason, it may be better to use income tax as a means of correcting the inequalities that arise from distortions in the labour market (eg directors effectively setting their own pay) rather than as a means of raising revenue.

Capping the corporation tax deductibility of market incomes to £27,779 per employee (the annual tax free allowance) may also help to mitigate reductions in the income tax take.

The redistribution of income arising from this variant of a negative income tax system is likely to have a stimulative effect on the economy. Poorer workers with a high propensity to consume relative to richer workers should increase demand and hence economic activity.

Self-employment and negative income tax

Introduction

Previously, in “Is Universal Credit the wrong approach?”, I proposed that a thoughtfully designed negative income tax system would be more effective in delivering UC’s stated aims. I believe UC is fundamentally flawed, primarily because it does not address the UK’s low and falling wages. The feasibility of designing incentives to make work pay into UC, in an environment with low and falling wages, may be logically flawed. This doubt exists in addition to the current uncertainty about UC’s technical feasibility. In this post, I set out how negative income tax (NIT), the proposed alternative to UC, would apply to the self-employed.

Recap of the negative income tax proposal

1. Income tax would be assessed on Comprehensive Realised Income (CRI).

2. An individual’s tax-free allowance would be calculated according to the number of hours worked. The value of each hour worked would be £20 and be capped at 40 hours per week (2,080 per year).

3. A single rate of tax would be applied to comprehensive realised income, By way of example, and for philosophical reasons, the single tax rate has been set at 50%,

4. Carers, the disabled, and the infirm would be credited with 40 hours per week by HMRC. This would release  a payment of £800 per week (40 hours x £20/hour) to individuals falling in these categories. Any earnings would not disqualify recipients from this minimum income guarantee. However, earnings would be taxed at the marginal rate of 50%.

5.  Job seekers would be paid according to the hours they work part-time, voluntarily in the charitable sector, and in work placements. These hours would be notified to HMRC by the placement providers using HMRC’s Real Time Information reporting system. Payments would be accordingly triggered at HMRC. The placements would not be compulsory – job seekers would have choice as to the  number of hours and type of work they took on. The role of the DWP would be to find and arrange work placements in cases where the job seeker has been unable to do it for themselves.

6. The self-employed (sole-traders and partners), would be allowed a tax-free allowance equivalent to deemed hours of work. The imputed hours would be capped at 40 hours per week (or 2,080 per year), as for all other cases. The hours worked would be imputed by dividing the tax-adjusted earned profits by the standard value of an hour (£20) and multiplying the result by the marginal tax rate. This arrangement would be necessary since no third party could attest to the number of hours worked.

H(n) = m x Y(n)  ⁄ c

Where

H(n) are the imputed hours for the period (capped at 52 x 40 = 2,080)

Y(n)  is the tax adjusted profit in period n

m is the marginal tax rate (set to 50% in the examples)

c is the standard value of an hour worked (set to £20 in the examples)

Example 1

Stephen enters self-employment at the start of the tax year. His (tax-adjusted) profits for the year come to £10,000. He has no other sources of income.

His imputed hours for the year would be

H(n) = £10,000 x 50% / £20 = 250

Hence Stephen’s tax charge for the year would be 

T(n) = 0.5 x £10,000 – 250 x £20 = £0

Stephen’s disposable income is hence £10,000 because his tax charge is zero. He has used up 250 hours of his annual allowance of 2,080 hours. He could have used the unused allowance to do part-time work and/or voluntary work. His income would have been supplemented had he done this.

Had Stephen also sold his house at a capital gain of £40,000, his income tax computation would be:

 T(n) = 0.5 x £50,000 – 250 x £20 = £20,000

Hence his post-tax comprehensive realised income would be £30,000. He is charged no tax on earned income but is charged 50% on his capital gain (an unearned component of comprehensive realised income)

 

Example 2

Anita enters self-employment at the start of the tax year. Her (tax-adjusted) profit for the year comes to £100,000. She has no other sources of income. Her imputed hours of work in year n are calculated as thus.

 H(n) = £100,000 x 50% / £20 = 2,500

The hours must be capped to 52 weeks x 40 hours per week = 2,080.

Her tax for year n would be:

T(n) = 0.5 x £100,000 – 2,080 x £20 = £8,400

Anita’s disposable income (take home pay) is hence £91,600. Her tax rate is 8.4% on her earned income. 

Had Anita also received rental income (i.e., unearned income) of £10,000 in the same year then her income tax computation would be:

T(n) = 0.5 x £110,000 – 2,080 x £20 = £13,400

Note that the unearned components of comprehensive realised income have again been taxed at a straight 50%. This feature, whereby an individual’s tax-free allowance is calculated on hours worked, assists in aligning the tax system with the “making work pay” agenda that underpins the government’s welfare reforms and UC.

NB. The parameters used in these examples, i.e., a working week capped at 40 hours, a marginal tax rate of 50%. and a standard hour set to £20, produces a tax-free allowance of £83,600 on earned income. This produces low average tax rates on middle earnings and is very generous by current standards. It is intended to incentivise. Of course, the average rate will approach the marginal rate of 50% as incomes rise.

Is Universal Credit the wrong approach?

“Work doesn’t pay” is the oft cited justification for Universal Credit (UC). It’s not clear that rolling up six separate benefits into one single payment will address this  problem, aka the unemployment trap. Wages in the UK are at best static and may have been falling in real terms over the last decade. Coupled with declining real wages has been the almost complete elimination of affordable council housing. Wages nowadays are insufficient to meet private housing rental costs which have soared due to shortages. So yes, it may pay claimants to remain on benefits, particularly Housing Benefit.

An alternative to UC is to integrate the tax system with benefits. Low earners, instead of paying income tax, would instead receive a generous negative tax payment. The incomes of low earners would be enhanced to the extent that they would no longer need benefits just to survive; in short, integrating tax and benefits could give low earners independence. But how can this be achieved? One framework to achieve this is a system of cumulative hourly averaging combined with comprehensive realised income (CRI) subject to a single rate of tax

Cumulative Hourly Averaging – the advantages

  • It rewards work – those who work will pay less tax on their comprehensive realised incomes

  • It can integrate benefits with tax – a generous negative income tax is facilitated

  • It supports flexible labour markets – the incomes of zero hours contract workers will be enhanced and less variable. There should be no need of a minimum wage.

  • It restores or strengthens the contributory principle.

Comprehensive Realised Income – the advantages

  • It addresses inequalities in wealth distribution – wealth transfers and other windfall gains are taxed at the same rate as earned income

  • It overcomes equitable objections to Inheritance Tax – legacies would be taxed according to the recipient’s circumstances and at the same rate as earned income

  • It reduces incentives to avoid tax – a single rate of tax can be applied to all sources of income

Cumulative Hourly Averaging – the Generalised Model

 The tax charge in period n would be calculated with the following formula:

T(n) = m∑Y(n) – c∑H(n) – ∑T(n-1)

where

T(n) = tax charge in period n

∑Y(n) = Cumulative comprehensive realised income received by the end of period n

∑H(n) =Cumulative hours worked by the end of period n

∑T(n-1) = Cumulative tax paid at the start of period n, and so ∑T(n) = T(n) + ∑T(n-1)

m = the marginal tax rate. I have used a single marginal rate of 50% applied to all components of CRI  without preference

c = the value of an hour of work. I have set this to £20 so as to produce a generous negative tax component which encourages work

 The Mechanics

Before illustrating how the tax calculation works, I have set out some parameters which I have used in the examples below. These are:

  • The standard working week has been set to 40 hours per week

  • The standard wage rate (or the value of an hour of work) is £20. Note this is an administrative value and has nothing to do with a minimum wage.

  • There is no minimum wage

  • A flat rate income tax of 50% applies to all components of comprehensive realised income without preferment. This is a limiting rate, meaning no one in work will pay tax at this rate however high their income.

  • Tax free personal allowances depend on cumulative hours worked and are valued at £20 per hour worked.

  • Tax free personal allowances are carried over to succeeding years, unlike the current “use or lose” system

  • No individual’s personal allowance can exceed 48 hours in a week

  • HMRC operates RTI (Real Time Information) so that incomes and changes in circumstances are reported as and when they occur.

 

Example 1

Freda starts work for 30 hours per week at £7 per hour (£210 per week). She has no other sources of income.

T(1) = = 0.5 x £210 – £20 x 30 = – £495

Freda will pay no income tax and instead will receive £495 under the negative tax mechanism. Her disposable income will thus be £210 + £495 = £705.  Not bad for a week’s work !

In the second week, Freda’s tax calculation is as follows:

T(2) = 0.5 x £420 – £20 x 60 – (-£495) = -£495

So again, Freda’s disposable income (take home pay) will be £210 +£495 = £705. Enjoy yourself, Freda. you deserve it! And so it will continue until Freda’s circumstances change.

Example 2

George starts work as a director of a large company. His monthly remuneration package comes to £60,000. His monthly hours of work are restricted to 208. He has no other sources of income

T(1) = 0.5 x £60,000 – £20 x 208 = £25,840

So George’s disposable income will be £60,000 – £25,840 = £34,160.

T(2) = 0.5 x £120,000 – £20 x 416 – £25,840 = £25,840

So long as George’s circumstances don’t change his monthly disposable income will remain at £34,160.

 

Example 3

Mark Anthony is a notorious playboy who has never done a day’s work in his life. His very rich father bequeaths Mark Anthony £500,000 in his  will. Mark’s tax liability will be:

T(1) = 0.5 x £500,000 – £20 x 0 = £250,000

In the second  period, Mark Anthony decides to do some voluntary work. He registers 30 hours with HMRC.

T(2) = 0.5 x £500,000 – £20 x 30 – £250,000 = – £600

Mark Anthony is rewarded for his voluntary work to the tune of £600 via the negative income tax mechanism. Work pays! Even unpaid work.

 

Example 4

Lois has a severe disability that limits the amount of work she can do in a week to 10 hours. She is paid £3 per hour (there is no minimum wage). HMRC credits Lois with 30 additional hours per week to compensate her for the hours she is unable to work through no fault of her own. She has no other sources of income. In week 1 her tax will be calculated thus:

T(1) = 0.5 x £30 – £20 x 40 = – 785

So Lois’s disposable income in week 1 will be £30 + £785 = £815. This is an example of how institutions can be used to compensate disadvantage.

In week 2, Lois receives a pay rise of £2 per hour to £5 per hour. Her tax calculation in week 2 will be

T(2) = 0.5 x £80 – £20 x 80 – (-785) = -£775

Lois’s disposable income in week 2 has risen to £50 + £775 = £825.  A pay rise of £20 per week has resulted in Lois’s disposable income increasing by £10 and the state subsidy falling by an equivalent amount.

Example 5

Tony is a homeless alcoholic, without work or income. He is offered 40 hourly work credits per week which will trigger weekly payments of £800 via the negative income tax mechanism provided he undergoes treatment for his alcoholism at a residential clinic. In Tony’s case, the  weekly payments are paid directly to the clinic instead of to Tony, Tony will need to price himself into employment when his treatment is completed, a task made easier absent a minimum wage.

Information requirements

HMRC will need to keep an up-to-date record of every taxpayer/claimant and changes in their circumstances. This is not as onerous or as intrusive as might at first appear; RTI, which requires employers to submit details of employee  hours and pay in “real time”,  has already been introduced. The road has already been dug.

 Here is a logical record of the information and processing that HMRC would need to collect and process for an employee. The particular employee shown in the record has had a particularly turbulent time, starting as a highly paid director, becoming unemployed, suffering disability, inheriting a sizeable estate, etc, all in six weeks!. The record is not intended to be of a typical employee but is illustrative of how income tax would work under cumulative hourly averaging with CRI .

Table of events

Conclusion

One thing writing this post has taught me is how difficult it is to design a safety net which both protects and incentivises.  A safety net  which is too generous removes incentives to return to, or to get into, work. A safety net built around stick and no carrot is cruel and damaging to individuals. I fear that Universal Credit, with its vicious sanctions regime and its heartless treatment of the sick and disabled, falls into this latter category. I venture to suggest that the negative income system outlined above, albeit with its fault lines, would be more effective than the proposed UC project should the latter ever go live. The system outlined above is certainly kinder than UC. Having said this, it may be that the proponents of Unconditional Basic Income win the day – UBI sidesteps the tension between incentive and protection. Perhaps this is the way to go.

Acknowledgement

It would be remiss of me not to acknowledge the brilliant work of Douglas Bamford in the field of taxation and philosophy. Douglas very kindly gave me sight of his then forthcoming book in advance of its publication. His ideas on cumulative hourly averaging have very obviously informed this piece, as has his idea of using comprehensive income as a tax base. His book is entitled Rethinking Taxation – An Introduction to Hourly Averaging. ISBN 9781907720918.

Any errors or sub-standard work contained in this piece are mine, and mine alone.

Addendum 2 September 2014

1. Quite rightly, it has been pointed out to me that the negative tax proposal outlined above does not say much about unemployment support. To answer this, I suggest work placements should be available for all jobless people, which they can choose to take up. There should be no compulsion as to participation or as to the type of placement. If a jobless person can arrange a placement of their choice, say in a museum, then so be it. The only requirement would be the readiness and agreement  for the placement provider to submit the hours worked to the HMRC as registered hours. The registration of hours worked each week under RTI reporting would then trigger a payment via the negative income tax mechanism to the worker in the same way as for other employees.

2. People who have caring responsibilities, either for children or for aged parents, should receive hourly credits equal to the standard working week  (40 hours according to the parameters used in my examples).

3. Profits on the sale of houses, even if a house in question is a Principal Private Residence (PPR), should be brought into the Taxable Comprehensive Realised Income calculation. Currently, the gain on sale of a PPR is exempt from taxation.

Analysis of JSA sanctions in Birmingham and Solihull

Are sanctions being applied consistently?

On 6 November 2013, DWP published sanctions counts by job centre. As far as I aware, this is a new data series – prior to this sanctions counts were not published, still less at the atomic level of individual job centres. Moreover, the published sanction counts are in time series for each job centre, and this too is helpful in building a picture.

At about the same time, perhaps coincidentally, Roger Godsiff, MP for Birmingham Hall Green, sponsored a parliamentary Early Day Motion to reflect his concern that sanctions are being over-used by the Sparkhill job centre, one of two job centres situated in his constituency. It may be relevant that the other Hall Green job centre, Kings Heath, is the origin of the Caitt Reilly case, where the courts found that insufficient decision-relevant information had been provided to her and other claimants.

Given this, it seemed worthwhile to conduct a comparative numeric analysis of the newly published data for each of the relevant parliamentary constituencies comprising Birmingham & Solihull.  Eleven of these constituencies have job centres and hence are relevant to the study.

By matching the JSA sanction counts published by DWP with the JSA claimant counts published by ONS, the sanction rates for the eleven parliamentary constituencies were computed for the months Nov 2012 to June 2013. This is as much as the new DWP data series permits at the current time. October 2012 was excluded because it is an incomplete month.

A national sanction rate for the country as a whole was also computed, so that sanction rates for each of the constituencies forming the study could be compared, the national sanction rate being the comparator. The ONS claimant count imposed a limitation in achieving this purpose because, prior to February, a claimant count for Great Britain, as distinct from the United Kingdom, is not provided. The Great Britain claimant count is needed because the DWP sanction count is only given for Great Britain. Thus matching the national sanctions count to the national claimant count is only possible for the months Feb 2013 to June 2013 where both series are provided in aggregate for Great Britain.

The graphs below show the results of this study.

Sanctions rates for Birmingham and Solihull parliamentary constituencies having job centres

Sanctions rate data 1

Sanctions rate data 2

Sanctions rate data 3

What do the graphs show?

With the exception of Selly Oak, the local sanction rates depart significantly from the national sanctions rate.

The local sanctions rate of Birmingham Hall Green and of Solihull appear to be particularly high for all of the five months Feb to June when compared to the national sanction rate. There may be valid reasons for this apparent over-sanctioning but to date a valid reason has not been identified. This has led to speculation that individual job centres are pursuing their own, or locally determined, sanctioning targets.

An alternative reason for the apparent over-sanctioning may be demographic. Younger claimants may attract sanctions more easily and frequently than older claimants. However, this is speculation. The age profiles of claimants in these two constituencies have not yet been ascertained still less compared to the national age profile of claimants.

The departures from the national sanction rate are statistically significant (ie more than 2 standard deviations away from the expected counts) for all constituencies, save for Selly Oak.

Appendix: Source data

Appendix 1 Sanctions Appendix 2 Sanctions