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.

Towards a truly progressive tax system

Is the UK’s tax system out of date and no longer fit for purpose?

Many people, including myself, would say it is.

Politicians, though, seem unable or unwilling to address the creaking tax and social security systems.

Here are some, perhaps radical, ideas that could transform the lives of ordinary people. The proposals are unlikely to meet with approval from the very wealthy, from those who receive very high incomes, or from those who otherwise have a stake in the status quo. Nevertheless, here goes:

1. Realised comprehensive income

By adding together an individual’s earned income, their dividend income, their savings income, their property income, their capital gains, and their receipts from legacies, one arrives at an individual’s realised comprehensive income.

Taxing comprehensive income simplifies the tax system and makes it harder to avoid tax because all types of income would be taxed at the same rate. The current system taxes the individual components of comprehensive income at different rates. The current system hence provides incentives for taxpayers to manipulate their affairs so as to take advantage of differential tax rates. For example, under the current system, it is usually advantageous for an individual to take the benefit of a transaction as a capital gain rather than as income. This is because capital gains are generally taxed at a lower rate for individual tax payers.

2.  Increase annual tax free allowance to £100,000

The first £100,000 worth of comprehensive income received in a year would be tax free. Such a move, were it to be implemented, would take most, perhaps as many as 98% of tax payers, out of income tax altogether. Only those with comprehensive incomes above £100,000 would be liable for income tax. Incomes above £100,000 are more likely to be unearned, they deriving from rent extraction activities, holding gains, and luck.  It is unlikely that extremely high incomes result from a commensurate contribution towards the common good. Genuinely earned income, that is income derived from an individual’s contribution to society, is likely to be lower than £100k per year and should therefore escape income tax altogether.

3.  Simplification of income tax

Every income tax payer would have the same marginal rate of tax. This would ensure the average income tax rate rises with comprehensive income.

A formula can be used to determine an individual’s tax rate taking account of their annual comprehensive income. The formula would only be applied to comprehensive incomes above £100,000 p.a.

An example of such a formula is a follows:

0.9 x (Y –  £100k)

where Y = annual comprehensive income, the £100k shown in brackets is the annual tax free allowance and the 0.9 (90%) is the marginal tax rate and the limiting tax rate (i.e., the tax rate will never exceed 90% however large an individual’s comprehensive income may be)

Here is a graph which plots comprehensive income against the applicable average tax rate using the formula shown in blue.

Top tax rates graph

Comments

The graph shows how an individual’s average tax rate is determined by their comprehensive income.  For example, an individual with an annual comprehensive income of £0.4 m would have an average tax rate of just under 70% of that income, (the exact percentage is 67.5%).

An individual with a comprehensive income of £0.1m or less would not pay tax on their comprehensive income at all.

As an individual’s comprehensive income increases the closer their average tax rate approaches the 90% limit. However, no individual, however high their comprehensive income, will have an average tax rate of 90%; but very high comprehensive incomes will come close to the 90% limit.

Taxing comprehensive income this way is consistent with free market principles. Company directors and others who can, and do, effectively set their own pay will continue to be free to do so. Using the proposed formula to assess tax on comprehensive income supports freedom but also enables society to benefit. A high marginal rate may also discourage “superstar” remuneration, and thus may help to address runaway inequality which is becoming increasingly prevalent.

4.   Universal Basic Income

The introduction of a universal basic income would guarantee every adult citizen of the UK an unconditional basic income. This would guarantee every citizen social security. This would obviously need to be funded and a Land Value Tax may provide such a fund. A quick estimate suggests that £208 bn per year would be need to be raised to pay a basic income of £100 per week to 40m adults. This is clearly a lot of money.

The universal basic income would have many benefits. For example, the minimum wage could be abolished. The bargaining power of workers would be be enhanced in wage negotiations with employers. Self-employment, because of the risk reduction impact of a basic income, should mean more workers eschewing employment in favour of self-employment. This would contribute to economic dynamism and creativity. A basic income may permit younger people to stay on at college to acquire skills from which they, employers and society benefit. The benefits of a universal basic income are manifold and, encouragingly, the concept is increasingly finding support from both the left and right ends of the political spectrum.

5.   Land Value Tax

A tax on the value of land is thought by many to be a rich potential stream of taxation income.  It has been suggested that, very approximately, one-third of the value of a house is due to the value of the land the house sits upon.

A land value tax would be an annual charge on land owners. It would be charged as a percentage of the value of land owned. Whether a Land Value Tax would provide sufficient funds to finance a meaningful Universal Basic Income is at the time of writing unknown to this author.

A powerful argument in favour of a Land Value Tax as a means of funding a Universal Basic Income is that it supports justice in distribution. Land is a God-given resource which should be available to everyone to profit from. But the land is owned by private individuals who capture the benefits of land ownership despite having acquired the land by means of dubious morality in the first instance. So it makes sense that landowners should fund a Universal Basic Income to compensate those who are forcibly displaced from the means of subsisting from the land.

Appendix

Tax rates for comprehensive income of up to £8m p.a.

top tax table