Osborne’s tax changes are regressive (not “progressive”)


Our Guest writers are Howard Reed, of Landman Economics and Tim Horton, Research Director of the Fabian Society

A few months ago we published an analysis of why the Liberal Democrat election manifesto commitment to spend £17 billion raising the income tax personal allowance was not a particularly progressive policy. Contrary to how it has been presented (as something “especially to help those on low incomes”), the measure does nothing to help the millions of families in the UK whose incomes aren’t high enough to pay income tax, and most of the giveaway goes to people further up the income distribution.

That Lib Dem manifesto commitment has now become the coalition government’s aspiration, and George Osborne started to move towards it today with a £1,000 increase in the income tax allowance.

The government is lowering the point at which people start to pay higher rate income tax so that taxpayers currently on the higher rate will not benefit from the policy. But, even so, as green line in the graph below shows, the distributional impact favours middle-income households rather than poorer ones (that is, middle-income households gain a lot more as a proportion of their overall income than poorer ones).


While the income tax cut is estimated to cost about £3.7 billion by the fiscal year 2012-13, it is overshadowed by an increase in VAT from 17.5% to 20%, scheduled for January 2011, which will raise around £13 billion.

VAT is a regressive tax – those on lower incomes pay a larger proportion of their income in tax than those on higher incomes. This is in large part because household expenditure takes up a larger proportion of income for lower-income households than for higher-income ones.

Incredibly, some of the briefing around the budget today suggested that the coalition saw the income tax cut as some kind of compensation for the VAT rise. But, as the graph above shows, that isn’t the case at all.

The blue line shows the combined impact of the income tax cut and the VAT rise using one standard method of calculating the distributional impact of VAT. (Basically, the distributional impacts of VAT are harder to estimate because this depends on the relationship between income and expenditure for each household. This technique uses spending figures and income figures from the UK Expenditure and Food Survey (EFS) and work out the distributional effects of the VAT increase as if it were a reduction in disposable income using EFS income deciles.)

The graph shows that the poorest deciles lose far more from the VAT rise than they will gain from the income tax cut. The graph also shows the impact is extremely regressive across the income distribution, with low-income groups losing out far more proportionately than middle- and higher-income groups.

And some groups will be especially badly hit by the VAT increase – especially those that don’t earn enough to pay income tax: pensioners, the unemployed and parents in low-paid part-time work.

The IFS has suggested that VAT is not as regressive as this, and instead that the impact is proportional to incomes. (This would mean that the impact of VAT is flat across the incomes deciles.) So the red line in the graph above shows the combined impact of the income tax cut and VAT rise using the IFS’ approach. As can be seen, the result is less regressive than before, but still regressive nonetheless. The reality is probably somewhere in between the two approaches.

Whichever one you use, however, it still undermines the coalition’s claim to be creating a fairer tax system. To cut income tax – a progressive tax – at the same time as increasing VAT – a regressive tax – is always going to hit the poorest hardest.

Elsewhere, the budget announced a further range of changes to the tax credits and benefits systems. Some of these, such as higher child payments for the Child Tax Credit, and increases in the Pension Credit, are progressive. But they are not generous enough to completely overturn the regressiveness of the tax package as a whole.

One further aspect of the budget will further exacerbate this regressiveneess over time: the announcement that benefits are to be indexed by the Consumer Price Index (CPI) rather than the Retail Prices Index (CPI). This is regressive in the short run, because the CPI is currently around 1.7 percentage points lower than the RPI. This amounts to a real-terms benefit cut in future years by stealth. The fiscal projections in the budget assume that the government will save almost £6 billion by 2014-15 through uprating by CPI instead of RPI. If this is an accurate estimate, the regressive effects of the uprating change will continue over the whole of this parliament.

Far from being ‘unavoidable’, all these policy changes are discretionary choices. A government committed to fairness could have done so much better.

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  • SadButMadLad

    “Far from being ‘unavoidable’, all these policy changes are discretionary choices. A government committed to fairness could have done so much better.”

    Yep, just like the last goverment did and left the country in such a state that it couldn’t cope with a recession. A goverment that planned ahead would have saved up in the good times in order to pay for the bad times.

    Instead progressive governments just like to spend spend spend because they like to spend other peoples (taxpayers) money. They imagine that spending money on helping young people get temporary jobs like FJF is somehow useful when in actual fact it’s a total waste of money as it causes more harm then benefits.

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  • s chapman

    I have just listened to Will Straw on LBC – what intellectual rubbish.I simply do not undertstand how you can’t comprehend that in the days after the election we faced how the UK was to be governed because of a hung Parliament.The Lib-Dems decided that forming a coalition with the Tories,with all its pitfalls politically and run the risk of loosing some of their core voters,to be part of making decisions and in power was the best way forward for EVERYONE.Therefore all that was said before the election is somewhat irrelevant.You can regurgitate all you like what was said before,but after the decision was made to form a coalition for the good of the country then thats the starting point.
    The budget today was forward looking,incredibly honest and brave and so way overdue.Your left foot fwd supporters here will be using this site for many many years in protest because they won’t be anywhere near Govt.This coalition has legs now and will run and run…..unlucky

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  • mike

    so how will this budget the millionaire cabinet or their millionaire friends

    will Mr Osbourne be on his Yacht in the Med this summer

    Nurses and doctors who have not have huge pay rises now face pay cuts

    Fair

    they dont understand the word

  • Ewan Blackledge

    @SadButMadLad
    Perhaps we should make international comparisons to see how conservative governments were doing during the same period (since you suggest it is only progressive governments who run deficits). We were, in fact, running a deficit which is approximately the same as or less than most of them. Over the years of the Labour government the average deficit was something around 2.5% of GDP, excluding the crisis period. The rules for the Euro Stability and Growth Pact–which almost every country in the Eurozone has violated, including Germany under Merkel’s strongly conservative government–dictate a 3% budget deficit as the limit. So in fact Labour was more fiscally prudent than most all governments in Europe during this period. No large wonder then that the Conservative Party essentially backed every year’s spending plans since 2004, despite rejecting certain individual elements, until after the financial crisis began.

    One of the two countries of the Eurozone not to break the Stability and Growth Pact was Ireland, who maintained a surplus every year. They are now the only country in Europe with a worse budget deficit than us. This perhaps demonstrates to you clearly the extent to which the deficit is linked to structural problems in the UK economy (which also existed to a larger extent in the Irish economy) rather than to Labour’s spending attitudes (which I have, I hope, made clear were substantially more prudent than the majority of European governments including ‘conservative’ ones).

    Admittedly that doesn’t excuse anything and Brown should have held more strongly by his Golden Rule. But I daresay the Tories would not have been substantially more fiscally prudent, with elections to win and European competitors not afraid of deficit spending.

    For your other point, I can only say that it is clear you have not met people who have been involved in a program such as the FJF, and you don’t seem to quite comprehend the problems caused by loss of skills and the stigma attached to long-term unemployment. I wonder if you might like to demonstrate how schemes such as the FJF cause more harm than benefits?

  • mike

    Also
    Please expalin if the Economy was doing so badly
    how come

    Bankers paid themselves record bonuses last year ??????

    Class War

    Governmnet by the Rich for the Rich

  • Fat Bloke on Tour

    Slow burn budget.

    Sounded bad at the time but the detail is positively gruesome.
    Sniffy really is poisoning the well with these figures.
    It will be very difficult to unravel them if required.

    Sniffy really is worse than Thatch79 or 81.
    She always had North Sea Oil in here back pocket to help smooth the shock as it went through the system.
    He is gambling with the whole economy and there is no safety net. Some of the stuff he is pushing through is absolutely shocking, Education will be decimated in cash terms and the Army will need a police escort in the very near future.

    He is gambling with the economy to try and generate a pre-election boom in 14/15. He like Dave the Rave is playing the long game, all the slash and burn now when the media are on honeymoon with the ConDemNation coalition followed by a bit of splash and bribe later on to get the Election party started.

    Everything about the budget is getting maximum pain into the system as early as possible and hoping for the economy to pick up in the last 18 months of the parliament by which time they hope that the electorate will get all “Stockholm Syndrome” with their economic captors. So much for not playing politics with the economic cycle.

    The depth of the cuts is breathtaking, the scope of his ambition is quite astounding, trying to eliminate all of the current structural deficit in one parliament.

    Again the bloated number of the structural deficit now being used to justify quite shocking cuts, 8.8% of GDP with 5.3% being seen as the figure for current spending and all based on a number for the output gap which at 4% seems to defy reality.

    Output gap high = Structural deficit gap low.
    No that just wouldn’t do so after a 6.2% drop in GDP over nearly 2 years, a 10/11% drop set against trend growth. Now we suddenly find ourselves with an output gap of 4%.

    And all signed off by the “Three Brothers Grimm”.

    Consequently Sniffy gets a big number for the structural deficit to frighten the troops.
    He then uses the current portion to generate a target for his small state, dog boiling cuts agenda. Sits back and waits for a pliant media to explain that there is no choice.

    All the while hoping for a stronger than expected bounceback to kick in and save him with a bigger than anticipated giveaway in 2014.

    Well that seems to be his plan.
    I fear we are in for a very tough couple of years.
    GB / AD built the foundations for a recovery, Sniffy has not only sent in a wrecking crew, he has called in the RAF, while they still have planes I might add, to bomb the ruins.

    Shameful, absolutely shameful.
    Totally political from start to finish.
    His economic beard is that he wants to put people on the dole to lower interest rates in the long term.
    He is now worse than a leech doctor.

    What asset bubble will be generated first?
    That will be very good for the upper middle classes who own all the assets.
    Very bad for everyone else as the one potential positive in the mix will have to end quicker than expected.

    I say potential positive because Sniffy and Dave the Rave’s have thought this one up on the back of a fag packet as an economic fig leaf for their all too evident dog boiling agenda.

    Sham, sham, sham.

  • Aled

    Not entirely true. The biggest losers today were the superrich, who effectively lost 13% of their spending power in taxes. As well as anybody who worked within the public sector who didn’t provide a tangible service.

    The education budget will be slashed by 25%, but since 50% of the current pupil fund is wasted on administration before it reaches the schools; you could make the argument that more could be spent on the schools and pupils tailoring their education.

    Alternatively, you’re only really interested in education because you get paid. We all know bureaucrats are more important than schoolchildren right?

  • Sevillista

    FatBloke

    Well said.

    The choice of ‘cyclically adjusted budget deficit’ (something that we cannot actually observe) as the fiscal target measure is interesting. Osborne is able to screw the economy from his cuts aimed to increase the ‘reserve army of labour’ to make the working class more pliant (the minimum wage is not going to last – high unemployment gives a great excuse for abolishment), increase the deficit compared to a more rational and gradual plan and still meet his fiscal target (which is highly sensitive to dodgy accounting assumptions).

    Where are the Lib Dems? They were meant to save us from this ideological insanity

  • Anna PS

    Does the IFS claim that VAT expenditure is proportional to income? If so, please could you link to this claim?

    This IFS report states that the bottom decile of households by income spends roughly 19% of net household income on VAT, while the top decile of households spends roughly half that, at just over 9%: http://www.ifs.org.uk/budgets/gb2009/09chap10.pdf (PDF – see Figure 1, in ‘Myth 2: VAT is a regressive form of taxation’).

    So in fact, VAT is not proportional to household *income* at all – there is a notable spike in VAT for the people with the very lowest incomes.

    The IFS goes on to claim that VAT as a proportion of household *expenditure* is a better method for measuring the impact of VAT, and indeed VAT paid as a proportion of expenditure is fairly constant across income deciles, or even slightly progressive (Figure 2 in the above).

    So, in this report at least, the IFS does not claim that VAT is proportional to household income, but rather to household expenditure.

    [As an aside - Why does the IFS believe that expenditure is a more reasonable measure for calculating the impact of VAT than income? Well, this report states that many people in the bottom decile of income are only there temporarily - e.g. students or those between jobs. Their spending (and thus VAT expenditure) may be relatively high compared to their income, since they do not need to reduce it during their short spell of poverty. While this is clearly true of some people in the bottom decile, it seems unlikely to be true of all of them - the IFS does not provide any analysis, so it's hard to evaluate. Meanwhile, ONS analysis suggests VAT is regressive even as a percentage of expenditure, as the IFS acknowledges here: http://www.ifs.org.uk/publications/4813 ]

    So, calculating by income deciles, the true impact of the VAT rise is always closer to the blue graph than the red graph. A truly bleak picture.

    This is clearly a complex topic, so have I missed something?

    One more thing – the IFS report warns that the Family Expenditure Survey ‘significantly under-records expenditure on VATable goods’ (p. 197), by a factor of around 1.4. Do you use a similar multiplying factor for the UK Expenditure and Food Survey in your blue graph?

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  • http://www.landman-economics.co.uk Howard Reed

    Anna – many thanks for your comments. In terms of the IFS analysis, I think the point they are trying to make is that the UK Expenditure and Food Survey (which is what they use to calculate the distributional impact of VAT changes) doesn’t measure household income very well as it’s based on a snapshot weekly income measure rather than (e.g.) an annual measure. There are a lot of households at the bottom of the EFS income distribution who seem to be spending a lot more than they are receiving in income. There are several possible explanations for this. They could be consuming out of savings, or expenditure could be “lumpy”, or the income measure could be volatile. IFS suggest using expenditure deciles to look at VAT changes because they are closer related to longer run income measures. On expenditure deciles, the impact of VAT is (roughly) proportional. So the idea of the red graph was to show how much difference it makes to the results if we assume a proportional impact of VAT. As it turns out, the tax package as a whole is still regressive even if we do that. And the true impact is likely to be somewhere in between red and blue as you say.

    That’s a really good point on ONS – they do suggest that VAT is regressive even based on expenditure, yes. So no – I don’t think you’ve missed anything.

    We do correct for the under-recording of VAT expenditure in EFS, yes. The figures here multiply up the distributional effects across deciles so that the overall yield from the VAT increase comes in at £13bn.

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  • Gary Vaux

    Sorry but the original authors have made one fundamental error in praising the ‘extra’ child tax credit as progressive. Taken in isolation, it would be, though not to a very great extent. Taken with the other regressive measures on tax credits, it is almost insignificant. Firstly the ‘progressive’ spin being put on it – part of the extra £150 per annum on the child element is simply to compensate for the switch from RPI to CPI, which will cause hardship right through the benefit system. But more importantly, extra CTC payments are counted as income when housing benefit and council tax benefits are calculated so £3 extra CTC per week equates to a £2.55 cut in those two benefits. In addition, the £1000 increase in tax allowances for the lower paid will result in a £200 increase in income per year – but this reduces to £30 per year when loss of HB/CTB is included. The other CTC cuts (loss of family element; withdrawal rate going up to 41% from 39%; loss of right to have CTC recalculated if income falls unless it falls by more than £50 a week) are all regressive, so the overall CTC package is deeply regressive when set in context. They also substantially increase the numbers and range of those paying marginal tax rates (95% or more, based on combined effect of taxation and withdrawal of means-tested benefits) that would make 1970′s rock stars wince!

  • http://pricewagesqueeze.blogspot.co.uk The Squeeze

    “There are a lot of households at the bottom of the EFS income distribution who seem to be spending a lot more than they are receiving in income.”

    Benefit fraud? Cash in hand tax dodges? Selling duty free fags and drugs? Yes there are lots of explanations!

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  • Andrew

    Economists, I would like to know how you take incentive effects into account when analysing these two tax changes. I would have thought that increasing the income tax threshhold provides an incentive to work? How do you take that into account? It seems that your analysis is static rather than dynamic?

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  • Liberal Neil

    I’m struggling to understand the figures. How can a 2.5% increase in VAT possibly decrease any household’s income by 3.5%?

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  • Aled

    I am uncomfortable with this analysis.

    Isn’t the TPA reporting that the budget actually outlined budget increases from £697B this year to £758B in 2015?

  • http://income-tax-calculator.org Income Tax Calculator

    Comments from the financial times have shreadded this idea to pieces

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