Does a starting rate of 10% make sense?

An important part of the Labour Party election manifesto was thee Warburton. introduction of a 10% starting rate of income tax. Chancellor Gordon Brown repeated this commitment both in his July Budget and in his November statement, with the only proviso ‘when it is prudent to do so’.

The public finances are now very strong with every expectation of a budget surplus next year, so it is difficult to believe that there will be a better time to honour his commitment. But does a 10% starting rate make economic sense?

The objective is to reduce the poverty trap, encourage people into work and reduce the disincentive to work and earn more. The problem is that a 10% tax rate, although sensible at first sight, is not very effective in practice.

This is because of the interaction with the benefits system. For example, the Institute for Fiscal Studies has recently calculated that 36% of the benefit of a 10% rate would flow to the top 20% income bracket in the UK with only 3% going to the poorest 20%. The problem is many benefits, such as family credit, are reduced by 70p for every pound of income through the tax system. This income is also calculated after tax, so in that bracket 70% of the saving is swallowed up in reduced benefits.

It all depends on whether the chancellor is more concerned about the political benefit of honouring a pre-election pledge, or seriously wants to improve incentives to the less well off. If the objective is to motivate the lower paid in work and those wanting to work, it would be more effective to do so through the benefit system than the tax system.

The other problem is complexity. We have just been through the biggest change to our personal tax system for a generation with the introduction of self-assessment. Despite the best efforts of the Inland Revenue, professional advisers and many tax payers, there were still 900,000 returns outstanding by the 31 January deadline, a reflection of the complexity of the tax system with which tax payers have had to cope.

We already have three rates of income tax: 20%, 23% and 40%. From April 1999, people with dividend income will have to cope with a higher rate tax liability based on 32.5% of the grossed up dividend, simply so that they can be compensated for the reduction in the underlying tax credit to 10%.

If we introduce a 10% starting rate, this adds to the burden. What will happen to pensioners who have saved up carefully for their retirement and receive investment income, on which 20% tax has been withheld? Will they be forced to put in repayment claims to recover the additional tax withheld on their 10% tax band? I fear many will be confused and fail to make the reclaim.

Mike Warburton is national tax partner at Grant Thornton.

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