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The tax trap: why a £70k family isn’t much wealthier than a minimum wage family

18 July 2017

10:15 AM

18 July 2017

10:15 AM

Among the many points of contention that arose during the election was Labour’s declaration that people earning more than £70k would be expected to contribute more in taxes should Jeremy Corbyn become Prime Minister. Fair enough, you might say – £70k is more than double the average wage.

However, it’s not gross income that determines how wealthy you feel – it’s net income, i.e., after tax and benefits have been deducted and added respectively.

Consider two similar families; both have two children and both rent a three-bedroom house in Hackney, North London. In each case, one of the adults works while their partner stays at home. The only difference is that one family has a gross income of £14k (close to minimum wage) while the other has £70k. The lower-earning family qualify for tax credits, housing benefit and child benefit; the higher earning family qualify for no benefits whatsoever. So, how much better off do you suppose this family is than their neighbour?

It turns out that, in this example, the family on minimum wage has fully 75 percent of the net income of the £70k family, as shown in the chart below:

Even if housing benefit is disregarded, the family on minimum wage still has 50 percent of the net income of the £70k family, despite earning only a fifth as much. However, it is unlikely that a family on minimum wage would be able to afford a property in Hackney, so it is far more likely that they will be renting.

In Hackney, the maximum amount of housing benefit for this family is £354.46 per week – almost £18,500pa. If the family were paying a mortgage on their own property, their net income (before mortgage/rent payments) would be a third lower than if they were renting. It is hard to believe that this can have no effect on declining home ownership levels. In London, if you have a family and you are earning less than £60k, you are far better off renting, massively subsidised by the taxpayer.

The reason for this is that any increase in income results in a lower tax credit payment which is then countered by increased housing benefit. This interaction means that the increasing gross earnings from £20k to £60k only increases net income by £7k – only £130 extra per week despite trebling your gross salary.

This was the trap that Iain Duncan Smith was trying to help people escape from with Universal Credit – people must be able to keep more of their incremental earnings. The trouble is that it further widens the gap between those who receive help with their housing and those who don’t. The chart below shows an estimate of how Universal Credit would apply in this situation (exact details for families in Hackney are not yet available).

Many of the problems that the government is wrestling with are visible in this data. Why would a company offer their staff a pay rise when the staff themselves will see little benefit? Why would an employee seek to move to a higher-paying job? Why would an employee increase their productivity? Why is home ownership declining?

There is also the matter of fairness to taxpayers. The family earning £70k will pay the same total amount through taxation as the family earning £14k receive in benefits.

Clearly, whether you think this is fair or not will depend on your political leanings. Even if you don’t think it’s fair, it’s impossible to fix without either slashing benefits or cutting taxes, particularly for high earners, both of which are unthinkable in the current political climate. Equally, though, it’s hard to see how the current system is sustainable. No wonder Theresa May is asking for ideas.

Andrew Willshire is the founder of the strategic analytics consultancy Diametrical Ltd. He tweets at @ajwillshire


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