Information about Working Tax Credit

Working tax credit, or WTC, is a component of the current tax credits system in the United Kingdom - the related component being the Child tax credit, or CTC - which have both been in their current form since April 2003. Previously WTC was combined with CTC in a single payment for low-income family and single-parent households called the Working families tax credit, or WFTC, which operated from April 1999 until March 2003. The WFTC was itself a transitional scheme between the earlier income-replacement benefit for families - the Family Credit, FC (that had operated from 1986) and the tax credits approach, which uses annual income to assess entitlement in a way that mirrors somewhat the completion of an annual tax return.

WTC is available as a non-wasteable tax credit - meaning that the actual payment may exceed and is not limited by the amount of annual tax paid by the claimant. WTC may be claimed by working individuals and childless couples as well as working families with dependent children. WTC and CTC are jointly assessed and families are eligible for CTC even if they do not work or are too rich to be eligible for WTC.

Components of tax credits

Both WTC and CTC are themselves made up of components related to individual circumstances that form the basic amount of tax credit receivable. Every claimant of WTC has an eligibility to a basic element (of £1,620 in 2006/07) to which may be added a couple or lone parent element (£1,595) where applicable. In addition, claimants can receive a 30 hour [working week] element, a disabled worker element (£2165), a severely disabled worker element (£920) and/or a 50+ return-to-work payment (two rates: £1,110 or £1,660) - depending on which secondary characteristic matches their circumstances. These secondary entitlements 'overlap' which means that where two (or more) circumstances apply together such elements will be added to the basic element

A full list of available Tax credit elements and rates can be found at the HMRC website: [1]

Withdrawal of tax credits

Being an income-related payment, a tax credit initially reduces (much like an earned income is reduced by the effect of income tax) under a so-called withdrawal rate as gross annual income exceeds a predetermined first threshold (of £5,220 in 2006/07). In the case of WTC (and also CTC) this first (and main) withdrawal rate for tax credits is 37 percent. This means that for every £1 earned above the £5,220 threshold, 37p of the WTC entitlement is withdrawn. As withdrawal of tax credits is based on their 'gross' and not 'net' income, however, the claimant is actually subject to three simultaneous forms of reduction: Class 1 NIC national insurance contributions at 11 percent, UK income tax at 10 percent (or 22 percent) and the tax credit, itself - at 37 percent – making an effective marginal tax rate of up to 70 percent. This high effective rate of tax falling on the recipients of WTC is an inescapable feature of any scheme whose main purpose is to raise the 'take home pay' of low and modest earners whilst seeking to remain affordable in terms of total public expenditure.

From the financial year 2008/09, the main withdrawal rate will increase from 37 to 39 percent. At the same time the basic rate of income tax reduces from 22 percent to 20 percent. This leaves the effective marginal rate at 70 percent (11 plus 20 plus 39).

Interaction of tax credit components

Under withdrawal, entitlement to WTC is first reduced and finally 'exhausted' at an annual income level which can calculated straightforwardly from the level of the first threshold and knowing the basic amount payable. For a couple, for instance, this would be:

£5,220, plus (£1,620 + £1,595) divided by 37 percent. That is £13,909 in round figures.

Where CTC is claimed, its components similarly combine to form the basic amount payable just like WTC. For a family of two children aged 4 and 7, for instance, this would consist of: a family element (in 2006/07) of £545 and a child element of £1,690 for each child, making a total of £3,925. This basic amount is then subject to withdrawal at the same initial rate - 37 percent - as WTC, but only from a higher, predetermined threshold set just above the point at which WTC would have become exhausted. In the case of CTC for 2006/07, this threshold has been set at £13,910. Tax credit components are thus designed to form an integrated, seamless allowance that is steadily reduced as family income rises. But unlike WTC, CTC does not continue to reduce steadily to nothing. Once CTC has been reduced to the level of family element of £545 (at annual income of £23,045 in this example), it remains fixed there until the household reaches a second income threshold of £50,000. Thereafter it will start to reduce again - but at a much more modest rate of 6.67% (1 in 15). Recipient households of WTC and CTC payments thus fall into two broad categories - those on a main-rate reduction of 70 percent (marginal tax) and those in a wide range of income up to £50,000 in receipt of small flat rate family element only and subject to normal marginal taxation.

Awards and Disregards

Tax credits (both WTC and CTC) for the current year will need to be paid on the previous tax year's gross household income as an interim award, as only this information will be available at the time of application or renewal . As incomes rarely if at all remain the same from one year to the next nearly all 'finalised' awards would need to be adjusted in subsequent years to allow for any change and the result of so many revisions would be undesirable. When first introduced, therefore, broad allowance was made for this (at the price of making the scheme less closely resemble 'true' tax credits) by disregarding the first £2,500 of any increase in the final income from one year to the next. Only changes in excess of this income disregard would need to be taken into account in establishing a final award. Overpayments could be recovered by adjustment over the same period (12 months) in the amount of the following years' interim award. For instance, if a couple in the above example were awarded £2,815 WTC/CTC in 2006/07 based on their income from the previous year (2005/06) of £16,910 but subsequently turned out to have received £21,450 in the current year - a rise of £4,540 - then only £2,040 of that increase would need to be taken into account and lead to a smaller reduction to the following year's award of £754 (£14.50pw).

Tax credits have not proved to be nearly as robust or well administered as the initial design envisaged. Claimants have not always recognised the need to report any change of circumstances immediately. Even when reported, however, the long time required by the system of administration to take such circumstances into account will add to any overpayment generated and shorten the time available for their recovery. One result has been significant levels of overpayments - only a proportion of which have been or may ever prove to be recoverable - even allowing for the scope of the income disregard to ignore changes. Probably in part to reduce significantly the problems of further such overpayments in subsequent years, the income disregard was raised tenfold from £2,500 to £25,000 with effect from 2006/07.

David Blunkett, former Cabinet minister has criticised the system stating, "The tax credit system is a shambles — such a shambles that I've had to help out one of my constituents financially, only the second time that I ever have done this, and the first was for a child.... what else can you do when the tax credit system is such a total mess?"[2]

Assessment of income

Income for tax credit purposes is assessed similarly in principle to the way income for payment of UK income tax would be determined. Thus 'income' (c/f 'taxable income') will consist of what the individual has received by way of gross earned and unearned sources - less certain allowances for 'expenditures' that would reduce that income. Unlike income tax however, the tax credits' measure of income is based on a 'household', which will consist of the pooled resources from both adults in any couple or in any family with dependent children. The distorting presence of the income disregard - to weaken the link between the income of a person (or couple) and what tax credits they may finally receive - cannot be ignored altogether, but to a first approximation the parallel with the operation of a negative income tax remains valid.

By comparison with remaining means tested benefits, of which the tax credits scheme is an example, the income treatment of claimants is especially generous in that it permits them to deduct the full gross amount of any personal pension contributions and any Gift aid payments they may make. Since increases in income (in the initial range) are subject to withdrawal at 37 percent, any offsetting 'reductions' allowed are effectively subject to 'rebate' at the same rate. Thus, whilst a pension (or Giftaid) contribution of £100 would result in direct cost to the employee of £78 after basic rate tax relief, it will attract an additional £37 in total tax credit awarded and so will reduce the direct cost to just £41 instead.

Other concessions with regard to the assessment of income (in contrast to means testing used elsewhere) include:

- Disregarding the first £300 of 'other' income (rent, interest or dividends etc).

- Disregarding any 'other' income deriving from tax-free savings and investments

- Having no explicit limit on capital resources (as it is only income from capital that is declarable) to the making of a claim.

Level of take-up

Around 2 million people do not claim Working Tax Credit or its companion Child Tax Credit, despite there being around 7 million people in the UK entitled to do so. The levels of Tax Credit take-up in the UK have not risen in recent years, despite a recent increase - according to official Treasury figures - of 100,000 (from 2004-05) of children living in households classed as "below the poverty line".

Further information:

For rates of all main UK social security benefits (including WTC and CTC)see:

2006/07:(UK Treasury - Pre-Budget Report, 2005) 2007/08:(UK Treasury - 2007 Budget)