A hammer to crack the work incentive nut

Gordon Brown's declared intention of reducing the starting rate of tax to 15 or even 10 per cent has generally been regarded in the City as an astute piece of political theatre designed to trump the tax card Kenneth Clarke is about to play. But the proposal could give Labour the perfect excuse to finance half the cost by a swipe at the corporate sector.

New Labour's fetching new pose as a low income tax party was intended to be provocative - and so it has turned out. An acrimonious war of words immediately broke out between Labour and the independent think-tank, the Institute for Fiscal Studies, over the relative merits of low tax bands and raising allowances.

Gordon Brown's contention was that a lower starting rate of income tax would be fairer than raising allowances. If combined with benefit changes, it would also be more effective in helping low earners and the unemployed off welfare.

If Labour were really serious about the fairness of the tax system, it would be pinning its colours to a cut in VAT, which is a much more effective way of helping poorer households. It is a sign of the times that Gordon Brown feels compelled to fight the Tories on their own chosen ground of income tax. But is his proposal the fairest way to cut income tax?

The charts below compare two ways of spending pounds 7bn on income tax reductions. The first pays for a cut in the starting rate from 20 to 10 per cent. The second pays for an increase in the tax-free allowance of pounds 1,500, while adjusting the higher rate threshold of taxable income to ensure higher rate payers do not benefit disproportionately.

The charts show that there is little in it. Both are certainly much fairer than using the same pot of cash to make a cut of almost 4p in the basic rate. But if you had to choose the two in terms of equity, you would plump for cutting allowances, since every decile in the poorest 50 per cent of the population does somewhat better.

Labour's case is no stronger when it comes to the question of work incentives. Here, Gordon Brown's argument is that a 10 or 15 per cent starting band of tax would be more effective than lower allowances in moving people off welfare into work, if combined with cuts in the rates at which means- tested benefits are withdrawn as welfare recipients earn money.

At present, for example, family credit is withdrawn at 70p in the pound and housing benefit at 65p in the pound. Since these withdrawal rates, called tapers, are applied to post-tax income, they can have the effect of creating extraordinarily high marginal tax rates, leaving welfare recipients only 3p better off for every extra pound they earn.

So what would happen if these withdrawal rates were reduced by 10 percentage points, taking the taper for family credit down to 60 per cent and that for housing benefit down to 55 per cent?

A further analysis by the IFS showed that more unemployed households would find it more worthwhile to work if this were combined with increased allowances rather than with a 10 per cent lower rate band.

For low earners, it is benefit withdrawal rates rather than income tax rates that matter. A similar reduction in the tapers under the present tax system would leave welfare recipients with 7p in the pocket for an extra pound of earned income. If the cut in the tapers were combined with a new 10 per cent starting rate of income tax, they would end up all of 1p better off, with 8p in the pocket.

According to the Department of Social Security such reductions in the tapers would cost pounds 500m. That's a lot of money, but only a fraction of the estimated pounds 7bn it would cost to replace the 20 per cent tax band with a 10 per cent lower rate.

On any cost-benefit analysis, cutting the lower tax rate band is taking a hammer to crack the nut of work incentives.

Even so, there is one way in which Labour could find about half the money for such a change - by exploiting the new rates to clobber the corporate sector.

Consider the following sequence of events. In the 1992 Budget just before the election, Norman Lamont outsmarts the late John Smith by introducing the new 20 per cent band. A year later, tax-exempt pension funds get a very unwelcome Easter present - the reduction in their tax credit on advance corporation tax rate from 25 to 20 per cent.

A similar reduction in ACT from 20 to 10 per cent would raise almost pounds 3bn, paying for almost half the new lower rate of income tax.

According to Paul Walton, equity analyst at Goldman Sachs, the effect of such a change on the market would be to slash share prices by 7 per cent. Now there's a political uncertainty for the market to brood on in a week in which it hit a new all-time high.