Britain's poorest hit by £2.5bn 'stealth tax'

Tax cuts for low and middle-income families in April will be dwarfed by hidden reductions in tax credits, according to a study for The Independent.

The analysis found that the £1bn of tax cuts in April will be outweighed by reductions of more than £2.5bn in the complex tax-credit scheme.

Most of the cuts to credits, which top up the wages of low-income families in work, will take effect from April and could catch families unaware.

The Government's flagship policy of raising income-tax thresholds has been trumpeted by the Liberal Democrats as their main achievement since the Coalition was formed last year – and a major boost for the low-paid.

But the Resolution Foundation think tank, which undertook the study, questions the fairness of the changes.

George Osborne, the Chancellor, increased the personal tax allowance from £6,475 last year to £7,475 in the current financial year, and it will rise to £8,105 in April. Nick Clegg hopes it will reach £10,000 by the next election to fulfil a key pledge in last year's Liberal Democrat manifesto.

But basic-rate taxpayers will gain by a "very small" £41-a-year after the April rise in tax thresholds, according to the think tank – which describes it as "a relatively inefficient way of targeting the low to middle-income group because those on higher incomes also benefit". Most higher-rate taxpayers will also gain £41 a year – although not those on more than £100,000 a year.

The foundation said the biggest winners will be those with middle to high incomes: "Overall, the measure remains regressive in the lower half of the distribution... Not only is the change huge overall; it is not widely understood or known about – being made up of a number of small changes to both the child tax credit and working tax credits."

The study concluded: "Low to middle-income households receive 56 per cent of all tax credits in cash terms – and so will be hit disproportionately."

Although 1.1 million people will be taken out of tax by April, the analysis concluded that family incomes have dropped "dramatically" since the Coalition was formed when inflation and earnings are taken into account. A couple with two children and an income of £40,000 a year will see it fall by 8.9 per cent between 2010-11 and 2012-13, and by 14.5 per cent by 2013-14.

"The scale of that obviously puts in context the very small impact of the personal-allowance increase," said the think tank. It defines low to middle earners as having incomes ranging from £12,000 for a couple with no children to £42,500 a year for a couple with two children.

Mr Osborne is expected to announce a further rise in the tax threshold in his Budget on 21 March. If he raises it to £9,000, basic-rate taxpayers would benefit by a further £128 a year.

Matthew Whittaker, senior economist at the Resolution Foundation, said: "April's personal allowance increase will undoubtedly benefit low-to-middle income workers, but millions of families will find that any gains will be dwarfed by cuts in their tax credits.

"With higher-rate taxpayers also set to gain from the personal allowance increase, the shift from spending on tax credits to reducing income-tax revenues appears an oddly inefficient way for the Government to support the incomes of hard-pressed families."

James Plunkett, secretary to the foundation's Commission on Living Standards, warned: "When it comes to tax credits, 2012 is the year [cuts] bite deepest. That means not just a tough year for low-to-middle income families, but also for the UK economy. With these households currently spending every penny they earn, this money will come straight out of tills on the high street."

A Government spokesman said yesterday: "This report acknowledges that the Government's commitment to raising the personal tax allowance benefits people on low and middle incomes."

Liberal Democrat sources insisted 25 million taxpayers would benefit from the rise in thresholds, while 80 per cent of households with children would see their tax credits rise in line with earnings. Nick Clegg said last week: "The things I regard as important ... are the things we said we'd do on the front page of our manifesto... I would single out lifting more and more people out of paying any income tax altogether."

Tax credit cuts: how they will hit

Couple with two children, dual earners working a total of 42 hours a week
Net annual income 2010-11 £44,798
2013-14 £38,281 (-£6,517)

Single mother with two children working 32.5 hours a week
2010-11 £33,666
2013-14 £28,410 (-£5,256)

Couple with no children, one working full-time, one part-time
2010-11 £17,183
2013-14 £17,406 (+£223)