Tax credits scheme may be scrapped as ministers launch welfare reforms

The coalition Government will consider dismantling Gordon Brown's flagship £20bn-a-year tax credits scheme for 2.4million households as part of a "big bang" reform of the welfare system. Before the general election, the Conservatives denied that they would scrap the pay packet top-ups, promising only to stop paying them to families with incomes over £50,000 a year.

But a merger of in-work benefits such as tax credits with out-of-work benefits such as Jobseeker's Allowance is being studied by Iain Duncan Smith, the new Work and Pensions Secretary. "It is one of the leading options," said one Government source.

Officials estimate fraud and overpayments in the tax credits system amount to £1.7bn a year and Mr Duncan Smith has ordered a crackdown.

Yesterday HM Revenue & Customs apologised after accidentally sending out private details about thousands of tax credit claimants. Individuals were sent other people's personal information in the post along with their annual award notice. A spokesman said: "An initial analysis shows that ID theft could not result from this printing error."

Ministers believe tax credits are so complex that the public do not understand them. Privately, some senior Labour figures agree – and regret that they never managed to "sell" them to voters. They fear the credits are vulnerable as the Government seeks ways to cut the £156bn public finances deficit.

However, unpicking the scheme may prove controversial. Withdrawing tax credits would be seen as a tax rise for many hard-pressed families and could reduce their incentive to work rather than live on out-of-work benefits – at a time when Mr Duncan Smith has promised a major drive to "make work pay".

Lord Freud, the Minister for Welfare Reform, said yesterday: "The heart of this issue is the separate in and out of work [benefit] structures we have got, which are enormously expensive. There are real savings to be made purely in getting these structures together." As well as savings from "mis-spending", there would be others from reducing running costs.

Mr Duncan Smith said his proposals to streamline the system would "cost nothing like" the £3bn blueprint he drew up at the Centre for Social Justice think tank he launched after being ousted as Tory leader in 2003. He argued that his plans had every chance of saving money. "It is costing now not to make these changes," he said.

He admitted he would have to convince his Cabinet colleagues, saying: "Nothing in life is certain – least of all dealing with the Treasury." He hinted he would step down if the Government did not endorse his ideas. "The purpose of my life here is to improve the quality of life of the worst-off. If somebody tells me I have to do something different, I won't be here any longer," he said.

In his first speech as Work and Pensions Secretary yesterday, Mr Duncan Smith said: "One of the biggest problems is that for too many people work simply does not pay. For some people, the move from welfare into work means they face losing more than 95 pence for every additional £1 they earn. As a result, the poor are being taxed at an effective tax rate that far exceeds the wealthy. We have in effect taken away the reward and left people with the risk. That must and will change."

He promised to review high effective tax rates for lone parents who want to work more than 16 hours a week – also a disincentive to work.

The welfare bill excluding pensions had risen from £28bn at current prices in 1978-79, to £62bn by 1996-97. Today it stood at £87bn, including tax credits, taking the overall bill to £185bn when pensions were added, he said. Some of his own civil servants had told him that the system they ran was "breaking and in need of urgent attention".

The former Tory leader admitted he would have loved to be starting his reforms with a strong economy delivering plenty of job opportunities and money. "Yet perhaps the fact that we are in such a poor state should give extra immediacy to our work. We literally cannot afford to go on like this," he said.

He suggested he would not bring in new benefit cash penalties for jobless people who turned down work or training, but hinted that existing sanctions would be applied more rigorously.

"If we are helping people to get back into work, we also have a right to expect that those we support are ready to take on work if it is offered," he said.

Mr Duncan Smith said voluntary groups and the private sector would play a bigger role in delivering a new single work programme.

What the reforms will mean

What is Iain Duncan Smith proposing?

To simplify the maze of benefits, possibly by merging the 52 separate payments into one, and tackle Britain's "dependency culture".

Don't all ministers promise radical change when they take on the welfare brief?

Mr Duncan Smith believes his Labour predecessors, such as John Hutton and James Purnell, had the right reform ideas but were thwarted by Gordon Brown. Colleagues say "IDS" will be different as he has done a lot of groundwork at his Centre for Social Justice.

Won't any reforms cost money at a time when the Government is trying to cut spending?

It is true such proposals often involve upfront costs and get squashed by the Treasury. But Mr Duncan Smith believes streamlining the system will reduce costs.

Will some people see their benefits cut?

Probably. Governments have often shied away from "big bang" reforms because they would create millions of "losers". But Mr Duncan Smith says the present system is unsustainable. Dismantling tax credits would be controversial. Labour would portray cutbacks as a tax rise for hard-working families, and warn that children would suffer the consequences.

Will the Liberal Democrats support the changes?

Probably. The party believes "middle-class benefits" should be reduced. Its manifesto promised to save £1.3bn on tax credits. But some Liberal Democrats may oppose cuts if they affect the vulnerable.