‘Children’s benefits mess’ leaves families facing effective tax rates of 80 to 96 per cent

Growing numbers of families with children will face effective tax rates of at least 80 per cent and up to 96 per cent next year, as two systems for supporting children (Universal Credit and Child Benefit) collide, according to new Resolution Foundation analysis published today (Wednesday).

The separate systems for withdrawing Child Benefit (when one parent is earning over £50,000) and Universal Credit (when the household earns from as little as £4,548 next year) were originally designed to affect two distinct parts of the population.

But a decade-long cash freeze in the £50,000 threshold at which Child Benefit starts to be withdrawn (via the High Income Child Benefit Charge) means that 50,000 families will see their Child Benefit withdrawn at the same time as their Universal Credit (UC) is tapered away next year.

Families on UC often pay high marginal deduction rates. Paying Income Tax and National Insurance contributions, alongside having their UC withdrawn as their earnings rise, results in three million working adults paying effective tax rates of 69 per cent or higher.

Freezing the Child Benefit threshold since 2013 has resulted in 1-in-13 families with children – equivalent to 600,000 families – also facing similarly high tax rates. As Child Benefit is withdrawn on a sliding scale for those earning between £50,000 and £60,000, families where the higher earner earns between £50,270 and £60,000 can face marginal deduction rates of 55 per cent for one child, 63 per cent for two children and 71 per cent for 3 children.

While the vast majority of those on UC are low-income families, it is possible for families to be entitled to UC on earnings above £50,000 if they have high housing costs, or receive help with childcare costs. As a result, an estimated 50,000 families earning between £50,720 and £60,000 are eligible for UC, but are also subject to the High Income Child Benefit Charge.

The collision of these two systems has led to the creation of the highest marginal deduction rates in the UK, at 80 per cent for families with one child, 83 per cent for those with two children, and 87 per cent for three children.

Accounting for student loan repayments and pension contributions, these rates rise even further, to 89 per cent with one child, 93 per cent with two children and 96 per cent with three. A hypothetical earner who falls into this category, with an income of £50,000 and two children, would take home only £800 more if they received a £10,000 pay rise.

These exceptionally high rates are set to affect increasing numbers of families over the next decade, rising from 50,000 in 2022 to around 90,000 by 2030, with a further 250,000 people (who earn between £40,000 and £50,000) at risk of being pulled into these high tax rates if they receive a pay rise.

The Foundation notes that it will become increasingly unsustainable for these two policies to continue in their current format, as rising numbers of families become trapped in a high tax rate which presents a significant disincentive to seek higher earnings.

But fixing this situation also presents significant trade-offs for the Government to wrestle with. Raising or even abolishing the Child Benefit withdrawal threshold is one solution, but could cost the Government up to £4 billion as it would extend eligibility to Child Benefit to high-income families.

Alternatively, the Government could integrate Child Benefit into UC, but this risks cutting crucial support for some lower- and middle-income families who aren’t eligible for UC, and removes what is a relatively secure and easy-to-access income stream for adults who are the main carers of children.

Karl Handscomb, Senior Economist at the Resolution Foundation, said:

“It is not the super-rich that have the highest effective tax rates in the UK, but some families with children. Growing numbers are facing effective tax rates of 80 per cent and above next year, as the UK’s two policies for supporting children collide.

“Freezing the Child Benefit threshold for over a decade has led to marginal tax rates rising to over 55 per cent for 600,000 families. But 50,000 families will face tax rates of between 80 and 96 per cent where they are also seeing their Universal Credit payments reduced with each extra pound they earn. The number of families affected by this double whammy are set to almost double by the end of the decade.

“This ‘children’s benefits mess’ needs cleaning up as it creates huge complexity and disincentives for these workers to seek higher pay. But the Government faces significant challenges in fixing this problem, as the solutions are either expensive, or deal a major blow to families’ finances.”