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The Tax-Free Minimum Wage - A Gimmick or a Real Giveaway?

03/07/2015 09:29 BST | Updated 02/07/2016 10:59 BST

Amid the flurry of pre-election pledges made by each party, the Conservatives' 'Tax-Free Minimum Wage' attracted a curious mix of attention. The policy - which will ensure that those working 30 hours a week or fewer on the minimum wage do not pay income tax - received widespread media coverage, but much of it described the policy as having limited impact. It was claimed that it was mostly a repackaging of the existing commitment to increase the personal tax allowance (PTA) - the amount a person can earn before paying income tax - to £12,500 by 2020; hence the charge of gimmickry. But this may well be wide of the mark. Rather than a trivial tweak, the implications of this policy are potentially substantial and could lead to additional tax cuts, which could be announced as early as at next week's Budget.

Those who downplayed the policy's importance pointed out that a person working 30 hours a week on the minimum wage already pays no income tax. Someone on the minimum wage today earns £6.50 an hour (or £10,168 annually) - below the current PTA of £10,600. Similarly, the Prime Minister has stated that the minimum wage is expected to rise to £8 by October 2020. This implies a PTA of £12,515, very similar to the already-announced £12,500 target. Both today and in 2020, the Tax-Free Minimum Wage requires little or no extra spending.

But while it is true that someone working 30 hours on the National Minimum Wage (NMW) currently pays no income tax, 2015-16 is the first year since the introduction of the NMW that this has been the case, as Figure 1 illustrates. A person working 30 hours a week on the NMW in October 2010 would have paid £630 in income tax in today's prices (CPI-adjusted). The Tax-Free Minimum Wage will therefore make permanent a situation which was previously an exception.

Figure 1: The evolving tax burden of a minimum wage worker

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Notes: Effective tax rate calculated for October of each year

And rather than being a policy with effects that will only be felt post-2020, the planned trajectory for the PTA could well be insufficient to keep up with the NMW - bigger tax cuts could soon be required. It was announced in the last Budget that the PTA will rise from £10,600 this year to £10,800 in 2016-17 and £11,000 in 2017-18. Any increases beyond this will require new money.

Whether or not further increases will be required depends on the rate of growth of the NMW. There is uncertainty about how exactly the NMW will grow, so we have modelled both the central scenario of £8 in October 2020 and an alternative in which the NMW grows more quickly and reaches £8.20. Figure 2 shows what both these NMW scenarios would mean for the PTA under the Tax-Free Minimum Wage pledge, versus the planned path.

Focusing first on the steady trajectory to £8 (purple line), the impact is felt from next year onwards. If the NMW was to rise by 3.6 per cent to £6.94, the PTA would have to increase to a minimum of £10,860 to ensure a 30-hour NMW worker paid no tax. That would be only marginally above the planned £10,800 PTA but would still cost a further £0.3billion in 2016-17 in today's prices. The impact of the policy is greater in 2017-18 when a further 3.6% NMW increase to £7.19 would mean a PTA of at least £11,250 is needed. This would mean an additional tax cut of £1.3billion in that year in today's prices. The cost of the policy in subsequent years depends on the pace of the increase in both the PTA and the NMW but this scenario could mean additional further tax cuts cumulatively worth £3 billion over this parliament, i.e. over and above the cost of simply getting to £12,500 in 2020.

Figure 2: Potential trajectories for the PTA under different NMW scenarios

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Notes: All start from the actual PTA of £10,600 in 2015-16. PTA if £8 NMW in 2020 is calculated by multiplying the expected NMW in each year (assuming it rises in equal percentage steps to £8 in October 2020) by 30 hours by 365/7 weeks, as per Tax-Free Minimum Wage law. Budget 2015 stated that the PTA would rise to £10,800 in 2016-17 and £11,000 in 2017-18. The same process is followed for the £8.20 trajectory.

But what if the NMW grows more quickly than expected in coming years? Annual increases of 4.1% towards a NMW of £8.20 in 2020 would mean additional tax cuts of £0.6billion in 2016-17 and £2billion in 2017-18. We shouldn't overlook the potential savings that a higher NMW could bring, too. Although hard to model accurately, HM Treasury analysis last year found that stronger growth in the NMW would be expected to slightly reduce government expenditure on in-work benefits. But we would expect this to offset only a small part of the additional cost.

Those commentators who drew attention to the potentially important consequences of the policy from 2020 onwards were correct to do so. But as we have demonstrated, we should not overlook the sizable impact that the policy will have in this parliament too, with further tax cuts, through a higher PTA, likely to accompany growth in the NMW. Opinion is divided on the merits of increasing the PTA and we have previously highlighted how much of the gains flow to the top half of households. But whether for good or for ill, it will become clear - perhaps from next week's Budget - that the Tax-Free Minimum Wage is more than a gimmick. Which means it is likely to come with a price tag.

Conor D'Arcy is a policy analyst at the Resolution Foundation