Analysis: Childcare Tax Credits - Fair and simple solutions

The Conservative party announced at its annual conference that tax credits will be restricted for families earning more than £50,000 if it wins the next General Election.

The Working Tax Credit (WTC), in particular its childcare element, has been a great boost to many working families who would have been unable to work but for the support afforded by the state.

The WTC is paid to certain people in work and on low earnings, while the childcare element - although structurally part of WTC - is paid along with the Child Tax Credit to the main carer of the children.

The childcare element is remarkably generous - 80 per cent of eligible costs, up to costs of £175 a week for one child (giving a maximum payable of £140) and £300 a week for more than one (giving a maximum of £240).

Nevertheless, the tax credits have given rise to difficulties that need to be addressed.

Overpayments

The generous level of support can give rise to correspondingly large overpayments, well beyond the claimant's ability to repay if they make mistakes in calculating their entitlement, or in understanding the complex rules about eligibility. Common causes of overpayments of the childcare element include:

- Claimants receive childcare vouchers from their employers and claim tax credits on the same costs. If someone other than the claimant pays for childcare, then the claimant cannot claim tax credits on them. This is not well understood.

- If a qualifying provider ceases to be 'registered' or 'approved', then the childcare they provide ceases to qualify for tax credits. Providers whose registration is withdrawn may not inform all their customers; it is up to the customer to check with the provider's regulatory body. Again, this is not widely appreciated.

Entitlement

Entitlement has to be calculated by taking an average of eligible costs over a time period, usually of 52 weeks. The Government itself acknowledges that many people are not confident working out averages - which in itself could lead to wrong calculations, hence overpayments (see Tax Credits: Improving delivery and choice, in More Information).

In addition, if childcare costs fluctuate, averaging fails to deliver what is needed when costs are above average - for example, during school holidays.

A third problem is that the strict rules state that claimants must inform HM Revenue & Customs (HMRC) if their average childcare costs drop by more than £10 a week. If claimants struggle to calculate their average costs, it will be equally difficult for them to know when to inform HMRC of any change.

A fourth is that the childcare element is so tightly targeted that if a person ceases to qualify for WTC, they also cease to be eligible for childcare credit. This can disqualify many deserving of support, including people who, while not actually working, may be aiming to find a job, such as a second member of a couple who is studying.

Furthermore, the design of the system is unforgiving of error. If a claimant makes a mistake and HMRC requires them to make a repayment, they may no longer be able to afford to pay for childcare as well, and therefore have to stop work altogether. Extreme hardship can result; indeed, the outcome runs counter to the Government's objective to encourage work and alleviate poverty.

Possible solutions

Any solution to these problems must address situations where childcare support is needed but unavailable under current rules, and the overpayment dilemma.

Couples where one partner studies

There is no support within the childcare element for couples, one of whom is working and the other studying, even if it is to improve their work prospects. Extending childcare support to such couples would seem, to us, in line with the policy objective behind WTC, which is to encourage work.

Couples where one partner is a carer

Likewise, there is no support for couples in which one partner is in work and the other is a carer. The burdens of caring full-time for a disabled child or adult may necessitate other children in the family attending childcare.

Childcare for disabled children can be hard to find and is disproportionately expensive, when it is available. We would, therefore, like the system to increase the eligible percentage of the childcare element from 80 to 100 per cent and to increase the maximum costs eligible for the credit.

Temporary absence abroad

The curious interaction of the childcare element and the tax credits rules can lead to withdrawal of childcare support from couples when one partner goes temporarily abroad (for example, for family reasons) while the other stays home and continues to work. In extreme cases, the partner in the UK has to give up work because they cannot pay for childcare without tax credits.

Informal childcare

There is no childcare support in the UK for parents who prefer to stay home to look after their own children, despite the resulting loss of income from employment. Nor is there support for childcare provided by a family member, unless very restrictive conditions are fulfilled.

Some countries provide support for parents who choose to look after their own children. In the UK, by contrast, the types of support available tend to drive both couples and lone parents towards work and paid childcare provided by non-family members.

Possible solutions to the overpayment problem

Overpayments and underpayments are an essential part of the tax credits structure. It seems sensible, therefore, to find a solution outside tax credits, which would pay the claimant directly as costs are incurred, or pay the childcare provider directly.

This need not compromise the level of support, and overpayments need only arise where the claimant misrepresents or fails to report a material fact.

However, even if childcare remains within tax credits, the worst effects of overpayments can be countered by shielding low-income households from immediate recovery, or by a system of vouchers or electronic payments if it could be delivered without being unduly susceptible to fraud.

Protection against overpayment recovery

One way of protecting more vulnerable claimants would be to put a ceiling on recovering overpayments.

Overpayments would remain on the claimant's account, as it were, but a set of tiered income thresholds would determine when no recovery, partial recovery or full recovery would be made.

This method would not eliminate the overpayment, but it would protect those who could least afford to repay large sums. Also, there would need to be adequate protection against any possible abuse.

Vouchers or electronic payments

A method of payment that, in our view, has merit would be to issue vouchers at the start of the tax year, based on 80 per cent of a forward estimate of childcare costs.

Once issued, the vouchers would be available to claimants to spend on qualifying childcare for the rest of the tax year.

If the estimate at the beginning of the year proved too low, the claimants could apply for more. If it was too high, no overpayment would result, because the money would not be spent until the voucher was presented for payment.

At the start of the next tax year the claimants would again estimate their forthcoming expenditure, and the process would be repeated.

Eligibility would still be linked to the working tax credit; there would be no need to keep track of average expenditure over a cycle; and the overpayment problem would be resolved because however many vouchers were issued, only those presented for payment would be counted.

A scheme of this type would have to be designed carefully to prevent fraud, or the development of a secondary market in vouchers. It would also be necessary to link the issue of vouchers to the claimant's current award levels, in case any part of the childcare award needed to be withdrawn because the claimant's income was too high. Alternatively, the level of award could simply be fixed for a year on the basis of the income of the preceding year.

Conclusion

Tax credits have undoubtedly played a part in increasing work incentives and reducing poverty. The childcare element of WTC has been particularly helpful, sometimes indispensible, to parents who wish to work. But there is room for improvement, both in widening the scope of support offered, and in reducing the fear and the impact of overpayments.

If something like a voucher system were put in place, in which no overpayments would arise because the only childcare costs funded would be those actually incurred, then the money saved could perhaps be applied towards extending support more widely.

The WTC childcare element is a solid foundation on which we hope that the Government's deliberations since the responses it received to last year's consultation will continue to build.

MORE INFORMATION

- The Low Incomes Tax Reform Group (LITRG) is an initiative of the Chartered Institute of Taxation to give a voice to the unrepresented. Visit: www.litrg.org.uk. For commentary see www.litrg.org.uk/help/lowincome/taxcredits.cfm

- Full details of the tax credit system are at: www.hmrc.gov.uk/Taxcredits/

- Tax credits: Improving delivery and choice - a discussion paper (The Modernisation of Britain's Tax and Benefit System, No 12) (HMRC, May 2008) is at www.hm-treasury.gov.uk/d/tax_credits_no12.pdf See para 7.15 for comments on averaging