How did tax credits transform the UK welfare system?

The new tax year marks the end of an era in the UK’s welfare state. Over 20 years since working tax credit (WTC) and child tax credit (CTC) significantly expanded its size and scope, these benefits are now being discontinued, as universal credit finally fully replaces them. In this comment, we briefly review the history of tax credits and how their legacy lives on in the universal credit system. 

What were tax credits?

Personal tax credits, despite the name, were a benefit programme with no connection to the tax system. The introduction of the tax credit system in the UK began in 1999, as the working families’ tax credit (WFTC) replaced family credit as the main in-work benefit. This was substantially more generous for working families with children. Further reform followed in 2003 with the introduction of child tax credit and working tax credit.

CTC was the main means-tested benefit supporting families with children, from 2003 until the roll-out of universal credit. For out-of-work families, or families with incomes below a certain threshold, it included a basic amount payable to all families with children, called the family element and worth £1,000 (here and throughout we refer to cash amounts in today’s prices), and an additional £2,600 for each child, called the child element. When families had gross annual incomes above £24,000, they lost 37p of their child element payments for every additional £1 of income they received (and the family element was withdrawn above a higher threshold). Additional amounts were payable for childcare (where all parents were working at least 16 hours a week) and for very young children. 

WTC was payable to individuals or couples working at least 16 hours per week if they had children, or 30 hours if they did not. This was a notable change from previously: under the WFTC and family credit systems, there had been no support for working people without children. Non-parents who were not disabled needed to be aged at least 25 to qualify. WTC consisted of a basic element of £6,900 a year (single adults without children received less), and additional amounts for working at least 30 hours a week, for childcare costs where all parents were working, for disabilities and for those aged 50 or over entering work. Families with annual gross incomes above a certain threshold (£9,300) then had their entitlement withdrawn at a rate of 37p per additional £1 earned, as with CTC.

Tax credit payments came in addition to a range of other benefits, including housing benefit (supporting renters’ housing costs), income support (to top up the incomes of the poorest families), jobseeker’s allowance (for those seeking work) and several others.

Since the introduction of tax credits, there have been various changes to the above rates, and some other reforms, including the complete removal of the family element for families whose first child was born from 6 April 2017, and removal of the child element for (most) third and subsequent children born from 6 April 2017 – known as the “two-child limit”.

When it was introduced, CTC represented a complete overhaul of the system of support for families with children who were either out of work, or in work but on lower incomes. It replaced a swathe of smaller policies targeting families with children, including the cash support and childcare subsidies delivered under WFTC, and child-related top-ups to a number of other benefits, including income support (the main means-tested benefit for out-of-work families), jobseeker’s allowance, and various retirement, incapacity and bereavement benefits. WTC, meanwhile, further boosted the incomes of many lower-paid working families, as long as they worked the minimum hours per week, with support withdrawn as their earnings increased.

The new tax credits were aimed at tackling poverty – in particular child poverty1 – and improving incentives to work, which we will review later. The government hoped to achieve this in two ways: first, through a substantial increase in the generosity of the system, which crucially benefited both out-of-work and in-work families, and which was further expanded through increases to benefit rates in subsequent years; and second, through how the system was presented and administered – tax credits were not labelled as benefits, and were administered by HM Revenue and Customs (HMRC) rather than the Department for Work and Pensions (DWP).

How did tax credits change family incomes? 

The new system of tax credits increased in-work and out-of-work benefit entitlements, and was particularly focused on families with children. Indeed, out-of-work families without children did not benefit at all. Compared with the 1997–98 level of £10,800, the annual income of an out-of-work lone parent with two children increased to £15,900 in real terms by 2003–04 (an increase of 47%); subsequent increases meant that this number reached £17,600 by 2010–11 (62% higher than in 1997–98). For a lone parent with three children, the increase was even larger.

Since 2010, reforms have pushed in the opposite direction, in the form of various cuts, freezes and below-inflation increases to benefit values. Cuts have been particularly focused on larger families, in part due to the two-child limit. Non-working families with three children have seen the majority of the benefit entitlement increases brought in over the 2000s wiped out, and some even larger families will be worse off now than under the pre-tax-credits system.

But as explained above, working families also benefited from the tax credit reforms. The net (after-tax-and-benefit) income of an example single parent under different systems is shown in Figure 2. It shows that net income for working families with children substantially increased following the tax credit reforms and that this momentum was sustained through the 2000s. For example, a lone parent with two children earning £16,000 per year would have taken home £20,900 in April 1997, £25,300 in April 2003 and £27,600 in April 2010. For this example family without earnings, the levels were lower. For single people without children, the increase in benefits from the new tax credits was much more modest.  

Since 2010, cuts to benefit amounts have partially reversed these increases, with larger reversals for families with more children, as in the case of out-of-work entitlements. For example, the lone parent with two children would only have taken home £25,000 in April 2024, compared with £27,600 in April 2010. In fact, the cuts were larger the lower a family’s income was. Nevertheless, for all but the largest families, the system remains more generous for lower-earning working parents than it would have been had the 1997 system been left in place.

How did tax credits affect work incentives?

Whenever the government sets levels of benefits, it faces two trade-offs. It may want to increase the living standards of recipients, but this comes not only with the cost of paying these benefits, but also the risk of disincentivising (potential) claimants from entering paid work or increasing their hours and pay. The fact that tax credits increased incomes for families in paid work as well as those out of work mitigated, to some extent, effects on incentives to be in work. 

But Figure 2 also shows that the new tax credits system failed to remove some its oddest work incentive effects. It left in place the 100% marginal tax rate induced by the withdrawal of income support for very low earners. This withdrawal induced the flat section in the graph, around which an individual could increase their earnings and see no rise in their net income at all. The tax credits system also maintained big jumps in benefits when working at 16 or 30 hours, meaning people were incentivised to work precisely these hours. These jumps induced the vertical sections in the graph. As we will discuss later, one significant effect of the universal credit system was to eliminate the flat section and smooth out incentive effects more generally.

Figure 3 summarises the effect of the tax and benefit system on work incentives for those in the poorest half of the income distribution (based on the current population), under the tax–benefit systems from April 1997, 2003, 2010 and 2024 (adjusting for inflation, and applying the tax credits system in 2024). It shows two key measures. The marginal tax rate (in the upper panel) shows how much of an extra £1 earned is lost through higher taxes or the withdrawal of means-tested benefits. It summarises how much the system disincentivises those in paid work to increase their hours or pay. The participation tax rate (in the lower panel) shows the amount lost through tax or withdrawal of benefits from working, compared with being out of work entirely. It summarises how much the system disincentivises working at all.2

Increasing in-work benefits (while leaving out-of-work benefits unchanged) tends to increase marginal tax rates, as more workers are subject to means testing, and reduce participation tax rates, as less money is lost when moving into work. Increasing out-of-work benefits will tend to increase participation tax rates. The existing empirical evidence suggests that workers are more responsive to participation tax rates than to marginal tax rates.

Figure 3 shows that the share of workers facing participation tax rates of at least 60% was reduced from 41% to 38%, amongst the poorest half of the population, as a result of tax and benefit reforms from 1997–98 to 2003–04, with increases to in-work and out-of-work entitlements largely offsetting each other. On the other hand, tax cuts and cuts to benefits between 2010–11 and 2024–25 contributed to a substantial decrease in the proportion facing these higher participation tax rates.

The share facing marginal tax rates of at least 60% increased considerably from 1997–98 to 2003–04, with more being brought in scope of means testing due to the big expansion in benefit eligibility. And increases to benefit rates after 2003–04, which extended eligibility further, brought yet more into means testing by 2010–11. Again, cuts to benefits and taxes after 2010–11 brought marginal tax rates down.

Another feature of the tax credits system was that it strengthened households’ incentives to have exactly one adult in paid work – since couples who both worked tended to have earnings too high to be eligible.

The existing evidence suggests that workers respond to changes in incentives from the benefits system. Brewer et al. (2006) found that the introduction of WFTC (the transitional reform between the old system and the new tax credits) led to a small increase in labour supply for fathers in couples (typically taking the family from zero workers to one) and a small decrease for mothers in couples (taking the family from two workers to one). Blundell et al. (2016) showed that lone mothers are particularly responsive to changes to in-work benefit rates.

How did tax credits affect spending? 

Tax credits significantly expanded the size and scope of the benefits system, and this generosity increased over the 2000s as rates were increased. Figure 4 shows real-terms spending on working-age income-related benefits and personal tax credits over time. It shows a sharp increase during this period, from £29.7 billion in 1998–99 (before tax credits were introduced) to £51.1 billion in 2003–04 (the year of the transition to the CTC–WTC system) and to £82.7 billion by 2010–11. This increase partly reflected demographic and economic changes, but primarily the tax credit reforms themselves. For example, the reforms between 1997–98 and 2003–04 served to increase the number of families entitled to at least some tax credits or out-of-work income support by 2.9 million (or 104%, compared with entitlement to income support and family credit under the old system).3 The total value of entitlements to these benefits increased by £68 billion (or 70%, compared with entitlement to income support and family credit under the old system).  After 2010–11, benefits spending started to decline, as various cuts and nominal freezes took effect, before a spike during the pandemic and a gradual rise since then.

How has universal credit reshaped the system?

Universal credit, which began to be rolled out in 2013, replaces six benefits (referred to as ‘legacy benefits’) – CTC and WTC, as well as three out-of-work benefits and housing benefit. The goal was to simplify the system and remove some of the strongest disincentives to work.

Universal credit gives families a standard allowance, with additions for children, rent, incapacity, and caring responsibilities, and then gradually withdraws the overall entitlement as earnings increase. Previously, these different entitlements were paid through different benefits, which were withdrawn simultaneously, sometimes subject to complicated rules on how they interacted. The introduction of universal credit is a comprehensive and far-reaching reform, and an estimated 8 million families will be eligible when it is fully rolled out.

Initially, the roll-out of universal credit was geographic, but from December 2018 almost all new benefits claimants (and those facing a change in circumstances) had to apply to universal credit. In recent months, DWP has ended remaining claims for tax credits and invited claimants to apply for universal credit. Transitional protections mean existing claimants of legacy benefits do not see a fall in their cash entitlement as long as they successfully move across to universal credit. Other legacy benefits – most notably income-based employment and support allowance – will still exist beyond April 2025, but these are all set to be wound up by March 2026. 

Comparing the net income of our example lone parent under the tax credits and universal credit systems, as in Figure 5, it is clear how universal credit has significantly simplified the work incentives faced by workers. The flat region faced by very low earners, where claimants cannot keep any additional earnings they make due to the withdrawal of income support, has been eliminated. Gone too are the sharp increases in income when working at 16 and 30 hours. Instead, entitlements are smoothly tapered away as income increases. However, other cliff edges not shown here remain – for example, due to benefits such as free school meals being “passported” from eligibility to universal credit.

There are also some procedural and administrative differences which will affect the experiences of claimants – and this is aside from the years of technical and administrative difficulties that plagued the roll-out for the first few years. Whilst tax credits were based on expected annual incomes (with overpayments clawed back and underpayments made up later), universal credit is based on actual monthly incomes. This has the advantage that fewer retrospective adjustments are needed, but it also means payments can be subject to volatility – for example, for claimants who are paid every four weeks. Universal credit is administered by DWP, unlike tax credits which were dealt with by HMRC, and will sometimes come with more conditions for claimants – for example, those on low hours and earnings may need to take more steps to increase their hours or earnings as a condition of receipt, and all claimants will need to sign a claimant commitment.

More generally, the transition of universal credit is a story of (sometimes big) winners and losers. The biggest winners tend to include couples with children, households in work and renters. More likely to lose are households with one adult above and one below state pension age, and households with more than £16,000 of assets. Some self-employed people also see big losses from the policy change (though many still gain). 

A changed tax and benefit system

The tax credit system, and subsequent increases to benefit entitlements in the 2000s, significantly boosted benefit income for families with children, reducing child poverty. It was able to do this without drastically harming work incentives by implementing higher benefit entitlements for families in and out of work – meaning that the cost of the benefit system increased substantially. Since 2010, there has been a partial reversal of direction, with benefits for larger families in particular significantly reduced. But the legacy of a larger welfare system, more targeted at children and low-income working families, lives on in universal credit.