What is a tax credit?

The Chancellor loves them, and invents new ones every year. They turn up in your pay packets, and are often quite valuable. They are becoming a key part of the welfare state. But just what are tax credits?

Put simply - and that is a thankless task with what is a hideously complex system - a tax credit is a means-tested amount credited to the net income of wage earners if they meet certain criteria - such as having children or being on a low income.

In his pre-Budget statement this week, Chancellor Gordon Brown signalled that by 2003 tax credits will provide billions of pounds to middle and low income households, with the chief aim of pulling some of the poorest families out of poverty.

Benefits, by comparison with tax credits, are old hat. They are provided by the unloved Department of Social Security, the traditional provider of giro-cheque benefits.

Tax credits, by contrast, are overseen by the Inland Revenue and are channelled through the payroll into employee pay packets. The Treasury says the "behind the scenes payments" reduce the potential for tax credits to stigmatise the recipient.

They also place the administration of the tax largely in the hands of the employer, leaving the Inland Revenue free to carry out checks, and where it suspects fraud, full blown investigations.

The working families tax credit

It has been with us since April 1999 and has added an average £79.58 to the weekly income of 1.26m low paid families.

It is paid to employees who work for at least 16 hours and have at least one child. Currently it provides a minimum income guarantee of £214 a week.

From next April it will provide a guarantee of £227 a week for a family with one child (based on one earner in full-time work, working 35 hours a week and earning the national minimum wage).

Calculating the amount of WFTC due to an employee is not easy, however. If they earn £250 per week, work over 30 hours a week and have three children under 16 it is calculated as follows. First they must find out the maximum due to them.

They receive a basic payment of £54. Add to this a supplement of £11.45 for working over 30 hours. Then there is a boost of £26 for each child, giving a total of £143.45.

The credit is paid at a rate of 55% on each pound earned over £92.90. So £92.90 is deducted from the £250 earnings, leaving £157.10. It is this amount which is subject to the 55% rate, producing a figure of £86.40. The £86.40 is deducted from the £143.45 we said the employee was eligible for and consequently the top up is reduced to £57.05.

The grand total take home pay, after tax and national insurance, is therefore guaranteed to be £307.05. The complexity of the calculation means that it is clear as mud for most beneficiaries.

Every six months workers and their employers must notify the Revenue of their salary. If their pay rises during a six month period then the Revenue can claw back benefit overpayments. It is paid to the higher earner, usually the male parent.

In 2003 the WFTC will be abolished and folded into the child tax credit.

The children's tax credit

It kicked off last April and pays £520 to the higher earning parent. Like the WFTC, the value of children's tax credit tapers off from a point determined by the Treasury. In the case of the children's tax credit the full amount is paid to workers who pay the standard rate of tax.

Once they start paying higher rate tax, usually around £34,000, the credit tapers off and disappears altogether once earnings reach almost £42,000. It will be abolished in 2003 and folded into the child tax credit.

The child tax credit

It will be a "single, seamless system of income-related support for families with children" paid to the main carer, usually the mother from April 2003.

Paid on top of universal child benefit, which goes to all parents regardless of income level, the government says the new tax credit will integrate all means-tested, income-related support for children into one payment.

Previously referred to as the integrated child credit, it will replace the child elements of the working families' tax credit, the disabled person's tax credit and income support or jobseeker's allowance, as well as the children's tax credit.

Details of how the child tax credit will work can be found on the Inland Revenue website (www.inlandrevenue.gov.uk), and rates and thresholds will be set in next year's budget.

The working tax credit

This extends the principle of making work pay to working households without children, says the Treasury. While the unemployment trap has traditionally been of greatest concern to families with children - they lose most benefits when the parents move off benefit into work - the government has found that families without children also suffer.

It has calculated that a workless couple with one child would be nearly £50 better off in work than on benefit, but a couple without any children would see their situation improve by only £20.

But the 1m potential claimants will need to wait until the next Budget in March to find out how much they will receive and April 2003 before it takes effect.