Tax system helps to reduce income inequality, says IFS

The UK’s tax system does help to reduce the gap between the rich and the poor – but benefits do most of the “heavy lifting”, according to the Institute for Fiscal Studies (IFS).

Its analysis found that, like benefits, the tax system has a progressive impact in redistributing wealth from the rich to those who are less well off

Taxes are responsible for at least a fifth of the total redistribution the tax and benefit system achieves, according to the research funded by the Economic and Social Research Council.

Direct taxes such as income tax and national insurance, alongside benefits, help to reduce inequality, according to the findings.

Before redistribution, the highest fifth of people by income on average have an income that is 12 times as large as that of the poorest fifth.

But after adding on cash benefits and deducting direct taxes, this ratio falls to five, the IFS said.

Across the whole population, the IFS calculates 30% of people are in households that receive more in cash benefits than they pay in direct and indirect taxes.

This is the case with 27% of those in working-age households with children; 13% of those in working-age households without children; and two-thirds (66%) of those in households with at least one pensioner.

Despite some taxes having a progressive impact in redistributing wealth, the IFS said council tax is regressive.

Even after accounting for council tax support, which reduces council tax liabilities for low-income families, the poorest tenth of the population pay 8% of their income in council tax, while the richest 40% pay 2% to 3%.

Indirect taxes such as VAT have a more neutral impact, the IFS found.

Overall, 15% of people’s expenditure is accounted for by indirect tax, about two-thirds of which is VAT, with little variation across rich and poor households.

Meanwhile, the impact of other taxes such as capital gains tax, corporation tax and inheritance tax is much harder to measure but is likely to be paid disproportionately by the better off, the IFS said.

Pascale Bourquin, an author of the findings and a research economist at the IFS said: “The tax and benefit system significantly reduces the gap between rich and poor, with benefits playing a particularly big role.

“Council tax is clearly regressive, income tax and NICs (national insurance contributions) are significantly progressive, and we should probably think of indirect taxes as being broadly distributionally neutral.

“But the bigger picture is that what matters for income inequality is the progressivity of the tax and benefit system as a whole, and not a specific part of it.

“The Government should achieve its desired amount of redistribution using those parts of the tax and benefit system best suited to that particular job.”