Deduct only each person's own tax and NI on earnings from UC earned income

[MaxGhenis]

Summary

uc_earned_income subtracted benunit_tax from the benefit unit's gross earnings. That is income tax and NI summed over every member, on all their income. So a claimant's tax on their own dividends, property or pensions came off their earnings, and any tax beyond a member's own earnings came off their partner's. The taper then bit less and UC was overstated.

UC Regs 2013 reg 55(5)(b) and reg 57(2) step 3 deduct only tax and NI paid by the person "in respect of" their employment or trade. This PR deducts, per person:

• their own income tax on their earnings;
• their Class 1 employee, Class 2 and Class 4 NI;
• their own pension contributions.

The work allowance then comes off the combined earnings, and the taper applies.

The #1942 counterexample: a couple in 2026, a pensioner aged 70 with State Pension £16,000 and a partner aged 45 earning £13,000, council rent £20,000. UC goes from £5,297.16 to £4,919.86, the legal figure.

On the Enhanced FRS the change cuts 2026 UC by £0.487bn against current main, from 258k benefit units (176 records), with no gainers. 90% of that is tax on dividends, and 17 records with over £50,000 of dividends carry £0.396bn of it. About 45% (£0.219bn) is one member's tax no longer coming off their partner's earnings. Those units get UC at all only because of a separate capital-modelling problem (#1948).

#1943 (State Pension as UC unearned income), which this was stacked on, has merged. Fixes #1942.

Law (legislation.gov.uk, read 2026-09-30 from /data.xml)

UC Regs 2013 reg 55(5) (https://www.legislation.gov.uk/uksi/2013/376/regulation/55):

In calculating the amount of a person's employed earnings in respect of an assessment period, there are to be deducted from the amount of general earnings or benefits specified in paragraphs (2) to (4)— (a) any relievable pension contributions made by the person in that period; (b) any amounts paid by the person in that period in respect of the employment by way of income tax or primary Class 1 contributions under section 6(1) of the Contributions and Benefits Act; ...

UC Regs 2013 reg 57(2) step 3 (https://www.legislation.gov.uk/uksi/2013/376/regulation/57):

Deduct from the amount resulting from step 1 or (if applicable) step 2 any payment made by the person to HMRC in the assessment period by way of national insurance contributions or income tax in respect of any trade, profession or vocation carried on by the person. If the amount resulting from steps 1 to 3 is nil or a negative amount, the amount of the person's self-employed earnings in respect of the assessment period is nil ...

Reg 22(1)(b) then tapers "their combined earned income" above the work allowance. So:

• Per person. Each person's deductions come off their own earnings only. A partner with no earnings has nothing for their tax to come off.
• Only in respect of the employment or trade.
  • Deductible: employee Class 1 (reg 55(5)(b) names "primary Class 1"), and Class 2 and Class 4 on the trade.
  • Not deductible: voluntary Class 3; the High Income Child Benefit Charge; the pension annual allowance charge.
  • ADM H5004: "All retirement pension income should be taken fully into account for UC; there are no comparable deductions for Income Tax and NI in UC."

Which part of a person's income tax is "in respect of" their earnings

When one person has both earnings and other taxable income, the law does not say how to split their tax.

• Neither the regulations nor the ADM give an apportionment rule, and no tribunal decision on it was found.
• In practice DWP takes employees' figures from RTI (reg 61(2)). ADM H3170 paraphrases the deduction as income tax and Class 1 "deducted or paid in that assessment period", without "in respect of the employment".
• HMRC usually collects tax on a working pensioner's State Pension through their employer's PAYE ("Your employer will usually take any tax you owe off your earnings, including any tax you owe on your pension", GOV.UK). So the RTI figure can include it: it behaves like earnings as the top slice, or more under a K code. LITRG (a secondary source) says DWP deducts any tax paid in practice.
• Reg 61(3)(b) lets DWP depart from RTI where it "fails to reflect the definition of employed earnings in regulation 55", but no ADM paragraph tells decision makers to strip out tax on other income.
• ADM H5004 treats pension income as gross ("there are no comparable deductions for Income Tax and NI in UC"). So any tax a rule attributes to pensions is deducted nowhere.

This PR follows the statutory words. It takes earnings as the lowest slice of the person's non-savings income, after the allowances they actually have (uc_income_tax_on_earnings):

• Savings and dividends sit above earnings and other non-savings income. ITA 2007 s.16 makes them "the highest part" of income, apart from the items s.1012 ranks above them, such as some termination payments. It does so for income tax purposes; UC is not one, so for UC this is an analogy.
• Property income sits above earnings. This is how the engine already stacks it. From 2027-28, Finance Act 2026 s.6 adds ITA s.16A, which places property income "immediately before the savings income", and s.25(3A), which sets allowances against other income first.
• Other non-savings income sits above earnings. That covers pensions, State Pension and taxable benefits. ITA 2007 fixes no order among these.
• The legacy notional-tax rules also tax earnings alone. HB Regs 2006 reg 39, IS reg 39 and JSA reg 102 take earnings less the claimant's personal allowance, at the basic rate. UC keeps that approach only for wholly notional earnings (ADM H3271-H3272).

The rule makes one invariant exact: unearned income never changes a person's deductions unless it changes their allowances (the personal allowance taper above £100,000, or Marriage Allowance). Tax reductions such as the married couple's allowance come off the tax on earnings first, as allowances do, so they keep the invariant. The property tests check this, including for working pensioners with a married couple's allowance. Tax refunds are an exception in law: reg 55(4A) counts a whole repayment as employed earnings, even tax on other income. The model does not model refunds.

For working pensioners whose State Pension is coded against their job, this deducts less than DWP probably does in practice.

The alternative is earnings as the top slice of non-savings, non-property income (rule C), which is closer to RTI when HMRC codes out a State Pension. In this model rule C never deducts less tax than this rule: its earnings slice is at least as wide and sits higher, and the marginal rates never fall. The runs agree, with no unit getting less UC under rule C. As a sensitivity, a real run of rule C cuts 2026 UC by £0.468bn instead of £0.487bn. The issue's own sketch, "tax on all income minus tax without earnings", would not fix a single claimant whose other income is within the personal allowance. For example, with £20,000 of earnings and £5,000 of property income it deducts the whole £2,286, the same as the bug.

Change

• uc_income_tax_on_earnings (new, Person):
  • taxes the bottom slice of earned_taxable_income that earnings occupy, reading the incomes outside that base from gov.hmrc.income_tax.earned_taxable_income_exclusions, so a reform that changes the list is followed;
  • uses the rUK or Scottish schedule, as earned_income_tax does;
  • takes tax reductions (gov.hmrc.income_tax.income_tax_subtractions) off that tax first, floored at nil, so it never exceeds the person's tax and never includes the High Income Child Benefit Charge or the pension annual allowance charge.
• uc_national_insurance_on_earnings (new, Person): ni_class_1_employee + ni_class_2 + ni_class_4.
• uc_individual_earned_income (new, Person): uc_mif_capped_earned_income less the person's own relievable pension contributions (none after 75: Finance Act 2004 s.188(3)(a)), tax and NI, floored at nil.
• uc_earned_income: the sum of uc_individual_earned_income over the unit, less uc_work_allowance, floored at nil.
• The UC docs page describes the deductions.

benunit_tax is no longer used by UC. It stays as a variable.

Household results (hand-computed, in uc_earnings_deductions.yaml)

Case (2026)	Deducted tax	UC before	UC after
Mixed-age couple from #1942	partner's £86 + £34.40 NI, not the pensioner's £686	£5,297.16	£4,919.86
Single parent, earnings £20,000 + property £5,000, council rent £9,600	£1,486 on earnings, not £800 on property	£6,748.50	£6,308.50
Self-employed £18,000 (start-up), pension £4,000, dividends £3,000, council rent £12,000	£886 + £325.80 Class 4, not £800 + £268.75	£1,453.10	£865.29

The YAML also covers:

• a Scottish taxpayer, where earnings sit below pension income in the Scottish bands;
• a Marriage Allowance recipient, whose £252 reduction lowers their tax on earnings;
• Class 3 NI, not deducted;
• a non-earner's pension contributions, which no longer come off the partner;
• the High Income Child Benefit Charge, not deducted;
• 2027 property rates of 22%, not deducted;
• a married couple's allowance, which comes off the tax on earnings first, including with pension income and with the pension annual allowance charge;
• pension contributions after 75, not deducted;
• a reform exempting pensions from income tax.

The "before" figures are from the pre-fix formula, run as a scenario.

Enhanced FRS impact (real runs)

Setup:

• Dataset: a copy of enhanced_frs_2024_25.h5 (sha256 e433e532…), one private copy per run.
• One Microsimulation per package state, all from clean trees:
  • main 3c48247, which includes Count State Pension as Universal Credit unearned income #1943 and Replace generic child and adult flags with each programme's legal definitions #1896;
  • this PR's head a57caf1;
  • rule C on this PR (scratch 74ddcefa);
  • the old deductions applied per person (scratch 03a9415e), for the split below.
• Scripts (dataset_impact.py, compare_impact.py, decompose.py, poverty_flips.py) and outputs are kept outside the repo.
• Earlier runs on older bases gave −£0.505bn (main 44240bd with Count State Pension as Universal Credit unearned income #1943) and −£0.485bn (main 7b9fc37 with Count State Pension as Universal Credit unearned income #1943). Main has since gained Count contributory ESA, Maternity Allowance, industrial injuries benefit and capped Carer Support Payment as UC unearned income #1958, Replace generic child and adult flags with each programme's legal definitions #1896 and others.

This PR against main:

Year	UC on main	UC change	Losers	Records	Lose all UC	Mean loss	Median loss (weighted)	Rule C instead
2025	£73.26bn	−£0.448bn	256k	150	13.1k	£1,749	£111	−£0.431bn
2026	£77.26bn	−£0.487bn	258k	176	13.9k	£1,888	£115	−£0.468bn
2027	£79.02bn	−£0.509bn	261k	180	16.9k	£1,947	£144	−£0.489bn
2028	£80.52bn	−£0.530bn	266k	184	18.6k	£1,987	£150	−£0.508bn
2029	£81.60bn	−£0.520bn	265k	198	21.4k	£1,960	£154	−£0.497bn
2030	£78.50bn	−£0.536bn	276k	193	22.1k	£1,939	£126	−£0.515bn

Checks across every year:

• There are no UC gainers.
• UC before and after the cap never rises.
• Earned income never falls, up to float32 rounding of about £0.02 on six-figure earnings.
• CTR changes by under £0.1m; Pension Credit and Housing Benefit do not change.
• The benefit cap reduction falls by £5-7m a year.
• No unit gets less UC under rule C than under this PR.

Where the 2026 loss comes from. The fix does two things, and a real run separates them:

Step	UC change	Losing units	Records
1. Apply the old deductions per person, so no member's deductions exceed their own earnings	−£0.219bn	71k	42
2. Then deduct only the tax and NI on earnings	−£0.268bn	205k	147
Both	−£0.487bn	258k	176

Step 1 is almost all couples (£0.215bn of it, 40 records), and £0.210bn of it is in units with over £10,000 of dividends. The pattern is a member whose tax, mostly on dividends, is larger than their own earnings, with the rest netted off their partner's earnings. A member with no earnings at all, as in the #1942 couple, accounts for only £0.00002bn.

By the kind of tax no longer deducted (decompose.py: each losing unit's loss split pro rata over the deductions it no longer gets):

Tax no longer deducted from earnings	UC change
Tax on dividends	−£0.440bn
Tax on pensions, State Pension and taxable benefits	−£0.019bn
High Income Child Benefit Charge	−£0.016bn
Deductions the per-person floor stops (e.g. a non-earner's pension contributions)	−£0.009bn
Property income tax	−£0.003bn

• The aggregate rests on a few records.
  • 29 records with over £10,000 of dividends carry £0.448bn (53k units).
  • 17 records with over £50,000 carry £0.396bn.
  • The top 10 records carry 84% of the loss.
• The rest is small. Units with at most £10,000 of dividends lose £0.039bn between 206k units (147 records).
• The high-dividend units are the separate problem. On main, 30.9k UC units with over £50,000 of dividends get £0.519bn of UC. Their £4.70bn of dividends is treated as the yield of £0.268bn of imputed capital, so it is dropped from unearned income while that capital stays under £16,000. This PR cuts their UC to £0.123bn, because their dividend tax no longer wipes out their earnings. Whether they should be eligible at all is UC-eligible units with six-figure dividends: dividends treated as yield of a few thousand pounds of imputed capital #1948.
• The UC earned income deducts the whole benefit unit's tax, including tax on pensions and other unearned income #1942 couple itself barely registers in aggregate. Only 19k of the 1.23m mixed-age units with State Pension get UC.

Poverty. AHC child poverty rises 0.30pp in 2026-27 and 2027-28, 0.18-0.21pp in 2028-29 and 2029-30, and 0.02pp in 2030-31 (all people: at most 0.11pp). Each year it is one to three survey households crossing the AHC line. BHC poverty moves by at most 0.007pp: one household in 2025-26 and one from 2029-30. All of this is sampling noise, not a finding.

Invariants (tests)

policyengine_uk/tests/test_uc_earnings_deductions_properties.py is a Hypothesis test (derandomized, 10 examples each). It runs over singles, couples and mixed-age couples with:

• employment, self-employment (with and without the minimum income floor), State Pension, private pension, property, savings and dividend income;
• children, tenure, rent;
• London, the North East, Wales and Scotland;
• the years 2020, 2026 and 2027.

1. Unearned income never changes earned income. Adding any kind of unearned income to any adult leaves every uc_individual_earned_income, and uc_earned_income, unchanged.
2. Monotone. UC before and after the benefit cap is non-increasing in each kind of unearned income for each adult.
3. Differential against the tax engine. uc_income_tax_on_earnings equals the income_tax the same person pays with their earnings as their only income; uc_national_insurance_on_earnings equals their NI. Neither exceeds the person's own tax or NI.
4. Differential against the old formula. Earned income is never lower, and UC never higher, than under the pre-fix formula, run as a scenario with Marriage Allowance claimed. The fix only removes deductions.

Invariants 1-3 keep adjusted net income under the £100,000 taper, keep ages below the married couple's allowance, and switch Marriage Allowance off, because a change in allowances legitimately changes the tax on earnings.

test_uc_state_pension_properties.py (from #1943):

• UC earned income deducts the whole benefit unit's tax, including tax on pensions and other unearned income #1942's strict xfail test_tax_on_state_pension_does_not_reduce_partners_earned_income now passes, and its marker is removed.
• Pound-for-pound and the property-income equivalence are widened to all families (with_earnings=False is gone), with Marriage Allowance switched off.
• New strict xfail test_state_pension_does_not_change_partners_marriage_allowance pins Marriage Allowance is booked on the recipient as the transferor's unused allowance, not the fixed s.55B transfer #1947.
  • The model books Marriage Allowance on the recipient as min(partner's unused allowance, £1,260).
  • ITA 2007 s.55B gives a fixed £252 reduction and cuts the transferor's own allowance.
  • So in the model the pensioner's State Pension raises the partner's tax on earnings. With £12,000 of State Pension the model gives UC £6,085.16 against £6,009.26 in law.

Results: the full YAML policy suite passes (1,394 tests), and both property files give 9 passed and 1 xfailed (the Marriage Allowance pin).

Not changed here (follow-ups)

• Marriage Allowance is booked on the recipient as the transferor's unused allowance, not the fixed s.55B transfer #1947: Marriage Allowance is booked on the wrong partner and scaled to the transferor's unused allowance.
• UC-eligible units with six-figure dividends: dividends treated as yield of a few thousand pounds of imputed capital #1948: UC-eligible units with six-figure dividends.
• Benefit cap, targeted childcare and local CTR use the wrong UC earned income figure #1986: the benefit-cap earnings exemption, the targeted childcare income test and four local CTR schemes each use a different UC earned income figure. All three predate this PR.
• UC gross earnings: trade losses offset employment, expenses and statutory pay mishandled, payroll giving missing #1997: gross UC earnings let a trade loss offset employment income, ignore employment expenses (reg 55(3)(a)) and statutory pay (reg 55(4)), and have no payroll giving deduction (reg 55(5)(c)). All four predate this PR.
• Dependants' earnings count in the unit's earnings today. Count only claimants' income in Universal Credit #1978 limits UC income to claimants.
• Minimum income floor. Reg 62(4) makes the floor a net figure after notional tax and NI. The model compares the gross floor with gross earnings and then deducts actual tax on actual earnings, as before this PR.
• Reg 55 has no express nil floor. The per-person floor here stops one person's deductions exceeding their own earnings. Reg 57 floors self-employed earnings at nil explicitly.

axiom: TheAxiomFoundation/rulespec-uk#387 queued (regs 52, 53, 55 and 57 are not in the pinned corpus, so no signed encode is possible yet; the EFRS oracle bridge feeds uc_earned_income into reg 22, so it cannot test this)

Merge

This merges on gates under Max's 2026-10-02 rule for PolicyEngine UK fixes under £1bn a year: CI green on the head, an independent review approving that head, and the impact above from real runs. #1943 has merged, so stack order allows it.

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[MaxGhenis]

Coordination note from #1950 (UC capital income). #1950 adds policyengine_uk/tests/test_uc_income_from_capital_properties.py. Its test_tax_on_dividends_does_not_raise_a_working_familys_award is a strict xfail(raises=AssertionError) pinned to #1942, which this PR fixes.

Whichever of #1949 and #1950 merges second should:

• remove that marker;
• drop with_earnings=False from test_interest_dividends_and_rent_leave_the_award_unchanged;
• re-run the combined Enhanced FRS impact, since the two PRs interact on dividend-holding units.

#1950's merge is waiting on a decision from Max (over the £1bn/yr line).

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[MaxGhenis]

#1950 merged (770bc06), so #1949 lands second. On rebase:

• remove the strict xfail on test_tax_on_dividends_does_not_raise_a_working_familys_award in policyengine_uk/tests/test_uc_income_from_capital_properties.py;
• drop with_earnings=False from test_interest_dividends_and_rent_leave_the_award_unchanged;
• re-run the combined Enhanced FRS impact.

#2107 gives that file's generated adults explicit claimant roles, so rebase on it if it has merged.

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