The government should take EDS to court if it has not paid the £26.5m compensation for tax credit IT problems by the end of the year, say MPs.

The supplier has only paid an extremely small proportion of the overall total of £71.25m that it owes for faults with the system, and is unlikely ever to pay it all because it is dependent on future contract wins, according to a Public Accounts Committee (PAC) report published today.

"It was always a very bad idea for the government to have to commission new work from the contractor EDS in order to recover compensation for the poorly performing tax credits computer system," said PAC chairman Edward Leigh.

"EDS has stumped up very little of the £26.5m of the settlement to be paid under this arrangement - if the full amount is not paid over by the end of 2008 then HMRC must be prepared to return to the courts."

In November 2005, HM Revenue and Customs (HMRC) reached the settlement of £71.25m with EDS to compensate for the computer problems with the tax credits system.

The system was designed to incorporate a degree of overpayment as initial tax awards are provisional. But it generated overpayments of £6bn in the first three years of the scheme, money which is supposed to be recovered from claimants.

So far £2.3bn worth of credits have been written off and unlikely to be returned. And overpayments that have not been written off have put many families in considerable debt to the government, said Leigh.

"About two million families a year have been placed in debt to the government in this way since the scheme was launched," he said. "The vulnerable ones face a future of trying to repay the money they owe, with all the hardship that involves."

Overall, the HMRC tax credit system is losing over £1bn to error and fraud every year – and the department still has no aims to reduce these levels, says the report.