Gordon Brown's flagship tax credit scheme suffered another setback as the public spending watchdog criticised overpayments and fraudulent claims worth about £1.5bn a year.

Tim Burr, head of the National Audit Office (NAO), refused to sign off the annual accounts of HM Revenue and Customs (HMRC), which runs the scheme, because of the mistakes. It is an embarrassing rebuke for HMRC, which lost the child benefit records of 25 million people on two computer discs last November.

The Government has dismissed problems with tax credits as "teething troubles" but the NAO expressed concern that between £1.31bn and £1.54bn – up to 8.4 per cent of the total – was wasted in error and fraud in the 2006-07 financial year. "Levels of tax credits error and fraud are significant when compared with the expenditure on the scheme," said Mr Burr. He said in a report that £1bn was overpaid in tax credits, down from £1.7bn the previous year. In March this year, £4.3bn remained to be recovered from claimants.

Philip Hammond, the shadow Chief Secretary to the Treasury, said: "Tax credit overpayments are still at stratospheric levels, meaning that thousands of hard-pressed families now face further hardship as these payments are clawed back."

Jane Kennedy, the Financial Secretary to the Treasury, said the amount lost through errors favouring claimants had fallen from 9.2 per cent in 2003-04 to 7.6 per cent, and through fraud from 0.6 per cent to 0.2 per cent. She said the HMRC had been given until 2011 to cut the level of error and fraud to 5 per cent.