Labour Market

Do tax credits ‘subsidise’ employers?


Economic Theory
Housing and Planning
An unusual alliance has in recent times lined up to support a significant increase in the minimum wage to the so-called ‘Living Wage’. One argument heard by proponents on both left and right is that a higher minimum wage is needed to compensate for the fact that tax credits ‘subsidise’ employers and low pay.

Despite the number of times I’ve heard this assertion, I’ve yet to read a comprehensive explanation or economic analysis of exactly what tax credits subsidise and what the mechanism is through which they depress wages – let alone any empirical evidence.  Yet the continual repetition of this line now looks like it could be leading to bad policy. So it’s worth thinking about the principle, theory and empirical evidence behind this claim.

Principle: does the existence of tax credits imply taxpayer ‘subsidy’ to employers?

Living wage campaigners and higher minimum wage proponents seem to believe that a failure of an employer to pay a worker an hourly wage such that they are able to live comfortably (thus necessitating top-ups through tax credits and other support) is equivalent to a subsidy.

Yet employers generally pay people according to the productivity of their work, not some pre-ordained amount to compensate them for a set standard of living. Suppose a worker has low productivity. Say their output is worth £6.50 per hour to an employer who decides to pay that amount in a competitive market (the exact level of the current NMW). Our worker may still be eligible for tax credits because of their family circumstances or the low income of the household as a whole. The Living Wage in London is judged to be £9.15 per hour. The logic in claiming that the tax credit payments are a subsidy to the employer seems to be that it is the employer’s responsibility to ensure his workers meet the living standards set out by the Living Wage Foundation and that any failure to do means he or she is ‘subsidised’ by taxpayers.

To which my question is: why? Whilst we’d all like to see people living comfortably without the need for taxpayer support, it’s not clear to me why the burden for this social ambition is the responsibility of the employer and/or customers of that employer as opposed to anybody else – especially if the employer is already paying the worker something equivalent to his marginal product. In fact, all you are doing in urging the payment of higher wages in this scenario is encouraging the employer not to hire the worker in the first place.

The only reason that you might believe that tax credits are subsidising employers then is if we are talking about an employer being a monopsony in a market – and having the market power to keep wages below the marginal product of its workers. This was one of the arguments in favour of the minimum wage in the first place. Yet proponents of a much higher minimum wage or a Living Wage have provided no evidence this is the case for low paid workers, and it seems very unlikely indeed that competitive industries such as retail, care homes or pubs are characterised by this degree of market power. In all then, the whole ‘subsidy’ rhetoric makes no sense.

Theory: could tax credits depress wages?

Even if you accept my argument above that it makes no sense that to think in the ‘subsidy’ framework, theoretically, there are still reasons why one might expect tax credits to temper wage increases over time. Not because tax credits ‘subsidise employers’, but because they might increase labour force participation and deter productivity growth.

The first of these is surely a feature of the rationale for working tax credits at least, not a bug – and given that extra workers can be complements to existing workers as well as substitutes (see the immigration debate), whether this effect is significant is doubtful.

A more significant argument has been put forward cogently by Howard Flight and others. Given that the current set-up of tax credits entails many households facing high marginal tax rates over large bands of income, one can imagine that on the margin the tax credit system deters human capital accumulation, and makes it less likely that individuals will accept or strive for promotion.

In effect, a means-tested tax credit with a significant taper rate gives poorer households money but makes it more difficult for poorer families to earn more income, thus meaning that compared with a situation where there were no tax credits, employees may be less inclined to upskill or push for higher wages. This can of course effect firms’ decisions too. They might decide to keep on more low skilled workers than invest in labour saving technology. But note again: this does not show firms being subsidised by tax credits, merely that a side-effect of giving means-tested assistance is to create high marginal tax rates which can disincentivise earning more income and so cause lower wages due to the decisions it engenders.

It should also be noted that this phenomenon occurs right up the wage scale. Depending on how many children they have, and on whether they qualify for the childcare element, families on well above-average earnings can still receive tax credits. There is no difference between the arguments used in relation to tax credits and the minimum wage and tax credits and wages at (say) £35,000. If tax credits suppress productivity, they do so a long way up the income scale. This is an argument for reforming or abolishing tax credits not for lifting the minimum wage.

Evidence: do tax credits depress wage growth through this mechanism? And is a higher minimum wage a substitute for tax credits?

Ultimately then, this looks like an empirical issue: is there evidence that wages have been substantially depressed by the existence or expansion of tax credits? There haven’t been many empirical studies on this. The Resolution Foundation has a brief summary of the literature from page 25 here which gives mixed evidence, but none of these existing studies are really transferable to the current UK setup. Nevertheless, they have sought to examine the broad effects by comparing wage growth both in the bottom half of the income distribution (where tax credits are concentrated) to the top half; and by looking at wage growth of eligible and non-eligible groups in the same (lower) part of the earnings distribution.

They find no evidence of differences in wage growth across the bulk of the income distribution between 1999 and 2008 (though acknowledge that there might be some ripple effects up the lower half of the income distribution due to higher minimum wages). Perhaps more importantly, their examination of wage growth among low-wage parents (who are much more likely to be in receipt of tax credits) vs. typical wage earners, higher-waged parents and low-to-middle earning non-parents suggests no significant differences either.

So, if there is little to no evidence that tax credits have led to slower wage growth, why exactly do we constantly hear that tax credits are subsidising low wages?

People continue to assert that increasing the minimum wage towards the Living Wage will save vast amounts of taxpayer money through lower tax credit payments – implying that a higher minimum wage is somehow a ‘substitute’ to in-work benefits. But both parts of this sentence are questionable. The government’s own studies (p.16) have found that increases in minimum wage rates are only likely to lead to minor improvements in the public finances by the time labour demand and the inflationary effects (higher benefit and pension payments etc) are accounted for.

Perhaps more importantly, and as I keep pointing out, the people earning between the current minimum and living wages are often very different from the people receiving tax credits. Three-fifths of those earning less than a Living Wage are part-time workers. Over two-fifths of workers earning less than the Living Wage are actually in the top half of the household income distribution (i.e. they might be second earners or young people in relatively affluent households). Tax credits on the other hand are much more highly targeted at those on low incomes.

What we can say with absolutely certainty is that those who claim employer subsidies amount to £29bn are wholly misguided, aside from any of the arguments above. Child Tax Credit (CTC) does not come with any work requirements attached. As a result, nearly a third of all tax credit recipient households – 1.4m out of 4.6m – have no adult in paid employment. This alone accounts for £8.1 billion. Many other recipients of in-work tax credits likewise work hours substantially shorter than a full working week – out of the 3.2m in-work tax credit recipient households, 0.7 million work fewer than 24 hours per week, and 1 million more work fewer than 30 hours. For these groups tax credits top up people working less than a full week, not low hourly wages.

Given all this, I wish an interviewer would examine much more critically the assertions we constantly hear that tax credits subsidise employers and low wages – and that higher minimum wages are the best means of mitigating this effect. Perhaps I’m missing something given the theory and evidence I’ve looked at. But surely the burden of proof is on those who are pushing for policy change?

Ryan Bourne is the IEA’s Head of Public Policy.

Head of Public Policy and Director, Paragon Initiative

Ryan Bourne is Head of Public Policy at the IEA and Director of The Paragon Initiative. Ryan was educated at Magdalene College, Cambridge where he achieved a double-first in Economics at undergraduate level and later an MPhil qualification. Prior to joining the IEA, Ryan worked for a year at the economic consultancy firm Frontier Economics on competition and public policy issues. After leaving Frontier in 2010, Ryan joined the Centre for Policy Studies think tank in Westminster, first as an Economics Researcher and subsequently as Head of Economic Research. There, he was responsible for writing, editing and commissioning economic reports across a broad range of areas, as well as organisation of economic-themed events and roundtables. Ryan appears regularly in the national media, including writing for The Times, the Daily Telegraph, ConservativeHome and Spectator Coffee House, and appearing on broadcast, including BBC News, Newsnight, Sky News, Jeff Randall Live, Reuters and LBC radio. He is currently a weekly columnist for CityAM.

20 thoughts on “Do tax credits ‘subsidise’ employers?”

  1. Posted 18/06/2015 at 08:50 | Permalink

    While this article fairly points to the lack of direct evidence that wages would be higher in the absence of tax credits (which is difficult to prove), it neglects a fundamental feature of the supply side of the labour market: the price at which workers are willing to supply labour and its consequences for the actual price at which labour is purchased. Basic economics tells us that wages are determined, like any other price, by the intersection of supply and demand curves, not just by labour productivity determining what employers are willing to pay. The fact that research for the Low Pay Commission and elsewhere has repeatedly shown that increasing wage floors has had little or no effect on the number of jobs suggests that many employers pay for labour at the price they can get it, not at the maximum price at which they would hire labour were it more expensive. Tax credits can sometimes allow workers to participate at lower wages than they would otherwise accept – especially where they help pay for childcare (so working an additional hour and paying for an hour’s childcare produces a reasonable gain) and where hours rules give a bonus for working a certain amount (which will be reduced under Universal Credit, but not abolished if “in-work conditionality” requires people to work a certain amount or lose their support). Of course, sometimes the withdrawal of tax credits can also deter labour supply, as the article points out. But it seems implausible that tax credits have no effect on the price at which labour is supplied. A study by Susan Harkness and Martin Evans has shown for example that far more mothers remained in work in the last recession than in the previous one because of in-work support especially for childcare. This would have allowed mothers to continue working at lower wages than otherwise.

    Interactions between tax credits and labour demand are thus complex and may not always point in a single direction. Simply removing in-work tax credits would certainly cause a huge increase in poverty, rather than causing employers to step into the breach with pay rises that made up the difference. However, it seems implausible that such a large subsidy has no benefit to employers in terms of getting some labour at a lower price than it would otherwise be available, and therefore perfectly logical to look for ways of increasing wages to save the state money, especially in sectors where the effect on aggregate labour demand is negligible.

  2. Posted 18/06/2015 at 14:40 | Permalink

    Ryan isn’t quite right in suggesting that there isn’t any comprehensive explanation or economic analysis of exactly what tax credits subsidise and what the mechanism is through which they depress wages, although ‘comprehensive’ does allow for a fair bit of wriggle room.

    Of course basic economics tells us that the price of labour is determined by supply and demand, and there has been a lot of work on this around the idea of the ‘reservation wage’ – the amount that people will get out of bed for in the morning and go to work – bearing in mind that there are other things they might be doing instead, whether looking after homes or children or writing poetry.

    Now if it takes £100 a week to tempt Jack into work and the only wages on offer are £80 a week, then Jack will stay at home and do other things. If employers need Jack’s labour then they will have to raise their wage and offer £100 a week. But if government offers in-work benefits of £20 a week, then Jack will go to work for a wage of £80 because the benefit will top up Jack’s income to the £100 necessary. In-work benefits depress wages by lowering the reservation wage.

    That might just seem like common sense, but the economics behind this and the equations for those who like this sort of thing can be found in a paper “In-work Benefits and Unemployment” by Tonin and Kolm at In this they prove to their mathematical satisfaction the proposition that “An in-work benefit will reduce wages and increase tightness and search effort. Moreover, an in-work benefit will reduce the rate of unemployment and increase labour force participation and employment”.

    Empirically of course that does appear to match the broad trend of the UK labour market associated with increasing levels of in-work benefits, and perhaps provide at least part of the explanation for why employment rates in the UK held up so strikingly well in the post-2008 recession compared with previous recessionary periods, and also for the unprecedented fall in real wages.

  3. Posted 22/06/2015 at 12:13 | Permalink

    Thanks for the comments, Michael and Donald. I don’t think, though perhaps this doesn’t across, that I dismissed the idea of ‘reservation wages’ or anything else in my piece above. The point I was making was that it makes no sense to think of the effects of tax credits on labour supply as a ‘subsidy to employers’ – any more than saying the existence of safety net welfare (which on the margin will reduce labour supply) is a ‘tax on employers’ which raises equilibrium wages. Governments decide the labour market framework, and of course individuals then decide whether to enter the labour market or not. But given the existence of minimum wage laws, employers also have to decide whether it is worth hiring someone given their expectation of the productivity of that worker. The argument of those in favour of much higher minimum wages seems to be that somehow tax credits are a consequence of firms paying lower wages though (perhaps through monopsony power) – not that tax credits induce labour supply. I have no doubt that tax credits do increase labour supply (as I said above – this is surely a feature and not a bug). Whether this reduces equilibrium wages is an empirical question though (just as with the immigration debate) and depends on the substitutability or complementarity of workers etc. We should avoid falling for the lump of labour fallacy – but it may well be that it has a small downward impact on structural wages for highly substitutable workers.

    Nevertheless, I think that the structure of tax credits means the analysis on labour supply is more complex than Michael suggests. Child tax credit has no work requirements – so will reduce labour supply for some, and increase wages. And as my colleague Kristian Niemietz put it to me on an email exchange on this subject: “With WTC, as soon as somebody qualifies, they get the whole sum. But from then on, due to withdrawal, they only maintain a small share of any incremental earnings. So graphically, this means that at 16 working hours, there’s a sudden jump in the labour supply curve, which is split into 2 parts. The remainder of the curve is much steeper, because withdrawal should make it more inelastic. This would mean that it could actually raise gross wages for some people. Let’s say an employer has a member of staff working for three days, and would like them to work full-time. The employer may well have to offer more than they would in the absence of tax credits, because they know that whenever they say “£10”, the employee hears “£2.70”. So tax credits could lower salaries for some, and raise them for others.” Or if we want to use the terminology of the campaigners who see labour supply changes as ‘subsidies’ or ‘taxes’ – our tax credits could ‘subsidise’ and ‘tax’ employers at the same time.

  4. Posted 22/06/2015 at 12:55 | Permalink

    Ryan, I find myself agreeing with a lot of that, including the very good point that tax credits’ effect on reservation wages are partly counteracting the opposite effect of out-of-work benefits. That is to say, I agree we don’t want a situation where the wage that an employer can afford to pay produces family income lower than on out-of-work benefits, and I also agree that in the absence of tax credits this is likely to occur. Your points therefore demonstrate that a simplistic justification for a higher minimum wage that employers are getting an unwarranted subsidy from tax credits does not work – or at least not on its own. However, if we are looking at how to tackle the high level of in-work poverty, there’s a clear argument for not relying only on increasing income transfers but also on all routes to improving family earnings, particularly at a time when public funding is scarce. Part of this is about encouraging progression, higher productivity and in some cases more work within a family. But if in addition, wages floors can be increased without damaging employment levels, this can help reduce the need for tax credits, by reducing the potential windfall employers get from paying below the rate that they could afford for a particular job. So it’s relevant that all the research for the Low Pay Commission has shown that increasing the NMW has not cost jobs.

    None of which is a justification for cutting tax credit rates in the Budget. This would hit low income families hard, in and out of work. Better wages can reduce the tax credit bill without reducing entitlements – by reducing the extent to which working families need to draw on them.

  5. Posted 22/06/2015 at 13:21 | Permalink

    My take is that if one accepts that the Living Wage is a ‘living’ wage, in that it is the level required for subsistence (absent welfare payments) then if employers do not pay that living wage, they will run out of employees – if pay is at a below subsistence level, people will not subsist. At that point, the productivity model for wages doesn’t work. We’re in the much simpler demand and supply model – by the government topping up employment income, the government maintains the supply of labour for the companies, at a rate below which the market would pay to achieve the same.

  6. Posted 22/06/2015 at 13:23 | Permalink

    The massive floor with the arguments for a living wage is that whether someone has a ‘decent’ standard of income depends on annual, not hourly wages. A person on £10/hour but only working 15 hours/week isn’t going to earn as much as a full time worker on the minimum wage.

    Proponents of the living wage aren’t being objective about living standards, they’re just advocating an increase in the NMW, and if any politician is foolish enough to mandate the LW all they’re doing is outsourcing the setting of the NMW rate to a pressure group.

  7. Posted 22/06/2015 at 13:56 | Permalink

    Whether or not increasing the supply of labour is a desired feature of tax credits, it will put downward pressure on wages, hence some of the money spent on tax credits should be considered a subsidy to employers.

    However, historically, the strongest effect has been to distort the supply of labour towards those working between 12-16 hours/week, and away from those working fewer hours, or more. The switch to Universal Credit will remove the discontinuity in the marginal benefit for each extra hours work, which can only be a good thing. (

    It will be interesting to see if there is a marked increase in employees working 2-12 hours/week (and especially 3-8 hours, when people currently not working find that some work pays). If those extra part time workers come mainly from the ranks of the unemployed, rather than existing employees reducing their hours, then we could see a downward pressure on wages, with fewer part time jobs having to pay more than the minimum wage.

    Finally, I’m not sure what relevance there is in comparing upper half wage growth with lower half wage growth. People in the upper half of the income distribution have different skills and productivity, so are competing in completely different job markets from those in the lower half (excepting a few at the boundary). For example, if many white collar workers have been replaced by computers, this reduction in demand for their labour in the upper half would hide the downward effect of tax-credit supply distortions on the lower half.

  8. Posted 22/06/2015 at 14:43 | Permalink

    It looks like the IEA has been taken over by socialists and crony-capitalists who seem to believe that the proper way to set wages is simply as a function of what these wise people think workers should be paid.

    Free marketeers (and indeed standard economics) believe that the price for any goods or services is the intersection of supply and demand. They also generally believe that government intervention *always* distorts the price. By how much is of course debatable as is whether this price inefficiency is worth whatever it is the intervention is trying to achieve.

    Ryan is of course right to say that there is no case for a higher minimum wage to offset the effect of tax credits. He does so, however, for the wrong reason. Increasing the minimum wage is simply adding an additional government intervention to counter the unintended outcome of a previous intervention and both have the effect of increasing the client state. It would be much simpler, and more pro-market, just to remove both interventions.

  9. Posted 22/06/2015 at 16:53 | Permalink

    nice to see freemarketeers shitting themselves at the prospect of cuts in benefits!

  10. Posted 22/06/2015 at 17:23 | Permalink

    George – I appreciate your viewpoint. Milton Friedman of course advocated a negative income tax. Was he a socialist too?

  11. Posted 22/06/2015 at 17:25 | Permalink

    While you’re at it, why not stop paying Universal Credit, Incapacity Benefit and Housing Benefit completely, as they all distort the market. Oh, and pensions, because they deter our wise old pensioners from supplying their labour too. The risk of starvation and homelessness would make the cost of labour plummet and the rich could reap the benefits.

  12. Posted 22/06/2015 at 17:30 | Permalink

    If tax credits weren’t paid what effect would it have on the economy,not on the jobs market Rents would be unaffordable more people being made homeless & unemployable or rent would be forced down?? saving welfare on rent? workers are the market if the market is to costly the market collapses,So anything that is paid to keep the market going is a subsidy,because employers & employees get financial help to rise pay exports can be sold cheaper cost of the employers contribution, ask any competitor & this is classed as a subsidy & unfair trading,So whilst getting part of your living cost paid by the government may or may not be a subsidy? the effect on the economy certainly act has a subsidy would!

  13. Posted 22/06/2015 at 18:28 | Permalink

    I think many people have missed the point here, its not really about whether it is perceived that tax credits or in work benefits are a subsidy to employers. Historically wages have been able to support families and individuals for many years, until the rise of technology wiped away vast swathes of employment. We are living in very difficult economic times, both for employers and employees. Globalisation and free movement of labour have contributed to a fiercely competitive market place which means companies will move there production to the cheapest part of the world,if logistics and acceptable quality are met. The companies who remain have a bottom line to maintain and shareholders to keep happy. Employers in this situation respond to the market place by employing people at the lowest possible rate allowable so as to curry favour with the accounts department. The ability for the said employee to rise in the company and earn more is stifled by the fact they have no opportunity as the position is deemed as low or semi skilled. This is where the employer shoots him or herself in the foot. Investing in employees is a risky business and training costs money. This is a risk that should be taken. I have done so in the past and out of 5 employees only one turned out bad. The rest up-skilled and went onto greater things.This got me thinking about skill shortages, there really shouldn’t be any! If companies persist in self pity about wages then they deserve all they get. In work benefits are a symptom of both Government and Industry policy. I remember the bleating and rhetoric that persisted over the minimum wage! Industry didn’t collapse overnight. Nobody wants to see people on benefits and despite the media most out of work people want to work, but they want a fair days pay which is not an unreasonable expectation. As for tax credits the perception will always be there, as long as employers don’t pay enough to exist it will always be seen as a Subsidy.

  14. Posted 22/06/2015 at 19:18 | Permalink

    Ryan, I’m generally against government generosity with other people’s money and increases in tax complexity, as I’d thought was the IEA. Gordon Brown’s tax credits are negative income tax and, yes, that is socialism.

  15. Posted 23/06/2015 at 06:55 | Permalink

    Looking through the above comments, I’m surprised to see everybody seems to be missing the most important factor. The limit of labour cost is set by how much the consumer will pay for the good or service. If the labour element of production is set too high, the total price will be too high & the consumer won’t buy it. So, far from the employer benefiting from subsidised wages, it’s the consumer ends up getting the subsidy.

  16. Posted 23/06/2015 at 08:24 | Permalink

    This article is completely irrelevant.

    Wages are being depressed due to the government’s war on unemployed people, meaning those who have been made redundant through no fault of their own are constantly harassed by heartless officials of the State and their private sector lapdogs and thus end up in minimum wage or workfare jobs.

    This is how the government carries out its policy of wealth redistribution from the bottom to the top.

    Today’s Tory party is a disgrace to free market conservatives.

  17. Posted 23/06/2015 at 10:18 | Permalink

    George – I’ve not really said anything in this article that suggests whether I am opposed or not to the tax credits system broadly. I am simply trying to address very faulty thinking about the idea that tax credits are employer subsidies, particularly from those in favour of the so-called ‘Living Wage’.

  18. Posted 23/06/2015 at 14:08 | Permalink

    I think this is actually cunning re-framing by the Conservatives. They have promised to cut 12 billion from the welfare budget whilst ring-fencing the pensioner part of that budget. That means the cuts have to fall on the working poor. However, in order to deflect the flak for attacking “hard working families”, they are attempting to frame companies as exploiters of low paid workers, and transfer the blame to them.

    There is some economic logic to this, though. UK productivity has lagged behind the US and many EU countries since the global recession. Perhaps some of this is due to the availability of cheap (arguably taxpayer-subsidised) labour making it unnecessary for firms to invest capital in labour-saving plant or technology. By driving up labour costs (or at least threatening to), are the Conservatives attempting to force employers into invest in improving productivity?

  19. Posted 23/06/2015 at 19:42 | Permalink

    If defining were this effects the economy so they are the ones ultimately receiving the benefit has the ones effected that’s easy SME particularly those forced into them hit twice i their own life line ii what little money that passes through the window of opportunity will stop ie their small market?! & the landlords.but that is naive simplistic,to believe they are the only beneficiaries

  20. Posted 10/07/2015 at 09:06 | Permalink

    There is a (perverse?) incentive for the low-earning, childfree, self-employed to declare a lower hourly wage in order to reach the 30hr pw tax credit threshold. Perhaps some employers collude, paying skilled workers for 30hrs work at minimum wage but not checking that the work takes up the full 30 hrs. It would be interesting to see what proportion of TC claimants only just hit the thresholds for hours worked.

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