Poverty targets and tax credits: don’t follow the will-o’-the-wisp

In hindsight, what would you say were the largest political achievements of the New Labour government? Whatever you have in mind now, I bet the answer is different from the one which the current edition of The Economist gives:

“A decade ago, the prospect of the Conservatives accepting the idea of relative poverty […] would have been fanciful. Nowadays, it is a reality. The government has retained Labour’s goal of ending relative child poverty by 2020. […] If the ultimate victory in politics is changing your opponents, this was among Labour’s biggest wins.”

New Labour may well have some achievements to show, but the dubious poverty target is not one of them. It led to contradictory policies during the Labour years and there is no reason why it should become a better policy guide for the present coalition.

Take Labour’s approach to tax credits. Tax credits are a tool for improving work incentives for groups with a weak labour market attachment. They are also a tool for redistributing income. Unsurprisingly, they are not very adept at promoting both ends simultaneously and their precise design will be determined by which of these motives is given precedence.

If the primary objective is to promote employment, then you would make the receipt of tax credits contingent on a minimum number of hours worked. If the aim is to promote full-time work rather than minor employment, then you would set this bar rather high.

But designed in this way, the impact on relative poverty will be limited. Working, say, four days a week in a low-paid job would become more attractive relative to working one day or zero days. But many of those below the poverty line will not respond to this incentive and many of the beneficiaries would not have fallen below the poverty line anyway. If the primary objective is to lower relative poverty rates, the best strategy is to maximise benefit take-up rates. This is most readily achieved through a means-tested transfer with no strings attached, hanging the fruit as low as possible.

Earned Income Tax Credit (EITC) in the US comes close to the pro-employment version. EITC initially rises with earnings, so if Joe works two days a week and Betty three days, both at the minimum wage, then it is Betty who will receive the higher EITC payment. If you are in favour of “targeted” income redistribution, you will be opposed to this, because the “less needy” Betty receives more than the “needier” Joe. If you are in favour of promoting work incentives, you will be sympathetic, because it means that for those on the very lowest incomes, the implicit marginal tax rate is negative.   

Torn between the goals of promoting work and reaching the poverty target, Labour’s version of tax credits became a confused hybrid model. Working Tax Credit, in isolation, makes employment more attractive relative to not working. But Child Tax Credit, along with other changes to the tax-and-benefit system, partially offsets that effect.

The poverty target’s only real achievement is that other parties felt obliged to adopt it, to avoid being portrayed as stone-hearted. If The Economist really counts that among “Labour’s biggest wins”, then this is hardly a compliment.