Supply side liberation must include welfare reform

A programme for the liberation of the UK economy’s supply side must include an overhaul of the dysfunctional welfare system. The present system contains various poverty traps which create dependency and undermine aspirations. There are now 2.4m long-term (>2 years) recipients of out-of-work benefits. 17% of all working-age households have no member in paid work. The Universal Credit (UC) will sort out some, but not all of the system’s deficiencies after 2014.

The system discourages entry into the labour market. Income support and Jobseeker’s Allowance are not particularly high by European standards, but nevertheless, people who take up work are often not much better off. This is explained by Housing Benefit (HB). In places like Hackney, Tower Hamlets, Islington, Haringey, Lambeth and Brent, HB rates for a two-bedroom flat can easily be £1,200 per month or above (this is after the impending HB cuts) – an amount which many people could not earn in the labour market. In each of these boroughs, more than 30% of all households receive HB. Note that this situation will not change with the introduction of UC. HB will become a component of UC, but retain its present structure.

In a functioning system, HB recipients must benefit financially from relocating to an area where they could realistically afford to live once back in work. This requires loosening the link between HB rates and local rent levels.

Once people have a foothold in the labour market, the present system discourages them from progressing from minor employment to full time work. This is caused by the interaction of taxation and the withdrawal of means-tested benefits. The UC will not dramatically change this. Suppose somebody on an hourly wage of £6.25 decides to extend their working week from three to five days, resulting in an extra £100 of gross earnings. They will then lose £32 in income tax and national insurance, and another £44 in the withdrawal of UC, leaving them with an extra income of £24. Would you get up early in the morning on two extra days per week for £24?

An alternative would consist of basing the entitlement to in-work benefits on full-time equivalent earnings. That would reduce the maximum amount payable, but it would make lower withdrawal rates affordable. In the longer term, we should also get away from the nonsensical practice of simultaneously taxing people and paying them income transfers. This should be a strict either-or. The simplest and most transparent way to achieve this is through a Negative Income Tax (NIT).

Another key element of the UC is the introduction of workfare elements. This is commendable in principle, but the centralised way in which the parameters are set is a reason for worry. Remember, tax credits (the previous government’s panacea) are a very simple idea in principle, but under centralised governance, they have degenerated into a bureaucratic nightmare. Why should this be otherwise with workfare, which is quite demanding even in principle? An alternative would be to administer workfare schemes locally, and fund them, to a large extent, through local taxation. This would enable a process of learning through experimentation, spurred by accountability. Voters in regions with unsuccessful workfare schemes would pay the price in the form of a higher tax burden, so they would have every reason to put pressure on local politicians to learn from best practice models.

The least well-off have been hit disproportionately by the recession. That is bad enough, but without an overhaul of the welfare system, there is a danger that they will not benefit from the eventual recovery either.

Dr Kristian Niemietz is the IEA's Head of Political Economy. Kristian studied Economics at the Humboldt Universität zu Berlin and the Universidad de Salamanca, graduating in 2007 as Diplom-Volkswirt (≈MSc in Economics). During his studies, he interned at the Central Bank of Bolivia (2004), the National Statistics Office of Paraguay (2005), and at the IEA (2006). He also studied Political Economy at King's College London, graduating in 2013 with a PhD. Kristian previously worked as a Research Fellow at the Berlin-based Institute for Free Enterprise (IUF), and taught Economics at King's College London. He is the author of the books "Socialism: The Failed Idea That Never Dies" (2019), "Universal Healthcare Without The NHS" (2016), "Redefining The Poverty Debate" (2012) and "A New Understanding of Poverty" (2011).