The extension of tax credits was part of a package of measures motivated by the government’s relative child poverty targets. They were presented as a way to break out of the old dilemma of welfare benefits, namely, the fact that they can make it economically irrational to seek work, and thereby provide a cure that is worse than the disease.
Since entitlement to tax credits was conditional on a minimum number of hours worked, it was argued they would both alleviate poverty and make modestly-paid work more attractive. So the level of tax credits was raised several times, especially for parents, and the taper rate at which they were withdrawn was reduced.
And indeed, these reforms helped raise parents’ employment rates, especially the previously very low employment of lone parents. So are tax credits a success story after all?
The picture is more ambiguous than that. Firstly, since a tough relative poverty target cannot be met through in-work benefits alone, non-work benefits have to be increased alongside. But this makes not working relatively more attractive again, partly offsetting the work-encouraging effect of the tax credits. Thus, in order to keep the pro-work effect of tax credits constant, the dose has to be raised.
Some estimates suggest that about three quarters of the employment-boosting effect of tax credits has been undone by other changes to the tax-and-benefit system. This is not to blame tax credits per se. But it does show that when embedded in a strategy inspired by a relative income poverty target, they can be an expensive instrument.
Secondly, tax credits are beset with a problem of their own. They are withdrawn as earnings rise, so from the recipient’s perspective, being on the tax credit taper is like being taxed twice. If, for each additional pound earned, you pay X pence in taxes, and lose Y pence of tax credit, then it is as if you were facing a marginal tax rate of X+Y per cent. It is not hard to guess what this means for incentives to progress in the labour market.
Lowering the withdrawal rate improves matters for those who are already on the taper. But it also extends the taper to people further up the income range. Due to the lowering of withdrawal rates, there has been a welcome decrease in the number of working parents who face effective marginal tax rates (EMTRs) of over 80%. But this has been bought by a much larger increase in the number of working parents who face EMTRs of over 60%.
The trade-off is stark: there will either be a few individuals who face huge disincentives against progressing in the workplace, or there will be a far larger number of people facing disincentives which, while not huge, are still very significant.
Policymakers therefore face a number of unpleasant trade-offs: high poverty rates among the workless, or poor incentives to take up work; poor incentives for the workless to take up some work, or weaker incentives for those in work to progress further; weak incentives to progress for many, or extremely weak incentives to progress for some.
But there are alternatives. For example, the US welfare reforms of 1996, which ended the ‘unconditionality’ of benefit receipt, attempted to address the dependency trap. Greater conditionality – for instance the requirement to undertake training in order to receive benefits – may reduce the incentives to remain out of work and help reduce fraud.
Another option is deregulation. Liberalising the land-use planning system would benefit the poor and improve incentives: it would have the direct effect of making housing affordable. But it would also get many people off Housing Benefit, which has a high withdrawal rate, and therefore has a particularly pernicious impact on labour-market incentives.
A further highly effective and non-distortionary way to improve the lot of the poor would be to abolish all direct and indirect barriers to trade. According to one estimate, this would raise the real incomes of the bottom decile by 4%.
Interestingly, if the cost of housing, food and clothing tumbled, the effect on relative poverty statistics would be nil. Relative income poverty figures cannot capture such effects, despite their obvious relevance to the poor in absolute and relative terms alike. Perhaps the government would be well advised to come up with a sensible poverty target first, and only then try to remedy the problem.