Is there a smarter way to cut tax credits?

A political storm is brewing around the Chancellor's proposed  cuts to tax credits. A broad range of economists have expressed concern about the cuts,[1] and an equally broad range of politicians have expressed their opposition to the government's plans, from Boris Johnson to Jeremy Corbyn. In the House of Lords, a variety of measures are under consideration to water down the government's plans on tax credits, or to stop them from becoming law.

While much has been said about the size of the cuts, little has been said about their structure. Less still has been said about whether there might be smarter ways to cut tax credits which might improve some unattractive features of the current system.

The point of this blog is not to advocate for or against cutting tax credits per se. Rather, it is to point out that if the tax credits system is to be reformed, then those reforms should be clearly focused on ‘making work pay’, a stated objective of the July 2015 Budget. The system should continue to reward those who choose work over benefits, while fixing flaws in the system which actually make it pay to stay at home for some workers, mainly second earners.

After explaining why the current reform proposals are not fit for this purpose, the blog goes on to propose a novel alternative policy which might both strengthen the incentives to work and save the government money. We explore the implications of this policy for a model household, a couple family with two children. The policy would strengthen work incentives for this model household, and might serve to both reduce spending on tax credits and increase tax revenues.

How do tax credits work?

The tax credit system works by topping up the wages of low-paid workers, rewarding those in work and helping to make work more attractive than benefits. This is especially important for households with children, particularly lone parents, who might face particular challenges in finding work which is both compatible with their childcare obligations and which pays more than their benefit entitlements.

While the current system is not perfect, it is thought to have contributed to increasing the share of lone parents in work. Indeed, since the introduction of tax credits in 2000, the share of lone parents in employment has risen from 51% to 64%.[2]

For couple families, however, the current tax credit system has less desirable effects. For many couple families, the tax credit system makes it more attractive for one partner to stay at home, rather than go out to work.[3] It is this adverse and unintended consequence of the tax credit system that should be a key focus of any reforms. Smart reforms to the tax credit system would ensure that work pays for a key untapped reservoir of potential workers: second earners in couple families.

What do the government’s proposals do?

The proposed reforms are not focused on ‘making work pay’ in general, and they do too little to ‘make work pay’ for second earners.  Instead, the government’s proposals withdraw benefits more quickly from all kinds of families as they earn more income. Far from rewarding those on low incomes who work more, the government’s proposals take benefits away earlier and more quickly from those who work and earn more. Figure 1 illustrates this for a family (lone parent or couple) with two children, where the single earner works less than 30 hours. Currently, tax credits are withdrawn at a rate of 41p for every pound earned beyond £6,420 annually. That is, benefits are withdrawn once the household works more than 19 hours a week at the current minimum wage of £6.50 or 17 hours at the proposed new living wage (NLW) of £7.20. The government’s proposals would begin to withdraw tax credits at much lower annual earnings of £3,850, and increase the rate of withdrawal to 48p on every pound earned. This means that tax credits begin to be withdrawn once a household works more than 10 hours at the NLW, and at a steeper rate than before.

Figure 1: The graphs shows tax credit eligibility for a family (either lone parent or couple) with two children working less than 30 hours weekly.

Thus, the new system does not ‘make work pay’ for these low income households. In a previous blog, I presented examples which show that for the vast majority of low-paid workers, the cuts in tax credits will far outweigh the benefits from increasing the tax-free income threshold or increasing the minimum wage for over-25s.

The government’s proposals also lower the incomes at which tax credits are phased out completely, from roughly £26,000 to £20,500 for a family (couple or lone parent) with two children working less than 30 hours, and from approximately £28,000 to £22,300 if at least household member works at least 30 hours weekly.  To be fair, work incentives would be strengthened for those families who no longer qualify for tax credits under the government's changes, but only because they have no benefits left to be withdrawn.

Why does work not pay for many second earners?

One of the flaws of the current system is that in couple households, non-working adults are treated as dependents, who increase the amount of tax credit the household can claim. Thus, non-working adults in couples are treated as dependents, worthy of government support, rather than potential earners, who should be incentivised to work. This seems to run counter to the intentions of the Working Tax Credit programme, which only pays tax credits to single adults if they are in work. Treating non-working people in couples as dependents strengthens the disincentives to work for second earners. The reason is that when they begin to work, their  contribution to household income is eroded by the loss in tax credits at the steep rate of 41% currently, or 48% under the government's plans.

How to improve the incentives to work for second earners?

We now propose an alternative and novel reform, which aims to strengthen the incentives to work for second earners. 

One way to help 'make work pay' for second earners is to treat them not as dependents, but as potential earners. Specifically, this would involve obliging each non-disabled working-aged adult in the household work a minimum number of hours in order to receive tax credits. This would focus the tax credits on the 'strivers', those households which are doing all they can to escape poverty. It would also recognise the differences in earning capacity between single parent households and households with two or more working-aged adults, and promote equity across family types.

Of course, in some cases, it might be justified to treat some adults as dependents who are not available for work, for example if they are disabled or are caring for young children. It also seems sensible to make some provision for adults who are temporarily out of work or are actively seeking work. 

An alternative policy that would strengthen work incentives for second earners involves:

  • eliminate the couples element of working tax credit (WTC), except for non-working dependent partners who are looking after young children or are disabled

  • each adult household member who works at least 20 hours weekly is eligible for the basic element

  • each household member who works at least 30 hours weekly is eligible for the 30 hours element

Thus, adults in households only increase tax credit eligibility if they are working or exempted from work (due to disability or the presence of young children). This is both a stick - removing the family element of WTC from those deemed able to work - and a carrot - as working partners add to the tax credit eligibility.

To be clear, these eligibility criteria would apply to WTC elements only. Under the current system, child tax credit (CTC) eligibility is not related to hours worked. It is a non-wastable benefit, which is also received by workless households with dependent children.

Impact on work incentives

The tables below compare work incentives for second earners under the current tax credit system, the government's current reform plans and our example of an alternative proposal to strengthen work incentives for second earners. We focus on a couple household with two older children.[4] In the one earner family, the single earner works the single-earner tax credit recipient average hours of 36.7 hours at their average wage of £8.78 per hour.[5] In the two earner family, the first earner works as before, and the second earner works 25 hours a week at an hourly wage of £8.50.

Table 1 shows the incentives to work for the second earner. Under the current system, the second earner would face an average tax rate of 45.1% - equivalently, she would only keep £4.67 of her £8.50 hourly wage. Under the government's proposals, the second earners incentives would worsen slightly. She could keep £4.55 of her £8.50 hourly wage, corresponding to an average tax rate of 46.5%. These are tax rates that are often considered to be problematic for people earning in excess of £150,000.

The policy alternative involves keeping the old threshold of £6,420 and taper of 41%, but eliminating the 'family element' of working tax credit worth £2,010. At the same time, second earners would become eligible for the 'basic element' of £1,960, as long as they work at least 20 hours weekly. In this case, the one earner household suffers roughly the same cut to their tax credit entitlement as under the government's proposals. The two earner household does better than under the government's proposals, and the incentives to become a two earner household in the first place are strengthened. The second earner can now keep £6.18 of her £8.50 hourly wage, corresponding to an average tax rate of 27.3%. The alternative proposal does a better job of 'making work pay' for second earners.

It is difficult to estimate the total impact on government spending of this alternative policy. However, based on this example, the alternative policy seems likely to reduce spending on couple families with two children relative to the government's plans. First, for existing one earner households, both the government proposal and the alternative yield roughly £1,900 in savings for the government (£1,917 for the government proposal, £1,970 for the alternative). Second, the government will save less on existing two-earner families under the alternative proposals (£2,077 rather than £10). However, by making work pay for second earners, the alternative proposals make it more likely that existing one-earner families become two-earner families, which leads to a gain of £3,019 per family which switches.

That is, the savings under the government plan would come from cutting tax credits by about the same amount from both one earner and two earner families. The savings under the alternative plan would come from two sources: a similar £2,000 savings from one earner families and more people choosing to be two-earner families, which would both reduce the tax credit bill and increase tax revenues from these households, for a gain of £3,019. It is difficult to know how many second earners would be incentivised into work by the alternative tax credit system. But by improving the design of the tax credit system, both households and government fiscal accounts might benefit.

 

Table 1: Comparing tax credit policies for couple families with 2 older children

 

Current

Gov't Proposal

Alternative

Family Type

One earner

Two earner

One earner

Two earner

One earner

Two earner

Gross Income

16,756

27,806

16,756

27,806

16,756

27,806

- Income tax

1,231

1,321

1,191

1,281

1,191

1,281

- NI

1,044

1,402

1,044

1,402

1,044

1,402

+ Tax credits

6,647

2,117

4,690

0

4,637

2,067

= Total Income

21,128

27,199

19,211

25,122

19,158

27,189

gains to each proposal relative to current system for existing one-earner families

Gov't gain

0

 

1,917

 

1,970

 

Household gain

0

 

-1,917

 

-1,970

 

gains to each proposal relative to current system for existing two-earner families

Gov't gain

 

0

 

2,077

 

10

Household gain

 

0

 

-2,077

 

-10

gains to becoming a two-earner rather than a one-earner family, for each proposal

Gov't gain

 

7,096

 

5,139

 

3,019

Household gain

 

6,071

 

5,911

 

8,031

work incentives for 2nd earners

Net wage

2nd earner

£4.67

£4.55

£6.18

Ave tax rate 2nd earner

45.1%

46.5%

27.3%

               

 

 

[1] These include the Institute for Fiscal Studies, the Institute of Economic Affairs and NIESR, among others.

[2] Office of National Statistics, Labour Force Survey household datasets, Table P.

[3] Since the introduction of tax credits, the employment rates of married or cohabiting parents have been broadly stable, rising slightly from 71% in 2000 to 72% in 2014 for mothers, and from 90% to 92% for fathers.

[4] We intentionally do not specify the age cut-off between young and older children. Ultimately, this is a political decision. Arguments could be made for age cut-offs ranging between 1 year (the end of statutory maternity leave) and 5 years (school-aged) or even older.

[5] This is based upon own calculations using data on tax credit recipients from the 2012/13 Labour Force Survey.

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