The working families tax credit.

Meadows, Pamela

Gordon Brown's first Budget as Chancellor signalled a new emphasis on microeconomic relationships in economic policymaking. Whereas in the past there has been implicit acknowledgement that macroeconomic policy relies on appropriate responses in individual behaviour, this time the policy focus was explicitly on the structure of the incentives facing employers and employees.

In 1999 the Working Families Tax Credit will be introduced. This will provide additional income to families with children who have low earnings, and who would otherwise face very strong disincentives to work. It has five key differences from Family Credit, the in-work benefit it is going to replace. First, it is more generous. It will be paid at higher levels of earnings and its withdrawal will begin at higher levels of earnings. Second, the withdrawal rates will be lower, so that families will face lower effective marginal tax rates. Third, payment will not generally continue to be made via an order book (similar to the order book used for Child Benefit payments). Claimants will normally be paid by their employers with their wages. Fourth, it will include an additional credit to cover childcare costs. Finally, because it will become a tax credit rather than a social security benefit, its treatment under standard public accounting rules will be different. (In fact it appears that its treatment will fall outside the rules as they have normally been interpreted in the past. Instead of being treated partly as public expenditure and partly as income tax foregone, as the US Earned Income Tax Credit is, it will be treated wholly as income tax foregone.)

The other key related change announced in the Budget was to the structure of National Insurance contributions. Under the present system earnings below the Lower Earnings Limit (currently [pounds]62 a week) are exempt, but once that threshold is crossed contributions are payable on all earnings. Thus, any increase in earnings from just below to just above the limit is subject to an effective tax rate well in excess of 100 per cent. Under the new system, as with income tax, contributions will only be paid on earnings above the threshold. The overall effect is that for everyone earning under around [pounds]400 a week both employer and employee contributions will be lower, while for those earning over this amount the costs will be higher. The whole change will be revenue neutral.

Chancellors in the past have not generally chosen to involve themselves in the minutiae of microeconomic incentives, although there have been exceptions, Nigel Lawson in particular. Although income tax rate reductions have been presented as having a positive effect on work incentives, this has never been claimed as their primary objective (if only because the evidence suggests that higher thresholds are more effective in this respect than lower rates). However, the new approach reflects the growing recognition that the supply side of the economy must be able to respond to changes in circumstances. These can be brought about by developments in technology, in international trade, by policy changes or by shocks, such as those resulting from the oil price rises of the late 1970s. A key element in the responsiveness of the supply side is the ability of the labour market to absorb additional people into employment without generating inflationary pressure. Every additional person who can be encouraged into work without any need for an increase in wages adds to the productive potential of the economy and leads to an improvement in public finances.

It is the potential scale of the prize which makes it attractive. There are currently around 7 million people of working age who are not working. Some of them would not work under any circumstances. They have small children or serious health problems. Many are engaged in full-time education. Some are independently wealthy or are happy to be supported by their spouses. But perhaps as many as half might under the right circumstances wish to be absorbed back into work. They include the unemployed as conventionally defined, but also some lone parents dependent on income support, some of those who have taken early retirement and some of those who are not currently working because of illness or disability, but who could work in certain jobs. Finding a set of policies that would encourage the movement of a significant proportion of these non-workers from the dependent half of the population to the working half would be a means of widening the potential range of macroeconomic policy choices.

It is some time since full employment was dropped as a formal objective of economic policy. Few governments or monetary authorities in advanced industrial countries believe that it should be the main or even an important focus of their attention (the main exception appears the be the United States). In Britain the promotion of employment has now been restored as an objective of policy, but it is not included in the remit of the Monetary Policy Committee, which is required to pursue an inflation objective. The instruments adopted for the employment objective are not those of macroeconomic policy. Rather they are those which concentrate on the microeconomic circumstances facing individuals.

A standard analysis of average replacement ratios (the income available to people who are out of work compared with what their earnings would be if they had a job) would place the UK well down the international scale in the generosity of its benefits system, and would suggest prima facie that the financial incentive to work for those without jobs was high. However, this is an example of averages being misleading. A large proportion of unemployed people have no dependants, and are therefore entitled only to a single person's benefit level, which is under [pounds]50 a week (and considerably less if they are under 25). However, for those who have limited skills and therefore low potential earnings, who have children, and who are receiving support for their housing costs either as Housing Benefit, or as mortgage payments, the financial advantage from working is more finely balanced.

Economists' perceptions of the incentives to work (or for those already working, the incentives to increase their working hours) faced by those with low potential earnings do not always coincide with the way those incentives appear to those who actually have to make choices. Moreover, the responses of the average person confronted with a particular set of circumstances may not be as important as the behaviour of those whose position is genuinely on the margin. The current system of means-tested in-work benefits (Family Credit, Housing Benefit and Council Tax Benefit), while it ensures that people with children who earn [pounds]80 a week have similar household incomes to those who earn [pounds]160 a week, offers virtually no incentive for anyone within this earnings range to increase their hours or move to a better paying job.

Although for high income groups the loss of 50p of every extra pound earned is regarded as having an unacceptably damaging effect on their work incentives, 740,000 people on low incomes currently face effective tax rates of 70p (and in around 130,000 cases over 90p). The Budget recognises this and for most (but not all) of those in this position the effective tax rates they face will be around 15p in the pound lower. The Treasury estimates that the number facing withdrawal rates of 70p or higher will fall to 260,000, although the number facing effective tax rates of 60p or more will increase from 760,000 to over a million.(1) This is because those on higher incomes who are being brought into the means-tested support system for the first time will be confronted with higher withdrawal rates than they faced under the standard income tax and national insurance systems. These changes will, therefore, still leave many less well off families with marginal tax rates that would be considered too high for those in the top decile of the earnings distribution.

Economic behaviour is, of course, influenced by factors other than money. In the same way that goods and services have a mixture of attributes, of which price is an important, but not the only component, jobs have attributes other than pay (hours and location being two of the most obvious). Changing the balance of incentives in a way which will produce a change in behaviour for a reasonable number of people requires all the dimensions of the problem to be taken into consideration. A change in the financial rewards available in work will be ineffective if it is not accompanied by similar action on the non-monetary costs and benefits.

Families on the margins of work are expected to make financial calculations which would defeat most graduates. For example, many lone mothers who are working have income from seven different sources: earnings, maintenance, Child Benefit, One Parent Benefit, Family Credit, Housing Benefit and Council Tax Benefit. They will often also be paying income tax and National Insurance contributions and may have childcare costs and travel to work costs. Not surprisingly, the evidence suggests that in practice people do not make very detailed and sophisticated calculations. They make rough assumptions which provide them with a reasonable and realistic basis for making decisions.(2)

Some people work even when they know that they would be financially better off not doing so. In part this is because there are intrinsic rewards from working in terms of self-esteem and access to a social life. But in part they may be taking a longer-term view of the financial balance: they believe that by taking a low paying job now, they are improving their chances of securing a better paid job at some stage in the future. Recent evidence suggests that undesirable jobs are not as good a route to future success as desirable ones, but they are better than remaining unemployed.(3)

One of the important factors entering into individual decision making is that of risk. Economists recognise the importance of risk in financial markets, but it is unusual for analysis of the incentives to work to include it. It is significant, however, since it is an important determinant of people's willingness to accept a low paid job. The one thing that life on benefits offers is security of income. Where families are living on tightly managed and balanced budgets, there are risks in abandoning known arrangements for unknown ones. Not only are potential entitlements to in-work benefits uncertain. Perhaps more importantly, there is uncertainty about how long it will take for them to come through.

Housing Benefit in particular causes problems in this respect. Local authorities, which are responsible for dealing with claims and payments, are generally unwilling to undertake hypothetical calculations for people who are confronted with a particular job offer. But more importantly, many authorities have long delays in processing new claims. It is not uncommon for it to take three months before the first payment is received. Few families on the margins of work have access to financial resources that would enable them to get through this waiting period. The Government has recognised that the Housing Benefit system is unsatisfactory, and a review is in progress to consider ways of replacing or improving it. However, it has not yet reached a conclusion.

Once account is taken of the non-monetary costs and benefits of working, the trade-off between the long term and the short term, and the issue of risk, it will be economically rational for some people to work for less than they would receive in benefits, and for others not to work even though they would be financially better off. There are two principles underlying the Working Families Tax Credit. The first, like its predecessor, Family Credit, is that it is intended to reduce poverty. It therefore represents a transfer from taxpayers generally towards low income families with children. Its second purpose is to improve incentives to work: to increase the incomes available in work to those who are not currently working in order to tilt the balance of their decision making, while also improving the rewards available to those who are already choosing to work.(4)

The last point is important, not least because it is unusual. Standard economic analysis would argue that paying people for something they would do anyway is simply deadweight. In the case of the Working Families Tax Credit, the scale of the deadweight will be large, and deliberately so. Family Credit is a benefit which is paid to around a tenth of families, with perhaps another 3 per cent who are entitled to it and not claiming it. It currently costs around [pounds]3 1/2 billion a year. The Working Families Tax Credit will be available to nearer a fifth of families, at earnings levels that will include some professional groups, for example nurses and junior grades of teachers.

Its estimated full year costs will be nearly 50 per cent greater those of Family Credit. However, these estimates by the Treasury are based on the assumption that there will be no change in behaviour. 5 In other words it assumes that no additional people are induced to take work, and none of those currently working give up their jobs, or increase or reduce their hours. Thus, all the [pounds]1 1/2 billion of planned extra expenditure is pure deadweight, and will go to people who are expected to continue to do the same jobs with the same earnings as they would have done without the change. Any additional people who are encouraged to take work by the improved assistance, or any reduction in household earnings by those already in jobs would require additional expenditure. If a further 250,000 people were to take jobs while drawing the credit then expenditure might be expected to rise by a further [pounds]1 billion, but there would be savings in social security costs to be offset against this.

Some of the Government's other policies, which are directed towards encouraging those who are dependent on state benefits to take work, are likely to lead to increased take up. The New Deal for lone parents has not had high levels of take-up so far, and the New Deal for disabled people has not yet got off the ground. However, the emphasis on the desirability of work for those who are able to do so means that the weight of policy pressure will be on increased rather than reduced numbers receiving in-work benefits.

Furthermore, if the take-up rate of the childcare element is greater than the Treasury's very conservative expectation, the overall costs could easily be more than double those of Family Credit. The relatively modest estimate for the cost of the childcare element assumes that few parents switch from informal childcare by family and friends to nurseries and childminders which will be eligible for payments. But the availability of the credit will change the incentive structure in the market for childcare, and the response to that change is impossible to estimate, particularly as the eligible population of parents and children changes over time, so changes in the balance of demand can be made without disrupting existing arrangements for individual children.

The increased generosity towards those already working is a matter of deliberate choice on the part of the Chancellor, and represents a challenge to the notion of deadweight. His argument is that incentives to work are reinforced by positive messages. Moreover, the extension of support well up the income scale sends a positive message about the Credit itself: it is not just for exceptional families, it is for 'normal' families.

As there is no past experience of families close to average earnings having entitlement to means tested assistance, the level of take-up among some of the higher income groups is uncertain. Nevertheless it is among these groups that potential adverse incentives may emerge. Thus, for example, in a couple where one partner is earning [pounds]16,000 a year and the other [pounds]3,500, the effect of the availability of the tax credit might be to induce the lower earner to give up her (it is usually her) job, since the net gains to the family from her working would be very small. Similarly, there may be some lone mothers currently working full time for whom there would be advantages to be gained from a reduction in hours.

However, the success of the change will probably not be determined by this group. Families facing low potential earnings have the chance of being noticeably better off, and this is likely to encourage more of them to take jobs, and to keep them once they have got them. How well the new arrangements will succeed in changing behaviour will depend not so much on the design, which looks promising, but on the way it works administratively. As the example of Housing Benefit shows, if the delivery system fails, it really does not matter how well designed in a theoretical sense the underlying structure is.(6) The delivery through employers is untested and remains risky, not least because some potential claimants might be reluctant for their employers to know their family circumstances, and because of the need to minimise the lags between the claim being sent to the Inland Revenue, and the payment being made by the employer on Revenue instructions.

Ultimately too, the level of deadweight should matter. If 80 per cent or more of the expenditure is going to people whose behaviour is not being affected, then there may be more efficient ways of achieving the same purpose. This was what happened in the case of the Working Income Supplement in Canada, which has now been abandoned in favour of increased universal child tax credits.(7)

Several alternatives might have been simpler. For example, the probable level of resources devoted to the Working Families Tax Credit over and above those going to Family Credit could have increased Child Benefit for all children by over a quarter, or by concentrating on younger children, where family poverty tends to be more a of a problem, by around a half. Although this too would have a deadweight effect, by going to families who would not need the extra resources, it would have the advantage of certainty for those moving into work. Alternatively, given that Family Credit is acknowledged to be one of the most effective parts of the social security system, it could have been made more generous without the added complication of involving the Inland Revenue and paying through employers. There is only limited evidence of any stigma attached to receipt of Family Credit. The Working Families Tax Credit is unlikely to change that, and it may make it worse by bringing receipt of means-tested benefits to the attention of claimants' employers.(8) These have the presentational disadvantage that they appear under social security expenditure in the public finances.

For lone parents receipt of maintenance is crucial to how well off they are in work,(9) and some form of maintenance guarantee by the Child Support Agency assuming the risk of collection might offer a cost-effective alternative.

The Working Families Tax Credit has real potential to make a difference to the ability of the British economy to achieve full employment, but it also has the potential to be an expensive means of changing the behaviour of a small number of families. A careful evaluation of its impact will be important. Overall, however, the growing emphasis on microeconomic issues in Budget decision-making is a desirable development. Too often macroeconomic decision-making has taken too little account of the microeconomic environment.

NOTES

1 Financial Statement and Budget Report p. 48.

2 See, for example, Ford, J, Kempson, E, and England, J, Into Work? The Impact of Housing Costs and the Benefit System on People's Decision to Work, York Publishing Services, 1995.

3 See White, M. and Forth, J., Pathways through Unemployment: The Effects of a Flexible Labour Market, York Publishing Services, 1998.

4 The Chancellor said in his Budget speech, in introducing the Working Families Tax Credit, 'For too long we have done too little to help those who work hard to advance up the ladder of opportunity from lower income into middle income jobs and upwards. The cap on aspirations must be lifted. ... It is time to reward the efforts of those who want to work their way up.'

5 Statement by the Chancellor of the Exchequer, Treasury Committee, Session 1997-98, Fourth Report, The 1998 Budget, Minutes of Evidence, p. 77.

6 See also Shaw, A, Kellard, K and Walker, R, Moving off Income Support: Bridges and Barriers, Department of Social Security Research Report 53, HMSO, 1996.

7 See Mendelson, M., The WIS that was, York Publishing Services, 1997.

8 Latest figures show take up of Family Credit is 72 per cent of eligible claimants, but 84 per cent of potential receipts. See Department of Social Security Press Release 98/249, 1 October 1998.

9 See Bryson, A, Ford, R and White M, Making Work Pay: Lone Mothers, Employment and Well Being, York Publishing Services, 1997.