Our panellists battle it outby Kate Andrews, Ken Clarke / November 12, 2015 / Leave a comment
Should the government rethink its policy on tax credits?
The Tax Credit system, where employees on low pay can reclaim some tax, was introduced by Gordon Brown in 1999. The government plans to phase it out by 2017, replacing it with Universal Credit. Those plans were halted in October by a House of Lords vote urging further study of the consequences.
It’s easy to understand why people might be conflicted about tax credits. On the one hand, tax credits are a direct handout from the state, often given to those only working part-time. On the other, they incentivise work and benefit those at the bottom on relatively low pay.
Combine this internal conflict with the UK’s welfare structure as a whole, and it would seem necessary for the government to implement some kind of reform to the various systems, tax credits included.
But the Chancellor is only interested in cuts, not reform.
And those proposed tax credit cuts will hit hard-working people the most. The truth is that in 2015, not all jobs can provide a livable income, and tax credits are one of the most efficient ways the UK currently has of supplementing people’s incomes. Rather than jeopardising jobs altogether, which the national living wage threatens to do, tax credits encourage those at the bottom to contribute to their own livelihoods.
Of course, tax credits are not the ideal form of welfare, and if the Chancellor were serious about tackling the deficit, he might consider implementing more radical welfare reforms that cut spending further, but not at the expense of low earners.
For example, a new Adam Smith Institute paper, “Free Market Welfare: The case for a Negative Income Tax,” shows how merging most means-tested benefits—including tax credits—into one single, individualised payment could save £6bn a year in administrative costs (compared to the £4.5bn saved from cutting tax credits outright).
The Institute for Fiscal Studies has estimated that millions of homes will lose an average of £1,000 per year as a result of the changes. For most families, that top-up is not pocket change; it’s a damaging loss of needed funds and it hits their incentive to work. If the Chancellor is allowed to go through with the proposed tax credit cuts, he will need to explain what reforms, if any, will be implemented to help keep the lights on.
As we have to reform the welfare state in present circumstances, and the government has a mandate to do so, the obvious action is to cut back on tax credits. It was never good policy to introduce a system whereby the government topped-up the pay of millions of people. Many of those who receive it are grateful, although I doubt whether they were induced to vote for the Labour government as a result. The benefit is of course shared indirectly with their employers, who have been able to keep wages low, with less incentive to invest in productivity, for many years as a result.
The Chancellor is trying to move back to a system whereby employers pay wages and salaries and the government has redistributive tax systems and offers legitimate welfare payments to those with a claim because of their vulnerability and circumstances. This was bound to be unpopular. A party political majority in the House of Lords has responded to this unpopularity with suggestions that unspecified “tweaks” might make it acceptable.
You do at least propose moving to a negative income tax as an alternative. People have tried to design such a system for the last 30 years and I doubt whether the Treasury and the Department for Work and Pensions (DWP) could rapidly produce such a system at the moment, however worthy the intention.
There will never be a better time to make the reductions in tax credits that George Osborne is proposing. A newly elected government has a mandate for £12bn of welfare savings. The labour market is stronger than it has been for years with real wages rising and many employers able to move away from a very low pay structure dependent on government subsidy. If we don’t get on with it now, the opportunity may not recur for years.
The government does have a mandate to reform welfare—and it should do so—but there is nothing obvious about cutting one of the few benefits that incentivises work. I’ll come back to this point, but let me first debunk this theory that tax credits are a subsidy for employers.
The theory goes that tax credits allow employers to keep wages down, when they could (and should) be paying their employees a salary that amounts to a comfortable wage. But this is simply not the case. In the UK’s competitive labour market, employees are paid according to their productivity (not according to the standards set by living wage campaigners) and they accept salaries around what they believe their productivity to be worth. It’s not that an employer won’t pay a security guard or cleaner above their productivity cost—they cannot, without poorly impacting their business.
Trying to force employers to comply to set wage levels rather than competitive market wages is one of the reasons the Office for Budget Responsibility estimates over 60,000 jobs will be lost when the new mandatory national living wage comes into play next April. This will set minimum pay at £7.20 per hour for all workers over 25.
We both want to achieve a smaller, more efficiently run welfare state. But until the Chancellor is willing to invest time and effort in real reform, tax credits are one of the best welfare systems we have. They work as a direct cash transfer to low-paid workers, who are looking at low-pay or no job until they become more skilled. They directly help tackle in-work poverty, while still delivering an incentive to work.
You are probably right that there is no better time, politically, to make cuts to tax credits. But if the Chancellor is so determined to cut spending, why is he insistent on protecting the triple-lock on pensions, where the state pension increases by the higher of inflation, average earnings or 2.5 per cent?
The Chancellor cannot have it both ways. If he cuts one of the best benefits, he needs to explain why he continues to protect the worst.
The debate about tax credits cannot be reduced to arguments about whether it incentivises people to work or incentivises employers to keep pay low. There may be an element of both, but it also has the effect of making part-time workers reluctant to increase their hours or people to move to better paid jobs, because of the reduction of their tax credit payments when they do.
Under the tax credit system, an employer pays an employee and then the government adds further pay on top of earnings to three million people. When a government puts tax credits up it buys votes, or so Gordon Brown believed. When tax credits are reduced, it is unpopular, as Osborne has discovered. Basically, it was a senseless invention in the welfare system and remains an obvious target for reform.
The vast majority of welfare benefits are paid to people in work or to pensioners. There is no easy alternative, politically, to the cut in tax credits that the government is making. I am rather vulnerable to your argument, because I am not an enthusiast for the national living wage. I hope that it does not cost more than 60,000 jobs and I am worried about slipping into a debate where political parties try to outbid each other on the level of the minimum wage. As someone who argued for Margaret Thatcher’s change to the then unaffordable annual up-rating of state pensions, I also agree that it is unfortunate that the state pension is now rising rapidly in real terms and compares favourably with almost any other income. These arguments, however, are an attempt to divert from the merits or demerits of tax credits. Any attempt to go back on the triple lock would no doubt be defeated by the Labour and Lib Dem majority in the House of Lords.
As a liberal country we need a welfare state that efficiently protects the poor, the vulnerable and the low paid. Many low paid people will continue to need housing benefit, free childcare, free school meals and so on. I believe that a populist subsidy added to the pay of millions of people is an obvious target if we are moving to a more rational and affordable system.
I agree with you that in a liberal society, we want to ensure the vulnerable and poor are protected. But there is another question to ask: should welfare recipients see their freedoms inhibited by benefits?
I pose this question to combat your last assertion, that “many low paid people will continue to need housing benefit, free childcare, free school meals and so on.” Not only does this kind of complicated welfare system—that requires lots of employees to dish out different kinds of benefits—breed inefficiency, but it also gives poor people less autonomy. It restricts everything, from where they can live to what their kids eat.
The benefit of tax credits is that they provide people with the ambition and drive to take charge of their lives and their day-to-day habits as well. A better welfare system is one that tops up pay and lets workers spend it in the marketplace as they please, rather than one that keeps their pay down, and lets the state play “provider.”
My mention of the national living wage and pension pots is not meant to be a distraction from the topic at hand—these examples show that this government has its priorities backwards. Regardless of their intentions, they have threatened low-skilled jobs and protected their voting constituency.
The welfare system should not be a political giveaway for anyone. Ideally, it should operate efficiently, at low cost to the taxpayer, and provide a safety net for those at the bottom.
But hacking away at tax credits— without considering something like a negative income tax to replace the lost income—is bad policy; and it’s going to hurt those who don’t have the resources to cushion the blow.
I am surprised that you take such an extreme libertarian view. I see the attraction in saying that the state should provide an additional wage to all those on modest incomes, leaving them free to spend it as they wish. In practice this leaves people at the mercy of events and their creditors. Free childcare, means-tested free school meals and so on do have the advantage of protecting essential purchases in financial crises. A targeted welfare state is the only affordable option for a country with a healthy economy.
You have never tried to defend the full extent of tax credits when families earning over £60,000 a year received it. It is still too expensive for the government to finance by tax revenue. It is assumed that the government will continue to borrow the necessary billions until the next financial crisis comes.
Whenever tax credits are reduced or tweaked, government is going to face unpopularity. The only time for change comes when the labour market is strong, employment is high and average earnings are rising.
Ironically, you and I agree in principle. I would love to see someone devise a negative income tax to end paying tax out of one pocket and receiving benefit in the other.
I agree that “Ideally, the welfare system should operate efficiently at low cost to the tax payer and provide a safety net for those at the bottom.” Perhaps that sentence ought to determine future policy.