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March 1998 - Ref No 278
The Government plans to use tax credits, rather than just social security benefits, to help low-income working families. At a series of JRF seminars, experts from the UK and abroad have looked at the options, and identified potential advantages and pitfalls. The Working Families Tax Credit would give tax rebates to low-income wage-earners with children (presently receiving Family Credit). Key objectives: The first two objectives are common to Family Credit and the proposed tax credit. The second two are distinctive to payment through the tax system. Policy options The introduction and development of the Working Families Tax Credit involves critical decisions on:
Other desirable outcomes: Family Credit has generally been considered a success. A tax credit will need to build on its advantages. The following are desirable:
Evaluating proposals for a working tax credit Careful evaluation will be required of the impact on:
The Working Families Tax Credit: Options and evaluation Introduction A tax credit is an attractive way of helping needy working families because it allows them to depend less on transfers from the state and more on their own retained earnings. However, it does not necessarily differ from a benefit for poor working families in terms of how much disposable income they will have at a certain level of earnings. The United Kingdom already has a well-functioning benefit of this type, Family Credit. In replacing it, it is important that the detailed features of the new system and its operation in practice are carefully considered. This is particularly desirable because other countries have found a range of unforeseen problems with tax credits, which have not always met their key objectives and have sometimes attracted widespread fraud. This Foundations considers five key issues that emerged in a series of seminars and in the reports listed at the end. Tapers, incentives and targeting An underlying issue applying to any means-tested income transfer is the way it affects the relationship between earnings and disposable income. A tax credit or benefit for low-income workers improves the attractiveness of low-paid work compared with unemployment. But it also reduces the rate at which low-income families can raise their living standards through higher earnings, to the extent that state support is cut as pay increases. At present, a family receiving Family Credit, Housing Benefit and council tax benefit may keep as little as 3p of a £1 rise in wages/salaries, because it receives less in benefits and pays more in taxes and National Insurance contributions. This can limit the incentive, for example, for the spouse of a low-paid worker to take a job. With any given level of income redistribution through the tax and benefit system, all means-tested benefits bring a fundamental trade-off between the adequacy of the minimum incomes implied and the rate at which low-income households are allowed to keep extra earned income. The higher the minimum income, the steeper the rate of withdrawal of help from those trying to rise above that floor. In taking future decisions about how to structure support for families, the Government needs to consider carefully the balance between incentives and minimum adequacy. The case of Australia described in the box illustrates this. Tax credits introduced in Canada and the United States as well as Australia's Family Payment are 'tapered' (ie benefit/credit reduces as earnings rise) only above a certain level of family earnings, and indeed the United States starts with a 'reverse taper': up to a certain level, the credit grows with earnings. A benefit that is not reduced as soon as the earnings of the poorest working families go up (as currently happens in the UK) potentially makes it easier for them to escape poverty, rather than trapping them on incomes which are just adequate. Policy in the UK needs to take account of several issues:
There is a strong case for integrating taxes and benefits targeted at low-income households:
Families and child poverty An important difference between existing support for working families with children and the proposed tax credit is that the latter will normally be received through the pay packet, in many cases that of the father, whereas the former is almost always paid to mothers. Although family spending patterns vary, new Joseph Rowntree Foundation research published in 1998, Distribution of income within families receiving benefits, suggests first that women are more likely to control income that they receive directly than through their partner's pay packet. Second, women are more likely to devote money they control to family spending. Third, women are more likely than men to forego personal spending in order to ensure that their children's needs are met; such sacrifices play an important role in reducing direct hardship for children, according to another recent JRF study, Small Fortunes. There is therefore a real danger that a smaller proportion of money received through the pay packet would be spent on children than that received through an order book. The Government's proposal to allow families to elect to which partner the tax is paid could have considerable benefits for children. Evaluation of its impact will need to look firstly at how many non-working women take advantage of this option and secondly at the final effect on spending patterns. Timing and rough justice The UK has a tradition of matching means-tested benefits very precisely to exact needs at exact times. Although this tradition has been somewhat modified in recent years, the benefit system has more precision either than those of most other countries' or than the UK tax system, in which exact precision is not a legal requirement. Tax credits in other countries have often been made in the tax year following the one in which eligibility arises. But in the UK, a prompt adjustment of PAYE codes would contribute considerably to work incentives, particularly to avoid two problems:
However, if the Working Families Tax Credit were treated exactly like a tax allowance, it could introduce two types of disadvantage compared to Family Credit:
A tax credit system with less precision than traditional UK means-testing could help reduce benefit dependency. Less tapering, discussed above, is one way of doing this. Another is to continue the practice of longer assessment periods, established by Family Credit. Administrative issues and the assessment unit Assessment for the tax credit could be done in three ways: automatically through tax returns, by employers or through claims by individuals. The first poses two difficulties. First, two-thirds of taxpayers have tax deducted at source and do not fill out a tax return. Second, the tax system uses the individual rather than the family as the unit of assessment. To change this would raise controversial issues about whether husbands and wives should be assessed jointly, which are unconnected to the question of supporting poor working families. Employers are likely to resist becoming directly involved in assessing their employees' eligibility for the credit. The best practical payment option is likely therefore to be based on an instruction from the Inland Revenue to the employer following a claim by the employee. This process could take two forms:
Fraud and exploitation The possibility of fraud should be taken seriously. In the United States, a high proportion of successful claims appear to relate to children who do not exist or are being claimed for more than once. Another form of potential fraud, of more direct concern to the UK, is collusion between employers and employees to reduce the level of declared income. It is hard to predict how attractive or easy such fraud will be in the UK institutional context, so again monitoring will be important. One form of non-fraudulent but undesirable behaviour could arise from the greater visibility to employers of tax credits as compared to Family Credit. There might be a temptation for firms to reduce pay, and hence their wage bill, with relatively small consequences for employees. A minimum wage may help deter this, depending on its level. Some European countries concerned about pay effects have raised minimum wages while shifting public resources from individual benefits to payroll-tax reductions, to avoid a rise in total pay costs. Lessons from abroad The United States, Canada and Australia all have recent experience of income transfers to poor working families. In the United States and Canada these have taken the form of a tax credit; in Australia, all benefits for families have been rolled together into a single Family Payment plus a small tax credit for one-earner families. Some key lessons that emerge from these experiences are:
There are also important ways in which the relevance to the UK of overseas experience is limited. In the USA, Canada and Australia, for example, families are normally compensated for low earnings the year after they occur. It is unlikely that such a system would work in the UK context, especially because it would create a work disincentive for those with the alternative option of immediate cash through Income Support (for example, lone parents and wives of unemployed men, who are not required to seek work). Another complication less serious in these other countries than in the UK is that they do not provide widespread means-tested support for housing costs, and so have less cause for concern over the combined effect of tapering more than one benefit. In Canada the reformed child tax-benefit system has absorbed allowances for children previously contained in Housing Benefits, which has enabled the latter to move to a flat-rate basis. Australia's Family Payment The case of Australia, which in the past had a similar benefit structure to that of the UK, but has now integrated child benefit and other forms of family support into a single means-tested payment, illustrates some of the choices available (Figure 1). Most families (but not the highest 20 per cent of earners) are eligible for at least the minimum basic payment, a smaller amount than the UK's child benefit. The exclusion of the most affluent is now uncontroversial given the small size of minimum benefits relative to their incomes. But this 'affluence test' is combined with less finely targeted means-testing at the opposite end of the income scale, by paying the maximum family payment not just to the 23 per cent of families on Income Support but also to the 10 per cent who are the lowest paid working households. The maximum payment is only reduced for families whose income is above an amount that slightly exceeds average female earnings, in contrast to the UK where benefit reductions start as soon as earned income rises. One advantage of flat-rate benefits over wide income bands appears to be better take-up: almost all of those eligible claimants not receiving their full entitlement in Australia are in the middle band, in which benefit varies with income, and have presumably not realised that they are eligible for more than the minimum payment.
Conclusions The Treasury Green Paper, The Modernisation of Britain's Tax and Benefit System, suggests that a Working Families Tax Credit should "build on the success of Family Credit". There remains a strong case, supported by overseas experience, for pursuing the same objective through improvements to benefits rather than through the tax system, but if a tax credit is to be introduced, awareness of both potential improvements for low-income working families and potential difficulties for them is necessary. The most important potential improvement that could result from the tax credit would be to ensure that working families receive adequate minimum incomes but face less severe overall loss of extra earnings through the tax and benefit systems than is presently the case. In deploying any extra resources (including redirected public savings resulting from the minimum wage), a balance would therefore be needed between improving income adequacy and reducing tapers. The latter can only be done effectively if the combined impact of all taxes and benefits, and in particular the tapering of Housing Benefit, is taken into account. There could be considerable advantages in integrating Housing Benefit for working households into the tax credit, and in removing the effect of overlapping tapers. A further area in which integration could create a clearer and more rational system is in bringing together existing Family Credit and child benefit into a single system of graduated payments. This would make it possible to reduce entitlements for the highest earners without doing so for those on average incomes. A switch to a tax-based system brings two particularly important risks. First, money may not always be available when it is needed. Second, there is a risk that receipt of the credit through the pay packet would reduce its effect on children's living standards, in cases where the main family budget is controlled by non-earning married women. The way in which the tax credit is established and distributed could minimise both these hazards. The proposed right of non-working women to continue receiving the payment is an important protection, although its effect should be closely monitored. Evaluation needs to look not only at the specific impact of the Working Families Tax Credit but also at how it interacts with other policies. Will the minimum wage significantly enhance family incomes? How many people will be 'trapped' on incomes dependent on both Housing Benefit and Working Families Tax Credit, both subjected to high rates of withdrawal? How will trends in rents affect the picture? How will the Working Families Tax Credit interact with other policies directed at single parents to improve their work incentives? Such questions need to be rigorously addressed in the months and years ahead. To obtain further information This Foundations draws primarily on the following reports: Integrated family benefits in Australia and options for the UK tax return system by Jane Millar and David Hole (ISBN 1 899987 71 1); The WIS that was: replacing the Canadian Working Income Supplement by Michael Mendelson(ISBN 1 899987 69 X); The integration of taxes and benefits for working families with children: issues raised to date by Pamela Meadows (ISBN 1 899987 52 5); and Lessons about tax-benefit integration from the US Earned Income Tax Credit Experience by Jeffrey Liebman (ISBN 1 899987 53 3). These titles are now out of print. |
