Policy Options - June 1997
The integration of taxes and benefits for working families with children

A case has been made for integrating the tax and benefit system to make the transition from benefit to work easier, improve the take-up of in-work benefits, take low-income families out of the benefit system and reduce its unpopularity for taxpayers. The Foundation commissioned a report on the American system by Professor Jeffrey Liebman of Harvard University and convened two seminars of experts to discuss the practical considerations for the UK. Pamela Meadows, Director of the Policy Studies Institute, summarises here the policy conclusions from these seminars:

• Three options for achieving integration are feasible:

- The Inland Revenue assesses entitlement based on taxable income and employers deduct the credits paid out from the total PAYE due.

- The employers make the assessment based on information provided by the employee using Inland Revenue calculation instructions.

- The DSS assess the entitlement based on claims and instruct the employer on what should be paid.

• All of these options would involve:

- A return to the family as the unit of assessment rather than the individual, reversing the privacy introduced with separate assessment.

- All taxpayers would complete a tax return (only 25 per cent do now).

- Some labour costs being passed on to the taxpayer and increased scope for fraud.

- Some 'losers', in that the assessment of circumstances would have to be simpler than the current Family Credit.

- A loss of benefits-in-kind currently available to recipients of Family Credit.

• Employers see no difficulty in being paying agents, but foresee problems if they had a role in the assessment.
• It is difficult to measure the extent to which employers in the US have received an effective wage subsidy from the system, but it is likely that some employers would find ways of using the system to lower their wage costs.
• It was concluded that the most notable gainers from an integrated system would be the small group who currently do not claim Family Credit, but integration would cause huge disruption and increased complexity for the rest of the population.

Background

As part of its research programme on 'Work and Opportunity' the Joseph Rowntree Foundation has reviewed some of the evidence and issues related to the integration of taxes and benefits for families with children, as a possible additional route back into work. This would replace current in-work benefits such as Family Credit.

The take-up of Family Credit is only around 70 per cent of those eligible (although take-up as a proportion of income due is around 80 per cent). Sometimes this is due to lack of knowledge of its availability. In other cases it derives from an unwillingness to be dependent on benefits. Many non-claimants are entitled only to small amounts and may therefore have a limited incentive to claim.

In addition, some people are deterred from taking low-paying jobs because they are uncertain about both the level of in-work benefits to which they would be entitled, and the time it will take for the payment to come through. They do not appear in the statistics of non-claimants because they remain unemployed.

There is a case for integrating taxes and benefits to overcome these problems and make it easier for people to make the transition to work as indicated in Box 1. However, integration would raise a number of practical issues. These relate to the four major differences between the tax and benefit system:

• The benefit system treats the family (a married or cohabiting couple or a lone parent and their children) as a unit. The tax system treats the individual as a unit.
• The period of assessment for income tax is the year to date, so that periods of high and low income during a tax year balance themselves out. Family Credit is assessed based on earnings over a six-week period. It is then paid for 26 weeks without reassessment.
• For employees, tax collection and the payment of rebates is done by employers acting on the instructions of the Inland Revenue. Family Credit is assessed and paid by the Department of Social Security.
• Family Credit is almost always paid to mothers. Integration would mean that for two-parent families, there would be a transfer of cash to the father's pay packet.

The United States already has an integrated tax and benefit system as described in Box 2. In the UK there are several ways in which integration could be achieved, but these are largely covered by three broad options, each of which could have detailed variants:

• The Inland Revenue could assess entitlement based both on taxable income and on family circumstances. Employers would deduct the credits paid out from the total PAYE due.
• The assessment could be done by employers based on information provided by employees using calculation instructions from the Inland Revenue.
• The DSS could assess entitlement based on individual circumstances set out in claims, and instruct the employer as to what should be paid.

All these options are feasible. Whether they are desirable would depend on the impact on cost, on popular opinion, on those who would not benefit as well as those who would, and on the relationship between employers and their employees.

Practical issues

Whichever option is adopted, issues arise in relation to in-work benefits, the tax system and the role of the employer.

Issues related to in-work benefits

Family Credit and Housing Benefit are closely tailored to individual circumstances. The former has differential rates for children of different ages and amounts for each child and disregards for certain sorts of income or expenses such as childcare. The latter takes account of the actual rent paid on the individual property. If we were to move towards an integrated system it would probably need to be simpler than Family Credit. This would inevitably produce some losers.

Family Credit recipients are automatically entitled to a range of benefits in kind. It is likely that this 'passport' would be lost if the benefit were to be integrated with the tax system.

Issues related to the tax system

It would almost certainly mean a return to the family as the unit of assessment. This would be unpopular with women, particularly high earners, who value the privacy introduced with separate assessment.

Integration would almost certainly require all taxpayers to complete an annual tax return. At present around a quarter do so each year.

The Inland Revenue sets a high priority on ensuring that employers are willing to continue to be unpaid collection agents. The evidence also suggests that PAYE is subject to low rates of fraud. Since integration would provide incentives to employers to pass some labour costs on to the taxpayer, this could induce both legitimate behavioural changes and increased fraud.

Payment by employers

Employers consulted saw no real difficulty in acting as the paying agents for in-work benefits. It would be no different in principle from dealing with deductions from pay because of court or Child Support Agency orders.

They did foresee problems if they were doing more than acting as the paying agent. If they had any role in the assessment of entitlement, employers felt that it would introduce unhelpful complications into the employment relationship, could be damaging to employee relations more generally, and could lead to potential confrontation. There was also a concern that the employer would be taking on responsibility for the award of credit without having the access to sources of information that would enable them to verify the claim.

In smaller organisations in particular, it was felt that people would be uncomfortable about colleagues knowing more about their private lives. If the information were to be collected on a voluntary basis only from those who chose to make a claim, the employers felt that take-up would be lower than it is for Family Credit.

Effect on wage levels

In a report for the Joseph Rowntree Foundation, Professor Jeffrey Liebman has said that there is no evidence from the US on whether employers are gaining any benefit from EITC in the form of lower labour costs. The minimum wage limits the ability of employers to capture such benefits.

The measurement of the effect of any form of wage subsidy on employers' behaviour in a market economy is difficult. If an employer does not secure enough suitable applicants for vacancies at existing wages, it is likely that the wages for that type of job will be increased. If a subsidy such as Family Credit or EITC encourages a greater supply of potential workers at the original wage rate, then it is clearly benefiting employers, but it is doing so indirectly, and without them being aware of the cause.

However, if employers' awareness of in-work benefits or credits increased markedly, some might develop creative accounting schemes and creative pay schemes which would enable their employees to claim higher rates of credit, thus allowing them to have lower wage costs.

The real objective

The real objective is to ensure that families faced with the choice between unemployment and low-paid work will have higher incomes, equal income security and greater self-esteem in work rather than out of work. It is not clear that any of these necessarily requires either full integration or payment by employers.

Integration with automatic entitlement would most notably benefit the small group of people who currently do not claim Family Credit, but who would receive credits under a new system. However, this improvement would only come about at the cost of a large increase in complexity and a good deal of disruption to the remainder of the population.

About the study

In order to consider whether the theoretical advantages of tax benefit integration could be realised in practice, or whether there are other avenues that should be explored, the Foundation commissioned a report by Professor Jeffrey Liebman of Harvard University and organised two seminars of leading experts and people who would be affected by any change (such as employers). The first was introduced by Andrew Dilnot of the Institute for Fiscal Studies and the second by Professor Jeffrey Liebman. The material presented here summarises the conclusions of these seminars.

Further information

A further analysis based on the seminars, The integration of taxes and benefits for working families with children (ISBN 1 899987 52 5) by Pamela Meadows, will be published in the summer. Professor Jeffrey Liebman's short report, Lessons about tax-benefit integration from the US Earned Income Tax Credit Experience (ISBN 1 899987 53 3), will be published at the same time. Both reports are priced £7.00 and the two may be purchased together for £10.00. plus £1.50 postage and packaging per order.

These titles are now out of print.