The impact of current benefit and tax uprating policies on poverty, incomes and living standards.
Each year, the Government decides how much to raise benefits and tax allowances. The basis for these upratings is rarely debated, yet has major long-term consequences for the relative living standards of different groups and for public finances. This report considers the implications of present uprating policies, which mean that some parts of the tax and benefit system are uprated by earnings growth, other parts by prices and some not at all.
Continuing with these uprating policies for 20 years, other things staying the same, would result in a near doubling of the child poverty rate alongside a substantial gain to the public finances. Some of this budgetary gain may be needed to meet other demands – of an ageing population for example – but the cost falls disproportionately onto poorer groups and could be raised more fairly.
Using results from three types of micro-simulation model, this study aims to stimulate debate on an often hidden area of policy-making.
Each year, the Government decides how much to raise benefits and tax allowances. The basis for these upratings is rarely debated, yet has major long-term consequences for the relative living standards of different groups and for public finances. This research considers the implications of present uprating policies, and aims to stimulate debate on this hidden area of policy-making.
Annual adjustments of benefit, tax credit levels and tax thresholds can seem like a technical exercise, scarcely noticed among announcements made in Budgets. In reality, they are among the most significant decisions taken by Chancellors. As with climate change, their gradual effects seem imperceptible on a year-to-year basis, yet they carry immense implications for the future.
The aim of this research is to make more visible the scale and implications of current uprating conventions, and of some alternatives, for income distribution, poverty rates and the public finances.
Different criteria are used in uprating different parts of the UK benefit and tax systems:
Which index is used can make a big difference. For example, if the amount of Jobseeker’s Allowance (or its equivalent) received by a single unemployed person had kept pace with average earnings since 1971 it would be double the value it is now.
Uprating rules have particular relevance for the prospects of meeting the present government’s child poverty targets in 2010 and 2020, especially those poverty targets for the proportion of children with household income less than 60% of median income. If median (middle) income rises faster than benefit incomes, poverty reduction will be virtually impossible to achieve.
A number of different principles might guide uprating practice. These are summarised in Table 1.
|Aim||Choice of uprating factor|
|Maintain current inequality||Average income (e.g. mean after-tax income)|
|Maintain current relative poverty||Typical incomes (e.g. median household income, as used to define the poverty line)|
|Keep up with a Minimum Income Standard||Change in income necessary to achieve a contemporary budget standard|
|Maintain real standard of living||Relevant price index (e.g. Retail Prices Index (RPI), Rossi or Consumer Price Index)|
|Constant return on contributions||Gross earnings|
|Public finance affordability||National income (GDP)|
|Coherence||Common uprating factor across the whole tax-benefit system|
A review of practice in other countries reveals that no single principle seems to govern uprating procedure. Instead, uprating involves compromise between a number of objectives and policy can fluctuate year-to-year as conditions and political priorities change.
In practice, uprating decisions can be used not only to maintain the status quo, but also to adjust the value of benefits or tax thresholds over time where a government thinks that their present level is too high or too low. This can provide a way of phasing in structural changes slowly, minimising disruption to household budgets. But it can also disguise the losses affecting some people and confuses the arguments for regular uprating.
To create greater clarity about the long-term effects of different uprating regimes, this research considered what would happen over a 20 year period from 2006/7 under various policy scenarios, if everything else stayed the same. The study assumed 2% per year annual real growth in earnings in line with recent experience. This is not a forecast of the future, since it does not take into account future policy responses or demographic change. It is a way of separating out the specific effect of different uprating options over an extended period.
The ‘base case’ for such calculations is the current uprating system. Under this scenario, after 20 years:
Not surprisingly, with benefits falling sharply in relative terms, other things being equal the percentage of people in relative poverty (in households with below 60% of median income before housing costs) would rise in this scenario: from 17% to 23% of the population. (The rise when measuring income after housing costs is similar – from 21% to 25%.)
This would, however, affect different groups very differently. Pensioners would see no substantial change in their poverty rate as they will be protected by upratings linked to earnings. However, child poverty would rise dramatically, from 18% to 33% on the Government’s preferred measure (before housing costs). Thus, instead of eradicating child poverty, the effect of continuing current uprating policies would be almost to double it.
Moreover, among people in all groups who fall below the poverty line, the depth of poverty would rise. In particular, the average incomes of people in poverty after housing costs would be less than two thirds of income at the poverty line (65%) compared to more than three-quarters (77%) today.
Overall, the budgetary effect is a substantial gain to the public finances, compared to what would happen if the system was adjusted in line with earnings growth. After 20 years this amounts to around 3.6% of GDP, or the equivalent of £47.4 billion relative to 2006/7 earnings. More than half (£27.2 billion) is due to the erosion in the value of benefit and tax credit amounts and thresholds relative to earnings, with the remainder being due to fiscal drag.
As shown in Figure 1, benefit erosion plays a much bigger role than fiscal drag at the bottom of the household income distribution, and the reverse is true at the top end. In combination, they result in a proportional reduction in incomes that is nearly four times as large for the poor as the rich. The 20% of households with the lowest incomes on average lose 17% of their disposable income relative to earnings. The 20% of households with the highest incomes lose 5%.
Source: POLIMOD using FRS 2003-04
Some of the potential gain to the public finances implied by the present uprating systems may be needed to fund extra government spending. In an ageing society, spending on the health service may need to rise as a percentage of national income, while spending on items such as pensions and long-term care will need to cover growing numbers of older people. Nevertheless, alternative ways of using the remainder would have very different distributional effects.
As an illustration, the researchers considered different ways of using £20 billion of the £47 billion budgetary gain. This would be enough to eliminate all the fiscal drag shown in Figure 1. It would allow, for instance, income tax rates to be cut over 20 years by gradually lowering the basic rate of tax from 20% to 17.6%. This might have superficial political attraction and would wipe out the losses of the highest earners but would have virtually no effect on the losses sustained by the poorest groups, as shown in Figure 2.
Alternatively, if £20 billion were used to uprate benefits faster than prices, bringing them closer to earnings growth, the effect on the poorest groups would be reduced sharply. Under this scenario, the costs would be similar at about 5% across income groups. Poverty would still rise, but only slightly – from 17% to 18% overall. If revenue gain is required by government over the medium term this would be a much more evenly balanced way of achieving it.
Source: POLIMOD using FRS 2003-04
The modelling conducted for this report has shown that today’s uprating systems imply substantial long-term reductions in personal disposable incomes relative to earnings. While all groups will be affected, those with the lowest incomes will be hit hardest, causing widening economic inequality. Some or all of the extra money raised may be needed for public spending to pay for demographic change and improving services. However, the raising of these funds appears unfair, falling disproportionately on poorer groups. A more open debate about this often hidden area of public policy may lead to different choices about how much extra money is needed and who should pay for it. Above all, this would mean that decisions that prevent the poorest members of society from keeping up with rising living standards would not be taken in the dark.
This study used three types of micro-simulation modelling to establish the effects of alternative uprating regimes after 20 years. POLIMOD, Holly Sutherland’s tax-benefit model based on Family Resources Survey (FRS) data, is used to estimate the effects for the UK population on incomes, poverty, work incentives and reliance on means-tested benefits, on the basis that everything apart from taxes, benefits and tax credits, remains the same. CARESIM, Ruth Hancock’s model of pensioner incomes and long term care is also based on FRS and is used to focus on the effects on groups of pensioners, allowing for differences in income composition across groups and over time. LOIS, Martin Evans’ model of hypothetical families is used to illustrate the evolution of incomes for particular families over the 20 years being considered.