IFS has published research that is relevant to two of the specific questions asked in the inquiry, and that we hope the committee will find helpful:
- What would be the impact of adjusting a) the taper rate or b) UC work allowances on employment incentives in UC? Which option for reform would be most cost-effective?
We can distinguish between two kinds of work incentive: the incentive to be in paid work at all (as opposed to not working), and the incentive for those in paid work to increase their earnings.
The incentive to be in paid work at all
Looking first at the incentive to be in paid work at all: either reducing the UC taper rate or increasing work allowances would strengthen employment incentives for those without a working partner (i.e. single people or the first earner in a couple); for a given amount of government spending, the two policies would have similar effects on average, but increasing work allowances would be more focused on incentives for the very lowest earners while reducing the taper rate would be more focused on low-to-middle earners. This reflects the fact that increasing work allowances is a flat-rate giveaway to all UC-receiving families earning above that level, whereas reducing the taper rate is worth more to families with slightly higher incomes. For one example graphical illustration of this, see slides 10 and 11 here.
However, for those with a working partner, both of these policies would weaken the incentive to be in paid work: in other words, these reforms would increase the incentive for couples to have one partner in work, relative to neither partner working or both partners working. This is because providing more means-tested support to families with one earner in work means that there is more support to lose if the second partner works as well. The relative effects of reducing the taper rate versus increasing work allowances on employment incentives for those with working partners depend on the earnings of their partner: since increasing work allowances targets the increase in support more on the very lowest-income families, it would tend to weaken employment incentives more for those with the lowest-earning partners, whereas reducing the taper rate would tend to weaken employment incentives more for those with slightly higher-earning partners (a slightly more numerous group).
The incentive for those in work to increase their earnings
Turning to the incentive for those in work to increase their earnings: reducing the taper rate would increase the proportion of each extra £1 of earnings that those on the taper got to keep. This gives them a stronger incentive to increase their earnings. However, the corollary is that withdrawing support more slowly means that it must be withdrawn over a larger range of income: some of those with earnings that are currently too high to receive UC would become eligible for some UC, and hence face losing it if they increased their earnings. Thus reducing the taper rate would mean the disincentive effects of withdrawing UC were slightly less severe, but affected more people.
Increasing work allowances does not involve quite the same trade-off: UC would still be withdrawn at the same rate over an equally wide range of income. But that withdrawal would happen at a slightly higher income level. This means that some people who previously faced a reduction in UC if they increased their earnings slightly would now face no reduction, because their earnings fell within the increased work allowance; whereas others (a slightly more numerous group) whose incomes previously placed them just beyond the scope of UC would be brought into it and face the UC taper.
Comparing the two reforms, there are two groups of workers for whom raising the work allowance would result in a stronger incentive to earn a little more than an equally costly cut to the taper rate:
1) those whose family earnings put them in between the pre-reform and post-reform work allowances – with a higher allowance, they would lose no UC at all were they to earn a little more; whereas with a lower taper rate they would still lose some UC were they to earn a little more.
2) those whose family earns slightly too much to be entitled to UC even under the higher work allowance – these people’s incentive to earn more would be unaffected by raising the work allowance (they would still have no UC to lose), but would be weakened by the cut to the taper rate since reducing the taper rate would bring more people into means-testing than an equally costly increase in work allowances.
People in families with earnings between those two levels – that is, in the earnings range that would be subject to the taper with increased work allowances – would, on the other hand, have stronger incentives to earn more after a cut to the taper rate than after a rise in the work allowance.
The effects of these policies on work incentives is thus not straightforward:
- Reducing the taper rate and increasing work allowances would both strengthen incentives for families to have someone in work
- But they would both weaken incentives to have a second earner in work
- Both policies would have an ambiguous effect on incentives for those in work to increase their earnings - strengthening the incentives for some but weakening them for others.
Nor can the two policies be straightforwardly ranked, as they strengthen and weaken incentives to different extents for different groups. As so often, reforms in this area involve delicate trade-offs.
- Should UC have different taper rates and/or work allowances for different claimant groups?
As with virtually all benefits policy, the government is facing multiple trade-offs when setting the level of the taper rate and/or work allowances. For a given level of generosity to those out of work, the higher the work allowance, or the lower the taper rate:
- the higher the cost to the taxpayer;
- the less targeted is UC on families with the lowest resources;
- the stronger are the incentives for families to have someone in work;
- the weaker are the incentives for families to have a second earner in work;
- the more families are brought into the scope of means-testing (which has practical implications as well as cost, distributional and incentive implications).
- In setting the taper rate, there is a further trade-off between having relatively severe disincentives for those on the taper to increase their earnings, and having disincentives that are less severe but affect more people.
The appropriate balance between these competing considerations depends partly on political value judgements about the priority attached to supporting different groups in society. It is not our place to make these: there is no single ‘right answer’. That said, the appropriate balance also depends partly on factual questions about the shape of the income distribution for different groups and the responsiveness of different groups to different kinds of work incentives (incentives for 1st vs. 2nd earners, and incentives to be in work at all vs. for those in work to increase their earnings).
In balancing incentives for 1st vs. 2nd earners, for example, policy-makers may feel that the more important objective is to protect families’ incentive to have someone in paid work at all (rather than their incentive to have a second earner in work); but they should also bear in mind the empirical evidence which tells us that (broadly speaking) second earners’ employment decisions can be highly responsive to financial incentives whereas the employment decisions of first earners in couples are not.
Given these delicate trade-offs, it is virtually inevitable that the theoretically ‘optimal’ values of the taper rates and work allowances would be different for different claimant groups. Policymakers may prioritise support for certain claimant groups. Different claimant groups have different earnings distributions, so for some claimant groups we might worry more about protecting the incomes and/or work incentives of low earners relative to higher earners. And different claimant groups respond differently to work incentives. To continue the example above, the trade-off between first- and second-earners’ work incentives may be different for families with and without children, or with children of different ages, or for families in which one person has a disability, and the trade-off does not apply at all to single-adult households.
All else being equal it is preferable to focus more on protecting incentives for groups who respond more to them, and less on protecting incentives (and hence more on other objectives that one might be trading off against incentives) in cases where people do not respond much to incentives. Chapter 3 (particularly Section 3.2) of the first volume of the Mirrlees Review describes in detail the evidence on how responsive different groups are to work incentives, in terms of deciding whether or not to work and how much to work. Chapter 4 of the second volume draws out some of the implications of these findings for tax and benefit reform.
Some degree of variation in the parameters across family types is therefore the likely conclusion of any exercise that attempts to trade off the considerations mentioned thus far. In addition, though, there is another trade-off: between theoretical optimality and simplicity. Whilst economics has a huge amount to offer in terms of identifying the former, we do not downplay the importance of the latter consideration. One plausible compromise is to vary some policy parameters between claimant groups while keeping others the same, as UC currently does by varying work allowances but having a common taper rate.
Empirical evidence on the characteristics and responsiveness of different claimant groups is crucial in weighing the pros and cons of applying different work allowances or taper rates to different groups, and whether the magnitude of potential gains justify the additional complexity involved. From decades of empirical research we already have a lot of information on how different groups tend to respond to financial work incentives. In addition, though, trials that varied these parameters under UC, in a carefully designed way which allowed the resulting effects to be usefully evaluated, could be extremely helpful. As explained above, they cannot reveal some objectively ‘correct’ set of parameters, but they could help to quantify the trade-offs policymakers face and so help well-informed decisions to be made.