The tax system reduces inequality – but benefits do most of the heavy lifting

New IFS analysis, funded by the Economic and Social Research Council, finds that though benefits do much of the work in reducing income inequality, taxes also redistribute from rich to poor, and are responsible for at least a fifth of the total redistribution the tax and benefit system achieves.

On the 30th May, the ONS will publish its annual report on the effects of taxes and benefits on UK household income. Last year’s report concluded that “overall, taxes had a negligible effect on income inequality”, a result that received considerable attention. However new IFS analysis improves on the ONS’s methodology and finds that the tax system is in fact progressive.

Our key results include:

• The system of direct taxes (income tax, NICs and council tax) and benefits reduces inequality. Before redistribution the highest-income fifth of individuals on average have an income that is 12 times as large as that of the poorest fifth. After adding on cash benefits and deducting direct taxes this ratio falls to 5.

• While taxes are progressive, benefits are considerably more so. The poorest fifth receives 16 times more in benefits as a share of their net income than the highest-income fifth does. Conversely, the highest-income fifth pays just 2.7 times as much direct tax as a share of income as the poorest fifth. Measuring benefits and taxes as a share of net income is the right way of thinking about their progressivity, though of course in cash terms the highest-income fifth does pay a much larger amount of tax (13.7 times as much) than the poorest fifth does.

• Across the whole population and at any point in time, 30% of individuals are in households that receive more in cash benefits than they pay in direct and indirect taxes. This is true of 27% of those in working-age households with children; 13% of those in working-age households without children; and 66% of those in households with at least one pensioner.

Different taxes have different distributional effects:

• Income tax and NICs, taken together, are clearly progressive. The highest income fifth pays about 4 times as much direct tax as a share of income as the poorest fifth and 20 times as much in cash terms.

• But council tax is regressive. Even after accounting for council tax support (which reduces council tax liabilities for low income families), the poorest tenth of the population pay 8% of their income in council tax, while the next 50% pay 4-5% and the richest 40% pay 2-3%.

• Indirect taxes (VAT and excise duties) measured as a share of expenditure are distributionally neutral. Overall, 15% of people’s expenditure is accounted for by indirect tax (around two thirds of which is VAT), with little variation across rich and poor households.

The ONS is right in saying that benefits significantly reduce inequality. The strong claim that taxes make a “negligible” difference, though, is not robust to different (possibly preferable) ways of measuring their effects.

Household surveys under-represent people with very high incomes. We correct for this, which means we better capture the fact that the rich pay a large share of tax. We also treat employer National Insurance contributions (NICs) as a direct tax just like employee NICs. Employer NICs are progressive, so this change also increases our estimate of the progressivity of the tax system.

The biggest choice is over how to account for indirect taxes. If you measure their effect as a share of expenditure they look broadly distributionally neutral. If you measure them as a share of income, as the ONS does, they look regressive. But this is driven by households with high spending relative to their income at a point in time – these households are disproportionately likely to be on a low income only temporarily or to have had their incomes under-recorded in the survey.

All this of course ignores other taxes like capital gains tax, corporation tax and inheritance tax whose impact are much harder to measure but which are likely to be paid disproportionately by the better off.

Pascale Bourquin, an author of the briefing note and a Research Economist at IFS said:
 
“The tax and benefit system significantly reduces the gap between rich and poor, with benefits playing a particularly big role. However, contrary to the ONS’s claim, taxes do also reduce inequality. Within that, council tax is clearly regressive, income tax and NICs are significantly progressive, and we should probably think of indirect taxes as being broadly distributionally neutral. But the bigger picture is that what matters for income inequality is the progressivity of the tax and benefit system as a whole, and not a specific part of it. The government should achieve its desired amount of redistribution using those parts of the tax and benefit system best suited to that particular job.”