The poverty trade-off: work incentives and income redistribution in Britain

Concern for poverty or inequality motivates governments to want to redistribute income, but providing benefits on the basis of low income reduces the incentive for people on low incomes to work themselves out of that position (over and above additional disadvantages of means-tested benefits such as stigmatising recipients, requiring burdensome form-filling and achieving less than full coverage among the entitled population). Similarly, cutting taxes on higher incomes encourages people to work to increase their income, but leaves behind those who do not do so.

Thus the two main ways for a government to help people with low incomes - providing them with support directly and encouraging them to earn more themselves - are in headon conflict with each other. How best to deal with this conflict has long been one of the central questions facing academic economists and economic policy makers.

For academic economists, the dominant framework for thinking about how best to handle the trade-off between work incentives and redistribution is optimal taxation theory, initiated in its modern form by Mirrlees (1971). This literature attempts to specify a 'right answer' to the question - that is, a complete tax-benefit system - subject to various assumptions. However, it requires at least two vital and controversial inputs. The first is a set of social preferences: how much does society (or the government) value the additional happiness of the poor relative to the additional happiness of the rich? This is not something we know, and we did not want to assume it for this project; but without it, we can hope only to delineate the set of feasible options, not choose between them.

The second input is a set of individual preferences: most importantly, how much individuals would choose to work when faced with a given tax and benefit system. Some models attempt to estimate this based on individuals' responses to past tax and benefit changes: see Brewer et al (2005) for a recent example. But all such estimates remain controversial and laden with assumptions, and we do not espouse any here.

In this project, therefore, we estimate only the direct effects of policies on incomes and on work incentives; we ignore any effect that people's responses to these changed work incentives might have on incomes. As a result, we cannot judge whether, for example, the weakening of work incentives caused by a particular redistributive policy will draw more people into poverty than the redistribution itself lifts out. This report aims to illuminate the trade-off between work incentives and redistribution, not to predict the ultimate outcomes associated with policy choices or assess their desirability.