Observations

July Budget measures will strengthen work incentives overall despite tax credit cuts

Date: 19 November 2015
Authors:
Publisher: Institute for Fiscal Studies

In advance of next week’s Autumn Statement, when the Chancellor is expected to announce amendments to his planned cuts to tax credits, the Institute for Fiscal Studies has today published a comprehensive analysis of the impact of the government’s current tax and benefit plans and the National Living Wage on household incomes and financial work incentives.

Our report focuses on the effects on work incentives of changes proposed in the July Budget. It finds that both the package of tax and benefit changes, and the new ‘National Living Wage’ will, on average, strengthen incentives to move into paid work and to work more if in work.

But within this overall picture, the effect of the tax credit changes on work incentives will be different for different groups. For example, the tax credit changes will weaken incentives for lone parents to move into work but strengthen the incentive for both members of a couple to work rather than just one. And for those looking to work more, although the tax credit changes will increase by a million the number of workers who get to keep at least 40p of every extra pound earned they will also increase by half a million the numbers keeping less than 20p of each extra pound earned.

The full report is available here, a companion report funded by the Welsh Government examining the impact of the reforms in Wales is available here.

A key finding of our report is that tax and benefit changes to be introduced between now and 2019–20 will on average strengthen people’s incentives to be in paid work despite the £4.4 billion planned cuts to the tax credits received by working families. However, these cuts to the in-work support provided by tax credits do mean that the impact of the changes on work incentives is relatively modest given the size of the £12.5 billion overall cut to working age benefit spending. Generally, cuts to benefit spending would tend to strengthen work incentives as people will see bigger increases in income if they move into work or work more hours. But the devil is in the detail.

The factors driving the strengthening of work incentives include increases in the income tax personal allowance and higher rate threshold and cuts to benefits for workless families, which increase in-work incomes but reduce out-of-work incomes for many people who are not entitled to tax credits when in paid work.

The impact of the cut to in-work tax credits will be different for different groups:

  • For around 6.7 million people the cut to in-work tax credits is greater than the cut to out-of-work benefits, weakening their incentive to be in paid work. These changes will on average weaken incentives for lone parents and those in couples whose partner does not work.

  • However, reducing the amount of support given to single-earner couples through the tax credit system will strengthen the incentive for both members of a couple to work rather than just one, as they will have less support to lose if the second person starts paid work. 8.6 million people with a working partner will see their work incentives strengthened by planned changes to the (pre-universal credit) benefit system.

As well as cutting the tax credits working families receive next year, the July Budget also proposed to reduce the amount of support universal credit will give to working families. But tax credits are being cut more severely than universal credit. So relative to the tax credit system currently planned for 2019–20, universal credit will increase the amount of support given to single-earner couples, particularly those with children. This will strengthen the incentive for one member of a couple to work (rather than none) but weaken the incentive for both members of a couple to work rather than just one, as the additional support given to single-earner couples is withdrawn when the second member of the couple enters paid work.

The proposed tax and benefit changes also on average strengthen the incentive for those in paid work to increase their earnings. This predominantly arises because the cuts to tax credits mean that fewer workers will be entitled to any means-tested benefit or tax credits, so that they no longer face withdrawal of means-tested benefits if they increase their earnings. Changes to the pre-universal credit benefit and tax credit system increase:

  • the number of people who get to keep at least 60p of each additional pound they earn, by around 1.6 million,

  • the number that get to keep at least 50p, by around 1.3 million, and

  • the number that get to keep at least 40p, by around 1 million.

However, around 2.1 million workers who remain entitled to tax credits will see their incentives to increase their earnings weakened as a result of a rise in the rate at which tax credits are withdrawn as income rises. This change will increase the number of people who get to keep less than 20p of each additional pound that they earn by half a million from 1.3 million to 1.8 million. But under current plans this will only last until universal credit is introduced. By combining multiple overlapping benefit tapers into a single one, universal credit will remove the worst incentives that exist in the current system where people face withdrawal of multiple benefits over the same range of income. As a result, universal credit will reduce the number of people who get to keep less than 20p of each additional pound they earn by 1.3 million or nearly three-quarters.

Another important reform announced in the July Budget was the introduction of the ‘National Living Wage’ (NLW), a higher minimum wage for those aged 25 and over. This will also strengthen the work incentives of those who potentially benefit from its introduction. Indeed, for this group the introduction of the NLW will do more to strengthen work incentives than tax and benefit changes will. The NLW will also increase the gain to these individuals from working an additional hour. Currently, those paid below the NLW gain on average £4.22 from working an additional hour after taxes and benefit withdrawal. Tax and benefit changes will increase this to £4.49 as they mean that this group will get to keep more of each additional pound that they earn, and the NLW will increase the gain from working an additional hour further to £4.89. These figures show the extent to which taxes and benefit withdrawal reduce the gain from working an additional hour as the National Minimum Wage is £6.70 and long run level of the National Living Wage will be around £1 more than this (in today’s earnings terms).

However, the effect of the NLW is smaller for those who have the weakest incentive to increase their earnings in the first place, as much of the higher wages will be lost in lower benefit and tax credit entitlement. Furthermore, it is important to bear in mind that although the NLW may increase the amount people are willing to work, it will also make it more expensive to employ those aged 25 and over, meaning that firms may want to employ fewer of them: indeed, the Office for Budget Responsibility (OBR) estimates that the NLW will on aggregate reduce employment levels by 60,000.