Tuesday, 3 November 2009

The Laffer Curve and means-testing benefits

Click to enlarge:

Out-of-work welfare benefits in the UK are savagely means-tested. The first £10 per week or so of earned income is ignored, and then the benefit is withdrawn by £1 for every £1 you earn, a withdrawal rate of 100%.

There are different withdrawal rates for different benefits and different income levels etc. People receiving in-work-benefits (Tax Credits) lose benefits and also pay tax on what they earn, so the total withdrawal rate is at least 70% on incomes all the way up to £11,000 per annum for an individual or well over £20,000 per annum for the head of a family with children.

Benefit withdrawal is to all intents and purposes the same as taxation - if your gross income goes up by £1 and your net income only goes up by 30p, the behavioural effect is much the same whether you are paying 70% income tax or facing a 70% benefits withdrawal rate.

Successive governments have justified these withdrawal rates by saying they save money (a lower withdrawal rate would mean more people are entitled to them, which may be true), but this is still complete rubbish, of course.

The traditional Laffer Curve plots total tax revenues against different tax rates, with the highest point in the middle somewhere (let's say an income tax rate of 40%). Exactly the same logic must apply to keeping the cost of welfare down - if the withdrawal rate is reduced from 100%, more people are likely to go out and work (and admit to it - rather than staying at home or working cash in hand). There must come an expenditure minimising point, which I have assumed to be where the withdrawal rate is 50%, for sake of argument, but the bottom of the curve is fairly flat - so there probably isn't much difference in the total cost of welfare whether it's 40% or 60%.

If I were setting income tax rates, I would also prefer to be on the left-hand side of the curve (so even if the revenue maximising rate is 40%, we ought to go for 25% to 30%, just to be on the safe side). Exactly the same applies to benefit withdrawal rates, shouldn't we prefer the left-hand side of the curve, i.e. a lower rather than a higher withdrawal rate?

Either way, a withdrawal rate of 50% must, by any reaonable standards of logic, lead to a lower welfare bill than rates of 70% to 100%. And just as importantly, with a lower withdrawal rate, people are less likely to be stuck on benefits for years and there'd be more people working, a bit less crime, it would be good for the economy etc. etc.


Anonymous said...

"The total withdrawal rate is at least 70% on incomes all the way up to £11,000 per annum for an individual or well over £20,000 per annum for the head of a family with children". Right, but actually that's an underestimate. Depending on the number of children, it can be well over £40,000. With four kids, that tax credit withdrawal at 39% goes on well into the 40% tax bracket. If you earn just over £40k, with four kids, your total marginal rate will be 80% (including 1% N.I.).

The extent of the income redistribution in the tax credit system has not been realised by commentators.

Mark Wadsworth said...

Adam, sure, which is why I said "well over £20,000" as I couldn't be bothered to look up the upper limit. I was trying to illustrate the general principle that high withdrawal rates do not necessarily reduce the welfare bill.

I'm not sure what you mean by your last sentence. If somebody on a very good salary is on tax credits and paying 80% effective tax rate, from and to whom is income being redistributed?

What bothers you more, the fact he is paying 80% tax (so 80% of his income is being taken away from him) or the fact that he still gets tax credits (so other people's income is being paid to him)?

Anonymous said...

I was merely pointing out that the tax credit system is more redistributive even than the income tax system, and that the redistribution from tax credits adds to that from income tax. A Socialist (like the one who introduced it) would approve.

He is not paying 80% tax, because the tax credits offset his income tax. The point is that the system leaves him only £2,000 better off than somebody earning £10,000 less.

Mark Wadsworth said...

AC, the tax credits system is sublimely awful, on that we appear to be agreed.

Anonymous said...

It's even worse than that because travel to work costs are not tax deductible so someone commuting to a low- or moderately-paid job has less money, after paying fares, than staying at home on the dole.