How the Budget 2012 will affect work incentives

 

Given an expected unemployment rate of 8.7% for this year, it is a bit surprising that the Budget’s sub-subchapter on labour market reform occupies no more than half a page. If that half-page contained actual policy announcements, this would be fine – most labour market measures do not have immediate budgetary implications, after all. But in the present situation, talking about ‘consultations’ and ‘calls for evidence’ is out of place. The impact of employment protection legislation on labour market performance has been studied for decades, and the weight of the evidence shows that stricter regulation reduces employment opportunities, especially for disadvantaged groups. So how much more evidence do they want?

While the Budget is vague on measures affecting the demand for labour, it is relatively clear on measures affecting the supply side. Work incentives are going to improve modestly at the bottom and the top of the income distribution. But for families with children and one earner in the £50,000 – £60,000 income band, they will worsen significantly, courtesy of the muddled way in which Child Benefit is withdrawn.

Let’s start with low earners. Next year, 840,000 people will be taken out of income tax, as the personal allowance rises above their incomes. That is doubtlessly a good thing; it will provide a modest boost to their incomes, and it will allow them to keep a larger share of any extra £1 they earn. But let’s keep things in perspective. A low-earner who pays income tax and national insurance, while also receiving tax credits, is typically faced with an effective marginal tax rate (EMTR) of 73%. Taking them out of income tax will lower this rate to 53%, which is still higher than the additional rate of income tax. If they receive Housing Benefit instead of tax credits, the effect is a lot weaker still. Yes, the increase in the personal allowance will increase their net income, but since the Housing Benefit taper also applies to net income, a good chunk of it will immediately be clawed back again. So for these households, the typical EMTR will only fall from 76% to 69%. Not bad, but nothing to boast about.

At the top end, the decrease in the envy tax, aka the additional rate of income tax, from 50% to 45% is unequivocally a good thing. Even in a static perspective, this measure costs the exchequer just £0.1bn, less than half of the extra revenue generated through changes in the tax treatment of company cars, and 1/35 of the cost of raising the personal allowance. Thus, even miniscule behavioural responses would be enough to make this measure self-funding, and if it turns out that we are already on the wrong side of the Laffer curve, it will be a net revenue-raiser.

The changes to Child Benefit, unfortunately, are a lot messier. At least the coalition has now realised the absurdity of its previous plan, which would have cancelled the entire amount as soon as a single income threshold is crossed. But the ‘solution’ now announced is not much better. Child benefit will now be withdrawn over an income range between £50,000 and £60,000, through the use of an additional taper. The taper’s rate is not specified in the Budget, but given the current amount of Child Benefit, it must be about 11% for a family with one child, and a whopping 18% for a family with two children. This comes, needless to say, on top of their current rates of income tax and national insurance. Expect some nasty surprises here.

This mess could have been entirely avoided. Child benefit should have been converted into an extra tax allowance, with a compensation for those not earning enough to benefit from it. If this had raised some follow-up questions about the wider inconsistencies of the tax-and-benefit system, all the better. 

 

Good article, as far as it goes. But please could you explain why this method of reform wasn't chosen, and what needs to be done in order to implement the 'allowance' method in the future.

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