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Tax credits, child poverty and low wages

2 July 2012
by Guest author

Yes, but do tax credits help?

Today’s post is from Matthew Whittaker, senior economist at the Resolution Foundation

Once a primarily Anglo-Saxon phenomenon, tax credits and in-work benefits designed to get people into employment and make work pay have been springing up across OECD countries over the last decade or so. In addition to the UK, US and Canada, work-related benefit systems are now in place in Belgium, Finland, France, Germany, the Netherlands and Sweden, with adoption taking place under parties on both the left and the right.

Their wide appeal reflects their apparent successes. International evidence suggests that the programmes have raised employment among target groups and helped tackle child poverty. Nevertheless, many have questioned the cost-effectiveness of the schemes. In particular, a suspicion persists that the credits have done little more than subsidise employers and disguise poverty.

There are two strands to this argument. First, that there is a general wage effect, with tax credits pushing down on earnings at the bottom by increasing the number of individuals prepared to work at low rates of pay. Second, that there is a relative wage effect. That is, recipients are discouraged from moving into higher paid work because of the loss in tax credits it entails, meaning that they tend to experience slower wage growth over time than (initially) low paid non-recipient workers.     

Assessments to date – though there have been few – have tended to support this hypothesis. However, new analysis published by the Resolution Foundation finds little evidence of either effect in the UK. Here, wages at the lower end of the earnings distribution appear not to have lost ground following the introduction of tax credits; instead the pay gap narrowed. As the chart below shows, nor have eligible workers (low-wage parents) recorded slower wage growth than their non-eligible peers (low-wage non-parents). If anything, parents fell behind in the pre-tax credit period, but subsequently recorded stronger wage growth. 

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The UK looks to have escaped the predicted wage effects for two reasons. First, the introduction of the National Minimum Wage has created a robust – and rising – earnings floor. Secondly, the UK’s credits extend much further up the earnings distribution than is the case with other systems of in-work support, helping to dilute any potential negative spill over.

Yet tax credits are being scaled back in the UK. In part this is down to financial realities, with the programme currently costing close to £30 billion a year, but it also reflects a shift in the political landscape. The coalition Government favours a more targeted family-based approach – with the new Universal Credit (UC) set to withdraw support more quickly as household earnings rise – aligned with a new emphasis on tax cuts for individual low to middle earners.

The system may help to maintain the UK’s downward trend in workless households. As the IFS has pointed out, UC will strengthen the incentive to work at all because it has a lower withdrawal rate and higher earnings disregards than the current out-of-work means-tested benefits. However, there is a trade-off. The Government has acknowledged that, in order to keep costs down, incentives for first earners have been given explicit priority over those for second earners under the new scheme, with around 2.5 million potential and existing second earners set to have their work incentives reduced.

While worklessness remains far too high in the UK, this approach risks compounding a new and worrying trend. Though the latest figures reported another decline in relative child poverty, the children who remain below the threshold – and there are around 2.3 million of them – increasingly live in working households. More specifically, they live in households with two parents but just one wage.

As the next chart shows, there is a specific problem for the traditional male breadwinner model. Workers at the 40th percentile of the hourly earnings distribution experienced real terms growth in their wage of around 17 per cent between 1994-95 and 2009-10. However, while mothers living in dual earning families who started at the same wage rate recorded an increase of almost 30 per cent over the period, fathers who are the sole earners in their family experienced zero growth. Perhaps most surprisingly, wage growth among single earner fathers also lagged that recorded among fathers with working partners.

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To some extent, this finding may reflect a selection bias. Increases in female employment mean that the population of single earner families looked somewhat different at the end of the period: further research is needed to get to the root of the problem. Whatever the cause however, the clear implication for families with children is that getting out of poverty and improving living standards more generally increasingly requires both parents to be in work.

Tax credits have done much to support the living standards of low to middle income families in the UK. In a new economic and political environment, the challenge for the coming decade is to design complimentary policies that encourage and support further increases in female – and more particularly, mothers’ – employment.

Useful links

OECD Tax Policy Study No. 21: Taxation and Employment provides both a broad overview of the effects of taxation on employment and a detailed analysis of selected issues.

Taxing Wages provides unique information on the taxes paid on wages in OECD countries. It covers personal income taxes and social security contributions paid by employees, social security contributions and payroll taxes paid by employers and cash benefits paid to in-work families.





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