Ben Southwood

Ben Southwood is Head of Research at the Adam Smith Institute.

Though barely anyone predicted it at the time, George Osborne’s 2015 budget looks like it will be defined not by his vaunted hiking and rebranding of the minimum wage, but by his massive cuts to tax credits. This is because everyone has suddenly realised that these cuts will take large sums of money—thousands of pounds in many cases—out of the pockets of blue-collar and sometimes Tory-voting workers.

The tax credits fight has reinvigorated the heretofore hapless Labour and Liberal Democrat leaders, Jeremy Corbyn and Tim Farron, giving them an open goal to shoot into, egged on by unlikely supporters like The Sun and the Adam Smith Institute. And it has prompted the Lords to seemingly break with constitutional tradition and vote down a money bill.

Tax credits are one of the best forms of welfare we have. They send money directly where it is needed; they make work pay, maintaining strong incentives for the badly-off to stay in the labour market; and they do not, according to the evidence, subsidise employers by allowing them to pay lower wages than they otherwise would have to. Many who voted to reduce the welfare bill probably didn’t realise that the tax credits they received counted as a form of ‘welfare’.

Having committed himself to a large fiscal surplus—£10billion in 2019-20, and £11.6 billion the following year—Osborne has to cut somewhere, and his options are running out. He has ring-fenced certain budgets, like the NHS and education, and non-ringfenced departments must already make huge savings. He should abolish the pensions triple lock, so that pensions rise only in line with prices and not wages, but it seems politically impossible

One way to square the circle is a drastically simplifying the welfare system, as detailed in a new ASI paper, Free Market Welfare.

According to a 2012 Freedom of Information request, the Department of Work and Pensions, which employs 34,000 people, spent £5.3 billion on administration that year, mostly on carrying out means tests.

Administration efficiencies are usually a chimera, but in this case there is a clear route to making savings: replacing basically all means-tested payments with a negative income tax. It only requires information about income, meaning that much of it could be done through HMRC’s existing Pay As You Earn (PAYE) system. Potentially most of the DWP could be scrapped.

Universal Credit has a similar goal but has failed in implementation—only a few thousand are receiving UC now, despite years of effort and over £600 million spent. This is largely because UC has tried to be everything to everyone, attempting to tie together dozens of benefits into one, rather than replace the system from the ground up.

The negative income tax proposal has a long history, but its most famous proponents were Milton Friedman and Friedrich Hayek, Nobel prizewinning economists who wanted to simplify the welfare system and give recipients more control over how they spend their money.

It guarantees everyone a minimum income, which is then withdrawn steadily and automatically as they earn money in the labour market. The initial generosity and the steepness of the taper—the withdrawal rate that functions like a marginal tax rate on doing extra work—can be set at lots of different rates while still maintaining fiscal neutrality.

As an example, imagine the guaranteed minimum income is £700 per month, and the taper rate is 50 per cent. If the recipient earns nothing in the labour market, they get the full benefit, £700. For each £100 they earn, they lose £50 of the benefit—someone earning £700 would take home £350 of benefits and £700 of pay. When they earn £1400 or more they stop receiving any benefits and start to pay into the system.

A system like this preserves a steady incentive to do extra and more productive work, as we’ve tried to do at the top end of the tax system since the 1980s, when top rates tumbled from 83 per cent to 40 per cent. By contrast, the current system has rates approaching 100 per cent, where extra work barely raises the worker’s income, and UC will only take withdrawal rates to around 75 per cent.

The system has even been trialled. In a range of 1970s experiments run by Donald Rumsfeld and Dick Cheney, randomly-selected families in poor cities were given negative income tax-style cash payments. The results were impressive: kids had higher birth weights, did better in school, and though the system was hugely more generous than the existing regime, labour supply fell only about two per cent (in our proposal, it is the structure of the system, not its generosity, that changes, and so we’d expect higher labour supply). What’s more, the finding that killed the idea turned out to be misreported—people believed that the payment had reduced marital stability but there was actually no robust link.

If Osborne wants to head off political opposition to tax credit cuts, maintain support to those who need it, fulfil his promise to make work pay, and still achieve his surplus target then he should look to the negative income tax, an idea whose time has come.

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