The Social Security Committee has agreed to the following Report:

Introduction

  1. The Labour manifesto stated:

    "We will examine the interaction of the tax and benefits system so that they can be streamlined and modernised, so as to fulfil our objectives of promoting work incentives, reducing poverty and welfare dependence and strengthening community and family life."[1]

  2. To fulfil this manifesto pledge, the Government announced in May 1997 the formation of a task force to consider the streamlining and modernisation of the interaction between the taxation and benefit systems. The task force is headed by Mr Martin Taylor, Chief Executive of Barclays plc. The "Taylor Task Force" has brought together officials from the Treasury, the Inland Revenue, the Department of Social Security and the Department for Education and Employment. The original announcement was that the project would last for about one year.[2] In the Budget speech in July 1997, the Chancellor announced that the task force would look at proposals for an Earned Income Tax Credit and that its findings would inform the Spring Budget.[3] Mr Chris Kelly, Head of Policy at the Department of Social Security, put the work of the Task Force into its context:

    "There is a very comprehensive review going on which covers all benefits. One of those reviews is the review which is being conducted by the Taylor Task Force. What the Task Force is concentrating on in the first instance - because this is what the Chancellor asked us to concentrate on, as he announced in his Budget - is the earned income tax credit notion."[4]

  3. Our initial terms of reference were:

•   to analyse the difficulties with the current tax/benefit arrangements;

•   to examine how greater integration of the tax and benefit systems might affect work incentives for claimants and family structures and to assess the net impact on public spending and resources;

•   to examine whether a more streamlined and integrated system would bring administrative and efficiency advantages to claimants, taxpayers and staff;

•   to examine the underlying principles of taxation and benefit; whether the assessment unit should be the individual, a couple or wider household; the question of control and transfer of money within households; the nature of support by the tax and benefit system for families and children;

•   to ascertain what useful lessons can be learned about tax and benefits from the experiences of other countries;

•   to contribute to discussion of the issues currently being considered by the Task Force under Mr Martin Taylor.

  4. We believe the issues involved in improving work incentives and ameliorating the effects of the poverty trap to be amongst the most pressing in current social policy. Furthermore, efficient and equitable tax and benefits systems underpin other important initiatives such as welfare to work. We are also concerned that tax and benefits structures may not at present fully support stable family life and child rearing.

  5. This Report is an interim Report, intended to provide an overview of the issues that need to be addressed, without attempting at this stage to provide solutions or proposals. We intend to look more closely at Government proposals once these have been unveiled.

  6. We wish to thank all those who have submitted evidence based on our original terms of reference. A list of Appendices to the Minutes of Evidence is at page xxxix. Many of the submissions we received contained detailed analyses and proposals relating to tax and benefits. We intend to make further use of this detailed evidence in our later reports on this subject. We are also grateful to those who accepted our invitation to give oral evidence who are listed at page xxxviii. We also wish to thank Mr Christopher Giles, of the Institute for Fiscal Studies, who has acted as our specialist adviser for this inquiry. We accepted the advice of the Chancellor of the Exchequer that it would be premature for us to take evidence from Treasury officials and Mr Martin Taylor at this stage of our inquiry. We look forward to having an early opportunity to question witnesses from the Treasury and elsewhere as part of the consultative process leading up to the next Budget.

The difficulties with the current tax/benefit arrangements

  7. The scope of this Report is wide, outlining the many and varied problems that can occur because of the interaction of taxation and benefits. It is impossible to tackle individual problems in isolation as change in one area of the system has an impact in another. The main problems identified and discussed in this section are:

•   the poverty trap

•   the unemployment trap

•   the administrative and bureaucratic obstacles that deter people moving into work.

Since the formation of the welfare state, the tax and benefits systems have operated wholly separately from each other (being currently administered by the Inland Revenue and Department of Social Security respectively). Different departments of government make decisions on their respective areas yet, taken together, these separate decisions can combine to produce unforeseen consequences. This is clearly seen in the workings of the post-war tax and benefits systems. In the 1930s most manual workers on average wages were not subject to income tax on their earnings and additionally there was no comprehensive welfare benefits system in place.[5] As the post-war welfare state developed, the tax and benefits systems came to overlap. The level at which income tax was paid crept down the income scale[6] and the provision of means-tested benefits was extended to the point that the tax and benefit system converged at the lower end of the income scale. The convergence gave rise to two main problems known frequently as the poverty trap and unemployment trap.

  8. The poverty trap affects the incomes of those who may be categorised as the `working poor'. Most benefits that help supplement the income of this group (including Family Credit, Housing Benefit, Council Tax Benefit) are means-tested. Therefore, they are withdrawn as earnings rise. Additionally, as earnings rise people pay more income tax or National Insurance Contributions[7] (or perhaps start paying them for the first time). The result is that the marginal tax rate on any extra earnings can reach 97 per cent. Table 1 shows the mechanics of the poverty trap.

Table 1: Cumulative deductions from each £1 of gross earnings

Tax or Benefit	Family	Single person or couple
Extra Income	£1.00	£1.00
Income Tax @ 20 per cent	20p	20p
National Insurance @ 10 per cent	10p	10p
Net earnings	70p	70p
Family Credit @ 70 per cent	49p	n/a
Income net of Family Credit	21p	70p
Housing Benefit @ 65 per cent	14p	45.5p
Council Tax Benefit @ 20 per cent	4p	14p
Net disposable income	3p	10.5p

Source: Report for Chartered Institute of Housing on Replacing Housing Benefit with Housing Credit.

The effective marginal rate from tax/benefit withdrawal is far higher than tax rates on income that exist elsewhere in the tax system (the top rate of income tax being 40 per cent). Yet it is levied on those whose earnings are at the lowest end of the income scale. As well as being widely perceived as unfair, it is also potentially economically and socially damaging in that it might discourage effort and lower morale of those seeking to improve their position. Table 2 shows the numbers of people affected by high marginal tax rates.

Table 2: Numbers affected by high marginal deduction rates (thousands)

Marginal Deduction Rate	1994/95	1995/96	1996/97
100 per cent +	0	10	5
90 per cent +	90	100	105
80 per cent +	355	420	360
70 per cent +	600	615	645
60 per cent +	620	630	655
50 per cent +	625	630	660

Source: Based on 1994-95 Family Resources Survey, uprated to 1996-97 levels, adjusted to benefit caseloads using Housing Benefit Management Statistics and the Family Credit Statistical Sample (taken from the memorandum submitted by the Department of Social Security Ev p.2.)

  9. The unemployment trap concerns the relationship between incomes of those who are in and out of work. Simply, if the difference between income that can be obtained in work compared to benefits available while unemployed is not sufficiently great, some unemployed people might be deterred from taking a job. Table 3 shows the numbers of the working population with high replacement ratios (defined as out-of work income as a percentage of in-work income).

Table 3: Replacement ratios for the working population, thousands

Replacement ratio	1993/94	1994/95	1995/96	1996/97
100 per cent +	10	10	15	15
90 per cent +	40	35	35	45
80 per cent +	175	190	165	195
70 per cent +	465	505	510	510

Source: Social Security Departmental Report 1997-98 to 1999-2000, Cm 3613, March 1997 (taken from the memorandum submitted by the Department of Social Security Ev p.3).

The memorandum from the Department of Social Security pointed out that the replacement ratios shown in Table 3 apply to those currently within the working population; for those outside the labour market the situation may be more acute because those currently unemployed may command lower wages on starting work than those currently employed and in consequence face higher replacement ratios.[8]

  10. The Department of Social Security memorandum described those groups most severely affected by the unemployment trap:

•   those with mortgages who are entitled to help with interest payments on out-of-work benefits but not if they receive Family Credit;

•   those with high in-work costs not taken account of in the tax/benefits system (eg on childcare or travel to works costs);

•   those without entitlement to Family Credit - all couples without children and single people (except where entitlement to Disability Working Allowance exists.)[9]

The loss of passported benefits, such as free school meals (the costs of which vary according to local authority and number of school-age children), also affects the financial equation. The National Association of Citizens Advice Bureaux provided some case studies which illustrated the difficulties of people caught in the poverty and unemployment traps.[10] The memorandum from Andersen Consulting contained the following diagram to show the relationship between in-work and out-of-work benefits.

Figure 1: Sources of income and deductions for a married couple with one child under 5 years old

  11. Non-financial factors also affect work incentives. Benefit claimants considering taking a job might not be able to calculate what their future in-work income would be. Calculations have to be made of the various different means-tests inherent in the benefits available plus tax and national insurance deductions (which are levied at different rates). A claimant also has to fill in forms to claim benefits and produce evidence of income, hours worked, savings, family members and household composition and deal with various branches of officialdom. Therefore, the uncertainty of in-work income, allied with the `hassle' factor of claiming benefits, can provide a powerful disincentive to take low paid work. This is especially true if the work on offer is temporary or uncertain to last, since at attempt to return to unemployed status can result in benefit sanctions. Added together, the claimant might not be prepared to leave the passive `security' that state benefits can represent.

  12. The Unemployment Unit told us that claimants had to deal with a plethora of different agencies and departments, none of which appeared to communicate with each other:

    "The Employment Service and the Benefits Agency share the administration of JSA claims while the Benefits Agency alone handles Family Credit. Housing Benefit and Council Tax Benefit are each dealt with by a different department in the local authority. Housing Benefit departments are in general particularly poor at providing a fast and hassle-free service."[11]

  13. The Children's Society drew attention to the upheavals in family income, both in moving into work and returning to benefits.[12] Ms Pamela Meadows of the Policy Studies Institute stressed the importance of avoiding dislocation of income when people move from benefit into work because families who are making the transition from not working to work have no spare resources.[13] Ms Janet Allbeson of the National Association of Citizens Advice Bureaux referred to the difficulties of people who have to switch between in-work and out-of-work benefits according to whether they worked more or less than 16 hours in a week:

    "You have also got people doing temporary work, increasing numbers of people, often as a way into work, temping, trying to get work experience, trying to get contacts, and that is incredibly problematic because you are having to claim and reclaim benefits and particularly Income Support and Jobseeker's Allowance are quite slow to kick in and also Housing Benefit."[14]

  14. The Department of Social Security recognised the importance of these non-financial `hassle' factors as deterrents to work.[15] Their memorandum outlined administrative measures taken to improve the transition to work, such as faster Family Credit administration for new claimants and the extension of entitlement to Housing Benefit for the first four weeks of starting work.[16] Welcome as such initiatives are, the `hassle' factor remains a significant factor in discouraging some claimants to take work. The memorandum from Electronic Data Systems (EDS) discussed how the "astonishing" growth in computer capacity could be harnessed to provide better services for customers.[17] In particular EDS discussed how call centres could be utilised to make more contact with the DSS by telephone and how the Internet could be used to improve access to information.[18]

  15. Clearly, there are several steps which could be taken, short of a wholesale re-structuring of the system, which could help to improve work incentives. The Institute for Public Policy Research outlined a number of other improvements to the social security system which would help bridge the gap between benefits and work.[19] These include flexible earnings disregards, better transitional and passported benefits and greater help with the cost of starting work.