APPENDIX 6
Memorandum submitted by the Institute
for Fiscal Studies (TAB 69)
SUMMARY
1. This submission considers a number of issues
arising from the announcement of the Working Families Tax Credit
and the reforms to National Insurance in the Budget on 17 March
1998.
NIC Reforms
2. The NIC reforms involve the removal of discontinuities
from the structure of contributions and the harmonisation of parts
of the NIC structure with the income tax system. These are welcome
developments to National Insurance, which will simplify the administration
burden on employers and ease the distortions produced in the labour
market.
3. In terms of their distributional impact,
the NI reforms are progressive. On average, only employees living
in the richest 10 of households see the combined employer and
employee contributions increase. For the other nine-tenths of
households, on average total contributions fall.
4. A number of issues remain to be addressed
within the NI system. First, the contributions of the self-employed
need to be reformed. Such reform should lead to the level of contributions
paid by the self-employed being moved closer in line with the
level of contributions paid by those in employment. Second, a
comprehensive review of the contributory principle for non-means-tested
benefits is urgently required.
The Working Families Tax Credit
5. The Working Families Tax Credit can be summarised
as a more generous version of Family Credit with an altered method
of payment. The impact of the structural change, as opposed to
the increase in generosity, hinges on whether the "re-branding"
of Family Credit will have any impact on behaviour. There is no
hard evidence on the importance or direction of such effects.
6. The increased generosity of the WFTC is concentrated
on households in the poorer part of the income distribution. In
terms of work incentives, the WFTC represents a trade-off between
negative and positive labour supply effects. For workless families,
it will unambiguously increase the financial returns to working.
It lowers some of the highest marginal tax rates, but only to
levels just below 70 per cent . Others will become entitled to
the WFTC and will therefore see their marginal tax rates increase
substantially. There are also significant incentives for second
earners, mainly women, in couples to leave employment altogether.
These effects are consistent with the government's statement that
"the highest priority must be to get one member of workless
households into work".[18]
7. The cost of the childcare credit in the WFTC
largely depends on the degree to which current informal childcare
arrangements are brought into the formal sector.
2. NIC REFORMS
8. The NIC reforms proposed in the Taylor Report
and implemented in the Budget represent a substantial step towards
the rationalisation of National Insurance system. Certain major
issues still need to be addressed, in particular how the contributory
principle can be adapted to conform to the new structure of National
Insurance.
Change in structure of Class 1 contributions
9. The changes to the Class 1 NICs can be broken
down into a number of elements. First is the removal of discontinuities
from the NIC system. This was achieved by abolishing the "entry
fee" to employer NICs and moving to a single marginal rate
for employer NICs. These measures should increase the flexibility
of the labour market insofar as rigidities are being generated
by the discontinuities in NICs. In addition, the reduction in
the number of rates in operation will simplify the administration
of the system.
10. The second element is the alignment of the
point at which NICs first becomes payable with the personal allowance
of income tax. In the case of employer contributions, this is
to be achieved by setting the LEL to £81 per week, the weekly
equivalent to the personal allowance. However, the LEL for employee
NICs remains at £64 per week, though the government is committed
to increasing this to £81 at some point in the future. This
alignment of values in the NI and income tax systems will not
produce large administrative savings. Only single people with
straightforward tax affairs start paying PAYE at the £81
per week. Married couples and those with children have higher
total allowances due to existence of the Married Couple's Allowance
and the Additional Personal Allowance. For those with more complicated
tax affairs, the Inland Revenue will often adjust their tax code
and hence the point at which they start paying PAYE. These problems
are compounded by differences in the period of assessment between
income tax and National Insurance.
11. The third element of the NIC reforms is
the degree of redistribution that is involved. The package ensures
that the total of employer and employee NICs for all employees
earning less than £480 per week will be lower. Employee NICs
fall for all workers. But the changes to employer NICs mean that
these will be higher for those on high earnings and for those
with earnings just below £155 and £210 per week. In
the short term this distinction between lower employee and higher
employer contributions might affect which party receives the gains
from the overall NIC reduction. In the long term it should have
no effect. Employers care only another total cost of employing
a person. Employees care about final amount earned in job. It
is the gap between these two amounts which matters, which is unaffected
by whether contributions are labelled as "employer"
or "employee".
12. Figure 1 shows the distributional impact
of the NIC changes. This divides households into 10 deciles ranked
by income. The figure shows the average change in total NICs paid.
On average, households in the first nine deciles see their total
NICs fall, while only those in the richest decile lose, with average
NIC raising by almost £4.00 per week. Note that this average
result for the richest decile hides a large variation within this
group. The highest paid employees will see there total NIC increase
by almost 2.2 per cent of their gross pay.
NICs and the self-employed
13. The Taylor Report outlined how the NIC reforms
could be extended to the self-employed.[19]
In the Budget the Chancellor committed himself to examine carefully
these options. The proposals to abolish the flat-rate Class 2
contributions and to align the Lower Profits Limit with the Lower
Earnings Limit would be a welcome development in line with the
reforms to employee contributions.
14. However, self-employed NICs present two
problems that do not occur with employee contributions. First,
the self-employed have a lower level of entitlement to contributory
benefits than the employed. There is little justification for
lower benefit entitlements to the self-employed, especially given
the dependence of the benefit system on means testing, which does
not distinguish between those who have been employed and self-employed.
15. Second, there is a strong case for increasing
the contributions of the self-employed. Under the current system,
the NIC liability generated when a person is self-employed is
substantially lower than when the person is an employee. For example,
consider a firm paying £200 per week to a person for a service.
If the person is an employee of the firm, the government will
receive £25.25 in NICs. If the person is self-employed, the
government will receive only £9.92. The distinction between
these contribution levels is only partly accounted for by the
lower benefit entitlement of the self-employed. The present situation
is not only inequitable, it is also distortionary. Granting tax
privilege to one form of work contract creates an incentive to
restructure economic activity to minimise tax liability, even
though on other grounds this structure is not efficient.
Integration of NICs and income tax
16. As was noted above, the increase in starting
point of NICs to the level of the personal allowance is a more
limited integration of NICs and income tax than it at first appears.
But even this integration is hampered by the current contributory
principle. Those with earnings above the LEL currently gain earn
contributions toward entitlement to certain benefits, while those
with earnings below the LEL do not. Simply increasing the LEL
for both employer and employee contributions to £81 would
also increase the amount of earnings needed to generate benefit
entitlement. To avoid this, the government could allow people
with earnings between £64 and £81 per week to retain
their benefit entitlements without making any contributions. However,
it would be problematic to justify this situation to a person
earning below £64 per week, who would also be making no contributions
but would not receive any benefit entitlement.
17. These problems highlight how outdated the
contributory principle has become. Under the NIC system announced
in the budget, a person earning £63.99 would make no contributions
and gain no benefit entitlement, while a person earning £64.01
per week will pay 0.1p per week in contributions and gain entitlement
to NI benefits. The time has clearly come to modernise the contributory
principle.
18. This should be accompanied by a re-examination
of the role of non-means-tested benefits in the current system.
To take one example, consider contributory Jobseeker's Allowance.[20]
This now provides a small weekly payment for six months to those
who satisfy the necessary contribution criteria. The payment no
longer takes account of the person's dependants. It is difficult
to see what this benefit is designed to achieve in the context
of the current benefit system. One alternative might be a non-means-tested
benefit that was designed to ease labour market transitions. It
would be available on a short-term basis at a reasonably generous
rate and with little accompanying monitoring. It would be intended
to facilitate a period of off-the-job search.
19. In paragraph 2.13, the Taylor Report makes
a strong case against full integration of income tax and National
Insurance. It notes possible large redistribution if employee
NICs merged with income tax. But this need not be the case. Savings
already have differential tax treatment from other income sources—why
not also income from employment and self-employment. The real
question that should be asked is whether we believe it is correct
to tax income from working more highly than income from other
sources.
20. However, in short term the conclusion of
the Taylor Report is probably correct—we cannot move directly
to integration of income tax and National Insurance as one "big
bang" solution. But aim of integration provides a clear and
coherent rationale for further modernising of the NI system.
3. THE WORKING
FAMILIES TAX
CREDIT
21. In terms of its structure, the Working Families
Tax Credit (WFTC) is little more than a "re-branded"
version of Family Credit (FC) with an altered method of payment.
In terms of its value, the WFTC represents a substantial injection
of funds into in-work support for families with children.
Structural changes
22. The structural differences between WFTC
and FC are limited to the method of payment. Claimants will still
have to make a claim to a government agency, which will be part
of the Inland Revenue rather than the Benefits Agency. This agency
will assess the claim and decide on the amount of the tax credit.
By default, a new tax code will be issued to the employer who
will make payments on behalf of the government. The only difference
from the current system will be that the money involved will pass
through employers' accounts and the "wage packet" before
reaching families rather than being paid directly to the families
by the government.
23. There are a number of issues that need to
be considered even under these minimal changes. First are the
psychological issues that arise. These take a number of forms.
Examples are
— As the WFTC will pass through employers'
accounts before being paid to claimants, it might have a more
direct relationship with working and therefore strengthen individuals'
attachment to employment.
— As the WFTC will officially be part
of the tax system rather than the benefit system, increasing its
generosity might be made easier by portraying the change as a
tax reduction as opposed to a benefit increase.
[21]
— If people did not regard the WFTC
as a welfare benefit, it might reduce the stigma associated with
receiving transfer payments and so increase take-up.
— As employers and potentially work
colleagues will observe the WFTC, it might increase the stigma
associated with receiving transfer payments and so decrease take-up.
— As employers will directly observe
the level of WFTC payments being made to their employees, they
might be more likely to lower gross wages in response to these
transfers.
There is no hard evidence about the importance
of any of these effects; the weight placed on these arguments
will depend only on one's beliefs about the likely reactions of
welfare claimants, employers, voters and politicians to the introduction
of the WFTC.
24. Aside from changes in take-up, the change
in the method of payment cannot affect the overall level of family
income. It will, however, represent a redistribution of income
within couples. Currently, FC is typically paid to the woman in
a couple. The WFTC will by default be paid to the principal earner,
which in over 75 per cent of couples in receipt of FC is the man.
To avoid compulsory transfer of resources from women to men, claimants
may opt to receive the WFTC as a direct transfer payment to women
from the government.
25. It is unclear how far this option will go
to meeting the main concern of the "wallet versus purse"
debate, which is that redistribution within the family may affect
the level of expenditure on goods for children. The evidence on
whether such redistributions do in general cause changes in expenditure
patterns is inconclusive. However, it is likely that in cases
where such problems occur, women will be unable to exercise a
choice as to who in the couple should receive the WFTC.
26. The WFTC will also involve employers as
effective payment agents. For most employers, this is unlikely
to be a major problem—the cost of the WFTC payments will
be netted off the main income tax liability paid by the firm to
the Inland Revenue on behalf of employees. Problems could arise
for employers with large numbers of WFTC recipients and few non-recipients.
In these cases, the company may be owed money by the Inland Revenue
each month. While the actual number of such cases may be small,
the system of payment from the Revenue to firms will have to be
extremely efficient to avoid serious cash-flow problems for those
affected.
Increased generosity of in work support
27. The WFTC will be substantially more generous
than FC. By the end of the century, the government expects to
be spending £5 billion per year on the WFTC, which is £1.5
billion more than was expected under FC. This will have two important
effects. The first is distributional, with the government transferring
greater resources to low wage families with children. The second
is the impact on work incentives and how the WFTC acts as a "welfare
to work" measure. Previous research has shown that in most
cases the distributional effect of a reform is by far the most
important.[22]
28. Figure 2 shows a simplified version of the
in-work support system. Both FC and the WFTC share this structure.
When an individual in a family with children works more than 16
hours, the family becomes entitled to in work support. The maximum
amount that can be received is equal to the total credits for
that type of family. FC continues to be paid at the maximum amount
until income net of income tax and National Insurance exceeds
a fixed level known as the applicable amount. After this level,
the amount of FC is reduced, or tapered, as income rises. The
rate at which it is tapered is currently 70 per cent, which means
that for a £1 increase in net income, there will be a 70p
reduction in the family credit payment.
29. The WFTC will increase the generosity of
in-work support relative to the FC system in three ways.
— an increase in the credit for children
under 11 from £12.35 to £14.85 per child;
— an increase in the applicable amount
from £79 to £90 per week;
— a reduction in the taper from 70
per cent to 55 per cent.
The effect of these changes on our simplified
version of in work support is shown in Figure 3. Those currently
receiving the maximum payment see a small increase in the level
of their payment if they have children under 11. Those with net
incomes between £79 and £90 move from being on the taper
to receiving maximum support. The others on the taper see the
taper rate fall from 70 per cent to 55 per cent. The largest cash
gains go to those people who are currently just at the end of
the taper. The increased generosity of in-work support also creates
new entitlement to in-work support.
Distributional effect of the WFTC
30. The distributional impact of the increased
generosity of the WFTC over FC is shown in Figure 4. The majority
of the gains from this change are in the poorer deciles, with
the second poorest decile gaining the most. Virtually none of
the gains from this change go to households in the richest half
of the income distribution.
The impact of a WFTC on work incentives
31. Two concepts—the unemployment trap
and the poverty trap—are useful for analysing changes in
the structure of in-work support.[23]
The unemployment trap refers to the situation where people are
little or no better off in work than they would be remaining on
benefits. A measure of the unemployment trap is the replacement
ratio, which measures income out of work as a percentage of in-work
income. Other things being equal, we would expect a person to
be more likely to take up employment if income in work is high
relative to income out of work, i.e. if they have a low replacement
ratio.
32. The second concept we use is the poverty
trap.[24]
For people in work, a poverty trap can arise where increases in
gross income result in much smaller changes in their disposable
income. The usual measure of the poverty trap is the effective
marginal tax rate. This is the rate at which disposable income
increases in response to a £1 increase in gross income. The
difference between the two will be accounted for by increases
in tax or National Insurance payments and by reductions in benefits.
33. There is a trade-off involved in designing
a system of in-work support. Increasing the level of payments
reduces replacement ratios, thereby alleviating the unemployment
trap. At some stage, these additional benefits have to be withdrawn,
which increases marginal tax rates and thereby worsens the poverty
trap over that range of income.
Impact on replacement rates
34. The impact of the WFTC on the replacement
rates of those in work is shown in Table 1. In most cases, the
WFTC increases the financial returns to working by increasing
in-work income. The main groups affected are lone parents and
men in single earner couples. In total, 275,000 lone parents see
their replacement rates fall 4 per cent on average, while the
replacement rates 350,000 men in single earner couples fall by
an average of 5 per cent.
| TABLE 1
|
| Number of individuals with altered replacement ratios
|
|
| Number of
individuals
| Average
initial level
per cent |
Average change
(percentage
points)
per cent
|
|
| Increased returns to employment |
| | |
| Lone parents | |
| |
| All | 275,000 | 67
| -4 |
| Single earner couples |
| | |
| Men | 350,000 | 77
| -5 |
| Women | 75,000 | 84
| -4 |
| Two earner couples |
| | |
| Men | 125,000 | 74
| -5 |
| Women | 100,000 | 82
| -3 |
| Decreased returns to employment |
| | |
| Two earner couples |
| | |
| Men | 975,000 | 47
| 3 |
| Women | 750,000 | 67
| 5 |
|
35. It is important to note that Table 1 is confined to those
currently in work.[25]
It therefore excludes the impact of the WFTC on families where
no one is currently working. For individuals in these families,
the increased generosity of the WFTC relative to FC will make
taking a job more attractive at certain hours and wage combinations.
36. While normally we think of increases in in-work support
as lowering replacement rates, for two-earner couples we can get
an opposite effect. A second earner might see their replacement
rate rise, making work financially less attractive. If the primary
earner's income alone entitled the couple to WFTC, then the WFTC
would form part of out-of-work income for the second earner. An
increase in the generosity of WFTC can therefore act as an increase
in out-of-work income for second earners. This causes in increase
in the replacement ratio.
37. This effect can be seen in the results at the bottom
of Table 1. Almost 1 million men and 750,000 women in two earner
couples see their financial returns to employment fall as a result
of the WFTC. In general, this effect will be more important for
women. On average, replacement rates of women are initially 67
per cent and these are increased by 5 per cent. This indicates
that for this group, the increased generosity of in-work support
may be used to allow the second earner to give up working altogether.
Impact on marginal tax rates
38. With the introduction of the WFTC, the rate at which
in work support will be tapered will be reduced from 70 per cent
to 55 per cent. However, the drop in overall marginal tax rates
will not be 15 per cent. This is because the taper operates on
income net of income tax and National Insurance and the WFTC interacts
with other means-tested benefits. Table 2 shows the impact of
the reduction in the taper rate on overall marginal tax rates
for those on various combinations of National Insurance, income
tax and means-tested benefits. The combined marginal tax rate
from National Insurance and FC/WFTC will fall by 13.5 per cent
to 59.5 per cent. The highest marginal tax rates, which are produced
by the interaction of a number of means-tested benefits, will
be less affected. For instance, the marginal tax rate produced
by NI, income tax, Housing Benefit and Council Tax Benefit falls
by only 1.3 per cent to 95.3 per cent.
| TABLE 2
|
| Impact of reduction in taper on marginal tax rates
|
|
| Marginal rates | Before (FC)
per cent
| After (WFTC)
per cent |
|
| NI+FC/WFTC | 73.0 | 59.5
|
| NI+IT+FC/WFTC | 79.0 | 68.5
|
| NI+IT+FC/WFTC+HB | 92.7 |
89.0 |
| NI+IT+FC/WFTC+HB+CTB | 96.9
| 95.3 |
|
39. Table 3 shows the number of individuals with altered
marginal tax rates. The first set of columns shows the number
of individuals whose marginal tax rates are in each range before
and after the introduction of the WFTC. The second set of columns
shows the number with marginal tax rates in that range or above.
There is reduction of 450,000 in the number of people with marginal
tax rates above 70 per cent. Most of the people in these groups
see their marginal tax rates fall to the 60-70 per cent range.
In addition, a large number of people are drawn onto higher marginal
tax rates through the increase in the number of recipients of
in-work support. These two factors contribute to the sharp rise
in the numbers with marginal tax rates between 60-70 per cent.
Overall, while the numbers with marginal rax rates above 70 per
cent falls by 450,000, the number with marginal tax rates above
50 per cent increases by 460,000.
| TABLE 3
|
| Number of individuals with altered marginal tax rates
|
|
| Range | Numbers in range
| Numbers in range or above
|
| Per cent | Before | After
| Change | Before | After
| Change |
|
| 50 to 60 | 0 | 207
| 207 | 810 | 1,274
| 464 |
| 60 to 70 | 79 | 790
| 711 | 810 | 1,067
| 257 |
| 70 to 80 | 266 | 17
| -249 | 731 | 277
| -454 |
| 80 to 90 | 235 | 145
| -90 | 465 | 260
| -205 |
| 90 to 100 | 222 | 115
| -107 | 230 | 115
| -115 |
| 100 | 8 | 0 |
-8 | 8 | 0 | -8
|
|
Childcare measures
40. The impact of the childcare credit to be introduced with
the WFTC is the most difficult element of the last budget to quantify.
Under FC, childcare expenses can be disregarded against income.
This in effect means that only those who have income above the
applicable amount can gain. The majority of lone parents, who
are entitled to full FC before childcare costs are taken into
account, receive no additional payments in respect of these costs.
The childcare disregard in FC has a low cost and a very low take-up.
41. Under the WFTC, support for childcare will operate through
an additional credit. This will be over and above normal adult,
child and 30-hour credits, so all WFTC claimants with childcare
expenses will be able to receive help with them. The credit will
cover 70 per cent of eligible childcare costs, up to a maximum
of £100 a week for one child and £150 for two or more
children. As such, the maximum amount of WFTC help available will
be £70 for families with one child and £105 a week for
families with two or more children.
42. Currently those receiving FC spend very little on formal
childcare. In all the results presented above, we have assumed
that the use of childcare will follow these present patterns.
But with the introduction of the credit many people currently
using informal childcare arrangements, such as that provided by
family and friends, may formalise these arrangements in order
to gain from the childcare credit. It is uncertainty about the
degree to which current activities may be formalised that makes
the overall cost of the childcare credit so difficult to estimate.
The government's current spending projections estimate the addititional
cost of the childcare credit to be in the region of £250
million per year. The maximum additional expenditure is substantially
higher than this, reaching £4 billion per year if all eligible
families spend the full £100 or £150 a week on childcare.
This represents a very wide range of potential costs for the credit.
This is one of the few budget measures where only experience of
its operation will allow us to determine its actual cost.
June 1998
18
The Working Families Tax Credit and work incentives, The
Modernisation of Britain's Tax and Benefit System, Number Three,
paragraph 4.10. Back
19
See the Taylor Report, paragraphs 2.25-2.28. Back
20
This replaced Unemployment Benefit in October 1996. Back
21
In the public accounts, the part of a WFTC that offset current
tax liabilities could be included as a tax reduction. However,
standard conventions for international comparisons would mean
that any "negative income tax" paid by the government
would appear as an expenditure item. This treatment is currently
applied to mortgage interest tax relief paid to non-taxpayers.
Aside from psychological considerations, the labelling of cash
flows is, of course, irrelevant. The overall level of redistribution
performed by the government is what matters and this is unaltered
by the naming of cash flows. Back
22
See Duncan and Giles (1996), Labour Supply Incentives and Recent
Family Credit Reforms, Economic Journal. Back
23
The complete analysis of the WFTC on work incentives requires
a full labour supply model to be estimated. The results of such
a model are not available at present. However, the more limited
analysis presented here does give a strong indication of the likely
direction and magnitude of the full labour supply effects. Back
24
The term "poverty trap" is used in the literature to
denote the situation where individuals face high effective marginal
tax rates in the lower parts of the income or earnings distribution.
It is not a normative claim about whether or not the people facing
such rates are in poverty. Back
25
To include the unemployed in this analysis, it would be necessary
to estimate the wage level they would receive if they were working.
This is not attempted here. Back
| 
