Select Committee on Social Security Fifth Report


The role of tax credits

98. Tax credits are seen by some as a way round the National Insurance versus means-tested debate.[175] Working Families Tax Credit (WFTC) and Disabled Person's Tax Credit were introduced in October 1999 and became fully operational in April this year. A new Children's Tax Credit will be introduced from April 2001 to replace the married person's tax allowance, and there are plans to introduce an Integrated Child Credit from 2003, bringing together the children's allowances from Income Support, Working Families Tax Credit and the Children's Tax Credit. Mr Field commented, "It is now clear that the Working Families Tax Credit is not a one off initiative, but the start of the most major recasting of the welfare state for people of working age."[176]

99. Some argue that the development of tax credits is not relevant to the debate on the future of the contributory principle. Professor Alcock told us, "There was a time when I think people would have argued that [WFTC] was in essence a form of means-tested benefit and really was incompatible with social insurance, but I am not sure that that is the case. It does seem to me that the Working Families Tax Credit, more transparently perhaps than some of the previous forms of income support, is actually a means of subsidising low wages... It seems to me there is a compatible relationship between tax credits for people in work and benefits for people out of work."[177] Ms Bennett saw little 'fit' between taxpayers, who benefit from tax credits, and benefit recipients: "the tax credits which have been proposed so far have largely been about people already in employment...National Insurance benefits are by and large (although not exclusively) for people outside the labour market, with some exceptions (such as pensioners and widows)"[178] But to the extent that tax credits are seen as overcoming the problems of means-testing, they may make means-testing more acceptable and therefore weaken the case for non-means tested, contributory benefits. Mr Field told us, "the growing strength of the tax credit system will inevitably lead to people logically arguing the insurance side becomes less and less relevant and therefore the means testing of insurance benefits will continue."[179]

100. Working Families Tax Credit, the main tax credit to have been implemented, does seek to overcome some of the problems traditionally associated with means testing. Although the mechanism for calculating entitlement is almost identical to Family Credit, the means-tested benefit it replaced, Working Families Tax Credit, differs in being more generous - both in amounts which can be paid and in the rate at which benefit is withdrawn as income rises, and in being paid through the wage packet rather than through an order book. The more generous allowances are aimed at tackling the 'why work?' problem. The withdrawal rate of WFTC ('the taper') has been set at 55 per cent, compared to 70 per cent for Family Credit. This is designed to ameliorate one of the side-effects of means-testing, the poverty trap, which affects people in work who are simultaneously paying tax and receiving means-tested subsidies. For those affected, the withdrawal of means-tested help combined with paying more in taxes, can mean that they are only marginally better off if their wages go up. WFTC, combined with changes to tax and National Insurance, will reduce the numbers of families with an effective "tax" rate of 70 per cent or more from an estimated 715,000 to 230,000.[180] It is also argued that payment of WFTC through the wage packet will reduce the stigma of claiming a means-tested benefit.[181]

Finally, as the TUC explained, it is argued that tax credits avoid the potential social divisiveness of means-tested benefits: "increased or maintained tax credits can be presented as tax cuts rather than benefit increases, and are therefore less vulnerable to the loss of middle class support. The US experience of the Earned Income Tax Credit is that it is far more politically popular than any means-tested benefit ever has been. The fact that the WFTC is provided for working families should also help boost support."[182]

101. But has Working Families Tax Credits really overcome the problems associated with means-testing? Two studies carried out by the Institute for Fiscal Studies[183], on the predicted impact of WFTC on work incentives, suggested that although families without earners were likely to increase their employment participation, there was a potentially negative effect on families where one partner was working. Both studies identified a drop in employment participation among married women with a working partner,[184] and one, which modelled exit from work as well as entry into work, also suggested a negative impact among married men with a working partner.[185] Overall, at best the employment effect of WFTC was predicted as an extra 32,770 families in work.

102. Moreover, the TUC pointed out that although WFTC reduced the number of families exposed to the most severe poverty traps, it actually increased the number who would be caught in the trap. Although in favour of WFTC, the TUC commented,

    "when you are designing any means-tested benefit, there is a balance between the depth of the poverty trap and the breadth of the poverty trap and with WFTC, the Government has decided to make it shallower, but at the expense of making it broader...The poverty traps are probably not, almost certainly not the most important Welfare to Work barrier when it comes to decisions about: "Am I going to be unemployed or am I going to work?" but it does affect decisions about whether to increase your earned income and the fact that more people are going to face that disincentive once they are in work could leave us with a problem with large numbers of people, as with Family Credit, getting into work and then staying put on the same earnings or hours. So that is our worry on WFTC."[186]

103. Mr Field saw WFTC as embodying all the problems of means-testing. It penalised success, in that the reward for working and earning more is a reduction in help; and it was a subsidy to low wages, benefiting employers who will quickly realise the advantages of paying less and allowing taxpayers to subsidise low wages.[187] In his view, "the estimated bill for the tax credit will quickly soar, while the distribution of earnings towards the bottom end of the scale will take a marked downward shift."[188] He also anticipated a high risk of fraud and concluded, "the only question is how long will taxpayers be prepared to foot an ever escalating bill resulting from people naturally working the system and, to a lesser extent, from fraud."[189] Even the TUC, a supporter of WFTC, warned, "tax credits could come to be seen as "stealth benefits", paid for by "stealth taxes". Spending on Tax Credits could grow very quickly - US experience suggests that Tax Credits are more vulnerable to fraud than benefits, and there is a real danger of employers using Tax Credits to subsidise pay when they issue them in the wage packet. A generation from now the need to control the costs of Tax Credits could be the biggest issue in welfare reform."[190]

The Australian experience of means-testing

104. Working Families Tax Credit represents an attempt to overcome some of the problems associated with means-testing. Earlier this year, the Committee travelled to Australia, a country which, unlike almost all other OECD countries, has no developed system of social insurance benefits. Instead, benefits are almost wholly means-tested and are paid at flat rates from general taxation. One of the key areas of interest to the Committee was how such a system worked, and whether the problems identified with means-testing in this country also featured in the Australian welfare system.

105. A key difference between the Australian and British means-tested benefits systems is the relative generosity of benefits in Australia, where access to benefits extends far higher up the income scale. Means-tests in Australia essentially exclude the top 20 per cent of the population rather than targeting assistance only on the poorest. Thus, means-tested age and service pensions are claimed by around 80 per cent of the pensioner age population in Australia. Around 80 per cent of all families with children receive direct cash assistance.[191] There were a number of features of the Australian system which appeared to address some of the problems associated with means-testing in this country. To encourage part-time and casual work, Income Support for the unemployed has a tapered withdrawal rate for income above a certain threshold. More generally, there appeared to be a greater use of tapers rather than income cut-off limits, as well as a 'free area' of income disregarded which varied with marital status and the number of dependent children. The problem of deliberately running down assets in order to increase entitlement to the Age Pension had been countered by the introduction of 'deeming' a minimum rate of return on financial assets, to encourage more sensible investment. The Australian system has also attempted to encourage the workforce potential of married women, by requiring both members of a couple to qualify for payment in their own right. This measure has been accompanied by the introduction of a Parenting Allowance; a restriction of a partner's allowance to people born before July 1955; a general requirement for partners born after 1 July 1955 who do not have dependent children to qualify for an activity tested unemployment payment; and a change in the income testing arrangements for couples, so that each partner is assessed on their own income, with one partner's income affecting the other's only if it is sufficient to preclude the payment of their own allowance. Capital rules are also more generous.

106. Yet despite these measures, and increasing pressure on unemployed people since 1996 actively to seek work and participate in work experience programmes , the Australian Government still sees itself as struggling with what it calls "the challenge of welfare dependency."[192] Despite economic and employment growth, the proportion of the workforce receiving Income Support in Australia has remained virtually unchanged since 1993. Only one third of the working-age population on benefit are formally unemployed; the rest are people receiving means-tested benefits as a result of disability, parenting (either as sole or primary carers of dependent children), or due to their age and limited recent workforce experience (Partner Allowance, Widow Allowance and Mature Age Allowance). Academics told us that there was a fairly high degree of public resentment against benefit claimants, known as 'dole bludgers,' who were seen as getting something for nothing. A recent policy research paper from the Australian Department of Family and Community Services discussed "the popular view that low-income working families are no or little better off than families completely reliant on social security payments." It commented, "while strictly speaking this is not correct,...a couple with two teenage children will increase their disposable income by around $315 per week for a $1000 private income. For a couple with four older dependent children, the change in disposable

income is $152 out of $1000 of gross income." The report concluded that "there is evidence that the 'low-income trap' (what this report calls the poverty trap) is potentially more salient in Australia than in many other countries."[193]

107. Having examined systems of means-testing in some detail, we conclude that some answers to the criticisms of means-testing are possible but that there are structural reasons inherent in means-testing which run the risk of undermining key objectives of the present Government of tackling poverty, making work pay, and equipping people to take control of their lives.

The role of private insurance and occupational pensions

108. The Government's 1998 Green Paper on welfare reform listed as a key principle that "the public and private sectors should work in partnership to ensure that, wherever possible, people are insured against foreseeable risks and make provision for their retirement."[194] In its 1998 Green Paper on pension reform, the Government set out measures designed to reduce the share of pension income coming from the State from the present level of 60 per cent to 40 per cent by 2050.[195] The expectation is that the private sector, which currently accounts for 40 per cent of pension income, will increase its share. As Ms Bennett commented, "the relationship between state and private provision for risks and savings is therefore changing, with potential implications for the contributory principle."[196]

109. Professor Alcock described the relationship which Beveridge saw between state and private provision as follows:

    "The way in which I think Beveridge originally conceived the relationship between those two systems is that they were mutually compatible. You could have social insurance and private insurance operating alongside each other because everybody would be clear about what their social insurance rights were and could then use private insurance in order to build on those, so it would be a quite separate relationship which would develop as an individual through a commercial base."[197]

The TUC saw private insurance as providing a useful supplement to social insurance, but argued that it could not be assumed that private provision could substitute for state support:

    "While unions are proud of their record of negotiating high quality benefits from employers, especially pensions, we are also aware of the fact that many workers are not covered by these schemes, and that those outside the labour market are, by definition, unable to benefit from them. Without statutory rights to such benefits reliance on occupational provision will produce patchy coverage which misses those who need it most."[198]

110. The limitations of private provision were pointed out by many groups.[199] Research carried out by Disability Alliance and the Disablement Income Group found that those people most at risk were the least likely to obtain affordable (or any) private cover. Thus "disabled people, women, people in manual occupations, part-time or casual work, or with interrupted work records, were the least likely to belong to an occupational scheme. Those with a pre-retirement disability tended to get less occupational pension than non-disabled colleagues.[200] The Low Pay Unit drew particular attention to the lack of an alternative to the State Retirement Pension for low paid employees with no access to occupational schemes. They pointed out that around three-quarters of full-time employees have access to company pension schemes compared to less than half of part-times. Almost all full timers (97 per cent) get occupational sick pay compared to two-thirds of part-timers.[201]

111. Individual's contributions are not affected by the likelihood of unemployment, sickness or long-term disability. In contrast, private insurance links an individual's premiums to their level of risk.[202] We agree with the Social Security Advisory Committee, who when they looked at this issue concluded:

    "In the fields of incapacity, disability and unemployment, we see little scope for developing private provision to an extent which would impact on state benefits. There is clearly a market for private insurance in these fields and it will doubtless continue to develop, as it has done in recent years to meet new needs. However, we believe that the state should remain the major provider of benefits for long-term sickness, disability and unemployment. The universal coverage of the state scheme is its great virtue and is essential for the protection of the most vulnerable who might find private cover difficult to afford or even to obtain, if they represented a high risk."[203]

112. In the case of private and occupational pension provision, the Government has acknowledged that "lack of knowledge, the Maxwell affair and the mis-selling of personal pensions has left many people lacking confidence and trust in any type of pension arrangement. People are not sure where to get advice and who they can trust. Much of the information that is available is of poor quality. Because of this, many people run the risk of making the wrong pension choices, their confidence and trust in pensions may be undermined and they may be put off saving altogether."[204]

113. The Government has introduced legislation designed to increase state pension provision for the lowest paid, whilst encouraging greater private provision for people on modest incomes and above. Most immediately, it has sought to boost the incomes of present day pensioners through the means-tested Minimum Income Guarantee (see paragraph 78 above). In the longer term, in a scheme which will fully mature in 2050, the Government has proposed legislation to replace the State Earnings Related Pension with a new State Second Pension aimed at people on low or intermittent earnings, for whom the cost of private, funded pensions are out of reach.[205] Carers, some disabled people and mothers with young children will receive flat-rate credits to the new State Second Pension. Those earning below £9000 a year, including carers, will be better-off under the State Second Pension than at present because they will be treated as if they had earnings at that level. The Secretary of State told us:

    "we are benefiting some six million low paid people, some two million carers, three million disabled people with broken work records, by developing the contributory principle and the contributory system through the new state second pension.[206]

114. For those on incomes between £9000 and £18,5000, the Government has introduced measures designed to encourage greater private provision through the introduction of low cost stakeholder pension schemes, and higher National Insurance rebates.[207] In order to combat the lack of confidence of many people in private provision, stakeholder pensions will be obliged to conform to minimum standards, for example on charging and flexibility, and have an approved structure of governance designed to ensure that schemes are run in the interests of members, are value for money, and give good quality information. For all middle and higher earners, the aim is that all should have private, funded pensions.[208]

115. We do not propose to embark on a detailed analysis of the Government's plans for pension reform, save to comment on three aspects which are relevant to our inquiry. We see no contradiction between a contributory system delivering state pensions and parallel private provision. However, the background to the Government's proposals is the declining value of the basic 'first pillar' of pensions, the State Retirement Pension. The basic state pension currently provides about a third of all pensioner income and is the largest single source of support.[209] The decision of the Government in 1980 to link the uprating of the pension to prices not earnings has caused its subsequent value to drop significantly. According to the Government Actuary, with continued uprating of basic retirement pension in line with prices, by 2060 it will be worth only around six per cent of male average earnings.[210]

116. CPAG told us, people are having to move towards private provision, not out choice but "because they are frightened, they are anxious about what sort of protection they are going to receive from the state."[211] Age Concern said it was dismayed at the Government's simplistic view that decent state pensions are not affordable, and therefore the answer is more private provision:

    "This ignores the fact that all pensions, whether private or state, funded or pay-as-you-go represent a transfer from one generation to another. As the Pensions Provision Group states[212] 'More pre-funding is not a panacea ¼. However they are provided, pensions are a charge on the economy at the time they are paid'. The Government Actuary[213] has also argued against relying too heavily on private funded provision stating that in his view the best option is a 'reasonable level of largely flat-rate pay-as-you-go social security provision as the basic first pillar'. Age Concern believes that in order to achieve better pension provision, overall we must pay more towards pensions, and this is likely to need improvements in both state and private provision."[214]

117. The state pension is the foundation of pension provision. Whilst we accept that individuals may well choose to supplement the state pension provided from compulsory contributions with additional voluntary provision, we have come to the conclusion that the state must ensure that every citizen has a sound financial platform on which to build. We note the Government Actuary's view that "real earnings growth will result in working people being relatively better off in future even if National Insurance contribution rates were to be increased to meet the cost of increasing flat-rate benefits in line with earnings. Based on gross pay and real earnings growth of 1.5 per cent per annum, real earnings relative to prices will, in the year 2060, be approximately 2.5 times the corresponding level in 1999-00. Allowing for higher National Insurance contribution rates and earnings limits, someone on average earnings would still have real net earnings, after National Insurance contributions, of approximately 2.4 times current levels."[215] We are mindful also that the State Second Pension will not fully mature until 2050.

118. A second area of concern is the relationship between the State Second Pension and the Minimum Income Guarantee. We agree with the present Government, which in its Green Paper on pension reform said that "people who work all their lives should not have to rely on means-tested benefits when they retire."[216] The intention of the State Second Pension is to allow people who receive it to retire at a level of income which puts them above the qualifying level for the Minimum Income Guarantee, thus avoiding means-testing. The problem, however, is that the Government has given no commitment that the State Second Pension will be uprated in line with earnings. In contrast, the Government is committed to uprating the Minimum Income Guarantee in line with earnings through the remainder of the Parliament. The danger is that pensioners who have paid National Insurance contributions throughout their working life and who retire on the State Second Pension will find themselves, within a few years, worse off than pensioners on the Minimum Income Guarantee. The risk is likely to increase in the longer term as the value of the basic state retirement pension diminishes. It is unclear whether the Second State Pension will expand to meet the shortfall. Such a scenario would make a mockery of the principle that the pension system should reward work.

119. Finally, we have reservations about the Government's decision that payment into funded pensions, including stakeholder pensions, should be on a voluntary basis. Through the State Second Pension, the Government recognises that saving for old age is impossible for people on the lowest incomes. It must also recognise that saving for old age is not at all easy for people on modest incomes of over £9000. In Australia, we were impressed by the widespread public support for compulsory superannuation. A survey by the Association of Superannuation Funds of Australia found that there was 97 per cent support for compulsory superannuation, while 60 per cent of those surveyed were willing to contemplate paying higher amounts than the 9 per cent of earnings planned for 2002. The Chief Executive of the Association told us that, although people in Australia were normally against compulsion, they knew they needed the discipline to save. Compulsion also removed the potential for a sense of unfairness: everyone else was having to save as well, to prevent them from being a burden on the taxpayer. However, this was in the context of contributions in Australia being compulsory for employers only. There was some scepticism as to whether compulsory employee contributions would attract the same support. The level of employer contribution in Australia was regarded by many as not sufficient to provide a reasonable pension level in the long term. We agree with Mr Field who told us, "you cannot run it on the basis of allowing people to choose in these basic areas because there are always more pressing needs and always the thought: 'well, if I do not make the contribution, taxpayers will pick me up later on.'"[217] We consider that a compulsory rate of saving for pensions may be essential to ensure that everyone is helped to make proper provision for their old age. This is particularly important for those on modest incomes who face a number of competing financial demands and where making provision for old age will not always receive the priority it deserves.

120. There is a clear and urgent problem in meeting the needs and expectations of less well-off pensioners, particularly those just above Minimum Income Guarantee level, in the light of growing inequality within the range of pensioner incomes generally. Our inquiry has identified possible causes and solutions, including the prima facie need to increase the basic state pension, but we do not wish to prejudice our more detailed inquiry into pensioner poverty issues by drawing conclusions and making recommendations before that inquiry is completed. The evidence we have collected as part of this inquiry will help inform our deliberations on this vital concern as our pensioner poverty inquiry progresses.

175   TUC, Ev p 30 para 63. Back

176   Frank Field, Ev p 132. Back

177   Q. 31. Back

178   Q. 187. See also the GMB, Appendix 11 para 8.2.2. Back

179   Q. 222. Back

180   Table 4.2, Budget 99, HM Treasury, March 1999, HC 298. Back

181   See, for example, Tackling Poverty and Making Work Pay - Tax Credits for the 21st Century, HM Treasury, March 2000: "As a tax credit rather than a welfare benefit, it reduces the stigma associated with claiming in-work support, and by demonstrating the rewards of employment over welfare should encourage families to move into work." (Para 2.8) Back

182   TUC Ev p 43 para 66. Back

183   The Labour Market Impact of the Working Families Tax Credit, R Blundell, A Duncan, J McCrae and C Meghir, IFS Report to Bank of England Monetary Policy Committee,1998; and Entering Work and the British Tax and Benefit System, P Gregg, P Johnson and H Reed, IFS, 1999. Back

184   Gregg et al predicted a fall in number of 29,050. Blundell et al predicted a fall of 20,000. Back

185   Blundel et al predicted a fall of 10,500. Back

186   Q. 61. Back

187   Ev p 132.  Back

188   Frank Field, Ev p 132. Back

189   Frank Field, Ev p 132. Back

190   TUC, Ev p 43 para 68. Back

191   The Australian system of social protection - an overview, Department of Family and Community Services, February 2000. Back

192   In October 1999, the Minister for Family and Community Services published a discussion document The Challenge of Welfare Dependency in the 21st Century. In June 2000, a government appointed reference group is due to present the Minister with a final report on the document, based on widespread consultation. Back

193   Page 32, The Australian system of social protection - an overview, Department of Family and Community Services, February 2000. Back

194   New ambitions for our country: A New Contract For Welfare, 1998, Cm 3805. Back

195   Para 18, A new contract for welfare: Partnership in Pensions, 1998, Cm 4170. Back

196   Fran Bennett, Ev p,112 para 2.4. Back

197   Pete Alcock, Q. 2. Back

198   TUC, Ev p 46, para 84. Back

199   For example, TUC Ev p 37-40, Disability Allianc, Ev p 91-2, Fran Bennet, Ev p 115 para 5.8. Dr Bruce Stafford Appendix 2, the GMB Appendix 11, Lancashire County Council Welfare Rights Service Appendix 14, Joan Brown Appendix 23 section 2.  Back

200   Disability Alliance, Ev p 91 para 7.2. Back

201   Low Pay Unit, Ev p 65. Back

202   See, for example, discussion by the Association of British Insurers, Appendix 19. Back

203   Para 6.1 State Benefits and Private Provision, Social Security Advisory Committee, 1994. Back

204   Chapter 3, paragraph 11, A new contract for welfare: Partnership in Pensions, 1998, Cm 4170. Back

205   Child Support, Pensions and Social Security Bill, HL Bill 54. Back

206   Q. 327. Back

207   Part I, Welfare Reform and Pensions Act 1999. Back

208   DSS memorandum, Ev p 183 para 81. Back

209   Cm 4179, Chapter 2, para 13. Back

210   Para 3.5, National Insurance Fund Long Term Financial Estimates, Government Actuary's Department, 1999, Cm 4406. Back

211   Q. 114. Back

212   We all need pensions - the prospect for pension provision, Pension Provision Group 1998.  Back

213   In a speech to the National Association of Pension Funds on 17 September 1998. Back

214   Appendix 3 para 7.2. Back

215   Cm 4406, para 1.18. Back

216   Cm 4179, Chapter 4 para 1. Back

217   Q. 234. Back

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