How Taxes and Benefits Can Discourage Work

This article from Kairos Journal is worth some time thinking about when we consider the huge tax burden that our children will have to pay if the current bill before the Senate is passed into law.
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How Taxes and Benefits Can Discourage Work

In Britain, as in most other Western economies, the government administers a bewildering range of taxes and welfare benefits in its efforts to achieve a number of ambitious objectives—the relief of poverty through redistribution of income towards the long-term poor; social insurance to help mitigate the effects of the great hazards of life (e.g., unemployment, family breakdown, and long-term illness or disability); and an attempt to smooth out income levels over an individual’s life cycle.1 On the face of it, these are laudable aims, approved by many Christians. But they have a number of unintended and not-so-beneficial consequences, not the least of which is the way this tax/benefit system discourages work.

This can happen in two ways. First, working people on low incomes may be dissuaded from working longer hours, getting a second job, or getting a slightly better job. The problem is simply that they may gain very little financially. A “poverty trap” comes about when a person’s gross earnings from working harder increase while his or her net earnings (after income tax and national insurance deductions and the loss of welfare benefits) amount to little or nothing—or even a loss. Second, the “unemployment trap” occurs when living idly on benefits is more lucrative than holding a job.2

Consider this poverty-trap example: A couple with no children earns together just £14,000 annually. For the financial year 2009-2010, they pay £548 in combined tax and national insurance contributions. Over the same period, they receive a state welfare benefit for low-income working families (the “working tax credit”) of £1129. This gives them a net income of £14,581. But if they decide to work longer hours and increase their combined pay to £16,000 a year, their tax and national insurance contributions would increase to £1,168, whilst their working tax credit would fall to £569.3 This leaves them with a net household income of £15,431. So although they gain an extra £2000 from work, they are only £820 better off. In other words, they pay an “effective” tax rate of 59% on the extra income.

A 2006 study by London’s Institute for Fiscal Studies4 found that over two million workers stood to similarly lose more than half of any small increase in their earnings. And around 160,000 would actually lose 90%—far higher than the marginal tax rate on the wealthiest people.5 The study concluded that although the government had pledged to “make work pay,” the extension of means-tested benefits actually exacerbates both the poverty and unemployment trap, increasing the disincentive to work.

Christians know from their study of the Bible that work is both a duty and a blessing, so there must be something seriously wrong with government policies which, innocently or not, end up discouraging people from more employment.

Footnotes:

1
For instance, the tax on people at peak earning power in their middle years can be used both to provide state retirement pensions for those towards the end of their lives and state welfare support for struggling young families.
2
The proportion of a person’s net income that will be replaced by the benefits system if he lost his job is referred to as the “replacement” ratio. Replacement ratios of over 100% are by no means unknown in Britain today, although the situation was marginally worse in the early 1990s.
3
Since working tax credit is regarded as a “gateway” benefit, receipt of which makes it possible for the claimant to receive a whole range of benefits like free medicine prescriptions, free optician and dental care, etc., the complete loss of working tax credit leads to the loss of many other benefits and could lead to higher real effective tax rates than shown in this example.
4
Stuart Adam, Mike Brewer, and Andrew Shephard, The Poverty Trade-off: Work Incentives and Income Redistribution in Britain. Available at the Joseph Rowntree Foundation Website, http://www.jrf.org.uk/publications/poverty-trade-work-incentives-and-income-redistribution-britain (accessed August 4, 2009).
5
The combined burden of income taxes and national insurance contributions in the UK on the very wealthy for the 2009-10 financial year is 51%—the top rate of income tax being 40% (paid on incomes over £37,400) and the rate for national insurance contribution being 11%.