Thursday, July 22, 2010

Time To Lower The Poverty Line

The one-minute summary

[Another long one I'm afraid]

We've blogged the welfare trap many times - the scandalous situation where millions of the workless poor find themselves with virtually no financial incentive to get off welfare and into work, trapped in a life of "indolence and vice" (as a previous generation of reformers so graphically put it)

Yes, we can blame the moral depravity of the welfare recipients themselves, but if you were facing an effective marginal tax rate approaching 100%, would you drag yourself out of bed at 6.30 on a cold wet morning to catch the number 27? Honestly?

The fundamental reason we're in this mess is the structure of the welfare system itself. And that is what we have to attack.

The problem essentially arises from the fact that most welfare benefits are means-tested. So the more cash you earn for yourself, the less you get in welfare. As your own earned income increases, your benefits are withdrawn, and that combined with the fact that you also have to pay tax and National Insurance, leaves you facing those monstrous effective marginal tax rates - much higher than those faced by the highest wedged denizens of the Wharf.

And overlaid on that, there's another problem - complexity. Whereas the Wharf banker faces a fairly straighforward tax schedule - ie he knows what is going to be taken from every extra pound he earns - the welfare recipient faces an extraodinarily complex and opaque system of rules and regulations governing what he will lose in benefits if he earns more. The system has grown up piecemeal over decades and there are now over 50 different benefits, all with different rules and withdrawal rates, and a total of 8,690 pages of guidance for DWP benefits alone. Even the officials can't always fathom it, let alone the recipients. Fraud and error costs us £4.5bn pa.

So what are the potential solutions?

Well, one is to scrap welfare for those of working age altogether. And Tyler has certainly met people who would do that. But old softie that he is, Tyler worries about children starving in gutters. Scrapping welfare is a non-starter.

A much more attractive solution is the Citizens Basic Income, which we have blogged several times. Under CBI, all adults get a standard handout from the state which is theirs to keep whether they work or not. It's a great idea, and would eliminate at a stroke all those crippling marginal tax rates - what you earn is on top of your CBI welfare benefit, not in place of it. The trouble is, in practice, it would simply be too expensive - try as we might, we've never been able to get the sums to add up (see this blog).

And right now, getting the sums to add up is vital. Like the man said, there's no money left. Any welfare reform that needs more money is out.

Which is why down at the TPA we've been crunching some numbers to see whether we could reform the system without spending any more (see full report here).

Fundamentally, what we need to do is reduce those high marginal tax rates facing the workless poor, and give them a real financial incentive to work. The trouble is that to do that we need to reduce the rate at which benefits are withdrawn as a family's own earned income increases. And that makes the system much more expensive.

The solution is one we've blogged many times - in order to fund a reduction in the withdrawal rate, we need cut the basic level of welfare provided. A cut which would in itself increase the incentive to work.

You see, as in so much else, there is an iron law trade-off here. Given a fixed pot of money, we either have to accept the current high rates of benefit withdrawal - with all their disincentive effects - or a lower level of basic welfare provision. We can't have both a high level of provision and low withdrawal rates.

What we've done is to model this trade-off, using official data on the circumstances and incomes of individual UK households.

We propose scrapping most of the existing welfare benefits for able-bodied working age people and replacing them with a single simple benefit - a negative income tax (NIT).

The maximum possible level of the NIT for an individual family would be set as a policy determined percentage of the median income across the country, much as the current official poverty line is already set. But whereas the current poverty line is set at 60% of the median, we've looked also at cheaper alternatives, setting it at 55% and 50% (which is where it was originally set decades ago).

Families with no other source of income would receive this maximum NIT (flexed according to family size). Families with some income of their own would receive lower amounts of NIT, with the amounts tapering away as income increases. This taper is the effective marginal tax rate faced by the family. Crucially, it is clear and open, fixed by policy rather than jumping around all over the place as under the current opaque and shambolic system. We have modelled tapers from 50% to 70% - all a vast improvement on the current 80-90% effective marginal tax rates faced by the poor.

So under our system, with a 50% poverty line, a workless two adult two child family would receive an NIT payment of just under £14000 pa (2008). If they then started earning for themselves they'd lose some of that, and the higher the selected taper rate, the more they'd lose. But the idea would be to keep the taper rate as low as we can afford to encourage work. With for example a taper rate of 55%, that same family earning £10000 pa (gross) would keep £4500, taking their overall income up to £18500 - much more than they'd retain under the current system.

So what would it cost, and what is the trade-off? The following table summarises the results for 2007-08 (click on image to enlarge):

Now in that same year of 2008-09, the current system of welfare for the able-bodied working age poor cost us £63.7bn (see paper for calcs). So that's the maximum amount we can spend.

Which means that 7 of our 12 modelled alternatives - ie all the nicest ones -  are simply unaffordable. We can put them from our minds.

It also means that the lowest possible taper rate we can afford with our current 60% poverty line is 70% - still way too high in terms of work incentive.

And that my friends is why it really is time to lower the poverty line. The current official target of 60% of median income is a major obstacle to improving work incentives for the workless poor. Reducing it to 50% would not only increase the incentive to work directly, it would also free up £20-£30bn pa to spend on allowing the poor to keep more of what they earn for themselves.

And to those who say that dropping the poverty line to 50% would give us children starving in gutters, we say rubbish. Incomes today are so high that even a poverty line at 40% of the median would hardly have people starving. For example, as we blogged here, families in the bottom quarter of today's income distribution are better off than families in the top quarter of the distribution 50 years ago - and they were living the life of Larry (whoever he was).

It's time to take some of those really tough decisions.

PS Yes, we would still rather define poverty in absolute terms rather than relative to median income, as the left prefer. But we are where we are, so let's take one step at a time. A step from 60% to 50% would take us a long way in the right direction (see Appendix C in the report for some more on this).


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