Tuesday 25 October 2016

UK tax credits - a policy that was too good to last

Published 23/07/2015 | 02:30

Former British Prime Minister Gordon Brown
Former British Prime Minister Gordon Brown

The mayor of Calais got it right, perhaps. In an interview a few months ago Natacha Bouchart gave her opinion as to why so many migrants were desperate to get across the Channel to Britain. One big reason, she thought, was the UK system of tax credits.

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This remarkable claim received scant attention in most of the British media. Not surprising perhaps: having a French politician criticise the UK welfare system as being overly generous hardly fits the media narrative - whether on the right or left.

But lo and behold, the credits were slashed in Chancellor George Osborne's Budget this month - a decision with all kinds of repercussions.

The logic of Gordon Brown's plan to boost the incomes of low earners is a striking lesson in the uncomfortable fact that all economic policies create a myriad of effects - not all of them intentional.

The logic of this kind of tax credit seems impeccable. Those whose earnings are too low to have them liable for enough tax to benefit from credits can receive the credit in cash. The scheme, accompanied by generous child credits, has certainly been a success. Almost all families earning less than £10,000 a year are benefiting. The one-third increase in lone-parent employment (an area where Ireland has one of the worst records) is attributed to the greater incentive to work that the credits provide. The incomes of the poorest 20pc of families rose by 12pc.

The unintended effect was that employers were able to pay less in wages. The generous credits meant workers were willing to accept lower wages because their total take-home pay was significantly higher.

In some cases it was probably higher than the workers could have earned in the marketplace. This, according to the mayor of Calais, was the attraction for the migrants - along with the absence of European-style identity cards and labour market regulation.

The credits worked because they are substantial; costing £30bn a year - more than the defence budget. The cuts provided the bulk of the unexpectedly modest £7bn reduction in the welfare budget but the ramifications cannot all be that attractive for Conservative government politicians.

They have been obliged to alleviate the effects on the lowest income groups by increasing the minimum wage from £6.50 an hour to £7.20, with a promise that it will be £9 per hour by 2020. At current exchange rates, that would be a whopping €13. One is always doubtful about the value of currency conversions in this kind of case but there are bound to be competitive consequences. These could work both ways in our case, since comparisons with UK minimum rates are bound to be made, especially with regard to the mooted 50 cent increase to €9.15.

In her inaugural address two weeks ago, Congress of Trade Unions General Secretary Patricia King called for the implementation of a "Living Wage". Such a wage, which union groups have calculated at something close to €12 an hour, "would create the 'virtuous circle' effect of increasing domestic demand, leading to higher tax revenue, and boost growth in economic performance which in turn would create employment and raise living standards", she said. 

So it would but, like every policy, it would do other things as well. In Britain, there were immediate post-Budget warnings that prices could rise as companies in low-paid sectors pass on the extra wage costs. Ratings agency Moody's calculated that a large UK retailer employing 50,000 people would have to fork out an extra £20m a year. It also suggested that companies might recoup costs by reducing staff benefits - discount prices for goods were mentioned. The consequences, whether good or ill, ripple outwards from any policy disturbance. In this case, lower prices meant the tax credit benefits spread beyond the workers directly involved to low-income customers as well.

Then there is the puzzle of the "productivity puzzle" - the fact that, across the rich economies, and particularly in Britain, recovery has not been accompanied by the expected increases in output per workers. The puzzle about this puzzle is whether it is a good thing or bad.

Almost universally, economists say it's bad because rises in real incomes can come only from increased productivity. One can forgive them for harping on about this, since no one else seems to believe it, including the people who run countries. But it is a rather more difficult question whether a 10pc rise in output per worker is unambiguously better than the same rise accompanied by an increase in employment, even if it reduces the productivity gain. If it is to be better, the larger productivity gain has to filter through in the kind of virtuous circle outlined by Ms King. How exactly it does so, however, depends on all kinds of other factors in the economy in question.

If those factors promote the virtue many would regard as most desirable - the creation of jobs for those who would otherwise be on welfare because of lack of skills or opportunities - it would be foolish to bleat about apparently poor productivity gains. It is also foolish to pretend that there is clear evidence to back up any of these theories. One must start with the evidence; not some dog-eared theory.

The figures show Ireland with a combination of high proportions of unemployed households, little tax on low incomes or employers' payrolls, and high wages. How do all those things fit together? After they have put away their scripts for the National Economic Dialogue (many of which could have been delivered ten years ago - and were) the participants might start to examine the situations they actually face.

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