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Withdrawal Symptoms: Why tax cuts aren't the best way to incentivise work

Friday, 5 February, 2016

Earlier this week we launched our new report The Aspiration Tax: How our social security system holds back low-income families. In it we argued that the government should let people on Universal Credit keep more of every additional £1 they earn, by reducing Universal Credit’s withdrawal rate. As luck would have it, recent research provides even greater support for reducing the withdrawal rate of Universal Credit.

A new study from the University of Essex suggests that benefit withdrawal rates are even more important than previously thought in disincentivising work. An experimental study was conducted which compared the behavioural effects of reducing people’s earnings, either through taxes or through benefit reduction. People in the study were given money for completing a task, as well as being given an additional benefit for participating. They were split into two groups. One group had their income taxed away, the other saw their benefit reduced. The study looked at how hard the two groups worked and for how long they worked. If people saw their benefit reduced as they increased their earnings this had a greater disincentivising effect than if their earnings were taxed away. People having their benefit withdrawn worked for less hard and for less time. This has profound implications for government policy on low pay, taxation and social security.

If people are more strongly disincentivised by having their benefit withdrawn than by having their income taxed, then it suggests the government should focus on withdrawal rates rather than on the taxation of income. In practice, the best example of how the government should respond to this research is to change the balance between the income tax personal allowance and the Universal Credit withdrawal rate. At the moment the income tax personal allowance costs the government over £86bn per year: almost three times the cost of the entire cost of tax credits to HMRC. The government is proposing to continue dramatically increasing the cost of the personal allowance by raising it further. One of the aims of the personal allowance rise is to incentivise work, but in doing so it offers extremely poor value for money. The lowest paid workers will see no benefit from this increase, and most benefit will accrue to richer households who are in less need of the support.

Only a tiny proportion of the personal allowance will go to low income households. A single parent with two kids on the average wage will only be £8.75 better off per month from the £4bn increase in the personal allowance. They would get to keep less than 1p extra of every £1 earned if they increased their pay from the minimum wage to the average wage.

A less than 1p in every extra £1 increase is not exactly an irresistible incentive to most. Now this study shows that it is an even worse incentive than the equivalent additional income from a lower social security withdrawal rate. If the cost of increasing the personal allowance was instead spent on reducing Universal Credit’s withdrawal rate, a single parent with two kids on the average wage would be £126.93 better off per month. If they worked hard and moved from a minimum wage to the average wage, they’d get to keep almost 7p more per extra £1.

This provides a much bigger incentive in purely monetary terms, but this study suggests that each £1 they are better off does more, and is a better incentive, if it comes from reduced benefit withdrawal than if it comes from tax cuts. This adds to the overwhelming evidence that we lay out in our report, and is further reason for the Government to cut the aspiration tax, and reduce the Universal Credit withdrawal rate to 55% instead of raising the personal allowance.

Tim Stacey, Senior Policy and Research Advisor

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