The UK chancellor's proposals combine drastic cuts to tax credits with a substantial increase in the minimum wage
Often, little decisions are more revealing than big ones. The UK government’s overall fiscal objectives are significant and debatable. But its decision to impose a cut in tax credits in the Summer Budget is far more controversial. Indeed, it is so contentious that the House of Lords has arguably overstepped the bounds of constitutional propriety by rejecting the enabling legislation. Whether that is the case or not, this is bad policy, dishonestly presented. The government should indeed think again.
The objections to the fiscal strategy are powerful. There is no strong reason to run an overall surplus by the end of this parliament: at a time of extraordinarily low interest rates, the case for borrowing is strong. Legislating the surplus is also objectionable. Again, the decision to make virtually all the post-crisis fiscal adjustment via cuts in spending is extreme, not least because the ratio of spending to gross domestic product will fall to levels briefly touched only twice since 1948.
Yet debate never focuses on such generalities, however big the implications. Only specifics are politically salient.
The annual net cut to benefits and tax credits planned by George Osborne, the chancellor of the exchequer, was to be £12.5bn. Of this, £3.3bn was to come from lower thresholds for withdrawal of tax credits and higher rates of withdrawal. Another £1.1bn was to come from cuts in the generosity of the system for people with more than two children. It is these changes to tax credits that the House of Lords rejected last month. Yet these savings from overall cuts to welfare amount to only 0.7 per cent of GDP, while those to tax credits alone are a little over 0.2 per cent. In the overall fiscal context, such sums are clearly small.
Yet these cuts matter a great deal to the people most affected. In his Budget speech, Mr Osborne claimed: “Taken together with all the welfare savings and the tax cuts in this Budget, [the living wage] means that a typical family where someone is working full-time on the minimum wage will be better off.” This argument must depend on what is meant by a “typical family”.
There will be high costs for a policy that lowers support for children and reduces the returns from work
In a thorough study of the planned changes, the Institute for Fiscal Studies concludes that even if Mr Osborne’s new national “living wage” were to have no effect on GDP, employment or hours of work (in fact, it will probably lower all three) it would offset only 27 per cent of the drop in household incomes from the tax and benefit reforms. For the 8.4m households that contain someone doing paid work and are elegible for benefits or tax credits, the average loss would be £750 a year, while the average gain from the new living wage would be just £200. The average household with children eligible for benefits or tax credits, of which there are 7m, would suffer a net annual loss of £1,130. For such households, the effect would be significant, if not disastrous. The losses from proposed tax and benefit reforms would be concentrated on the lower deciles of the income distribution; in the second decile from the bottom, for example, the reduction is estimated at about £1,300 a year, or close to 8 per cent of net income. Meanwhile, the biggest gainers from the living wage fall in the middle of the distribution.
One of the questions raised by this story is how policies are sold to the public. Whatever the merits of the living wage may be — in my view, it is a risky gamble — it is not going to offset the cuts in benefits for those affected.
Beyond this, the new policy raises questions about how best to motivate people to work, sustain the incomes of households with poor job opportunities and shield children from the burden of growing up in relatively impoverished households. There will be high costs for a policy whose central elements are to lower support for children and greatly reduce the marginal returns from work. Consideration could also be given to improving the existing system, not least to encourage second earners into jobs, which would not be hard.
The proposed reforms to tax credits raise a still wider question. Technological change and globalisation are lowering the returns to work for the relatively unskilled in most high-income countries. What, then, is the right political and policy response? One possibility is to do nothing, thereby accepting whatever happens to the distribution of household incomes and the fate of children. Another possibility is to raise minimum wages but ignore the risks to employment. The best route is to combine a carefully assessed minimum wage with subsidies aimed at supporting families with children and encouraging them into work. That is precisely what the UK had. There is no good reason to throw this away so casually.
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