IFS

Tax credits: time to stop weakening work incentives?

Mike Brewer, Institute for Fiscal Studies

© Institute for Fiscal Studies, 2005

Outline

• Recent tax credits changes are weakening incentives to work

• Can we reduce child poverty without weakening work incentives?

© Institute for Fiscal Studies, 2005

Background

• Transfers to poor (ie not paid to rich) weaken work incentives– Out-of-work income rises, in-work income rises

less– EMTRs rise because transfer withdrawn as

income rises

EMTR = effective marginal tax rate= how much of a small change in income is lost to extra tax and reduced transfers

© Institute for Fiscal Studies, 2005

Recent tax changes and parents’ incentive to work

• Between 1999-2003– Increased % of lone parents in work– Slightly reduced % of women in couples in work

• Since 2003– Incentive to work all & incentive to progress

weaker now that in 2003, particularly for those in couples with children

– Set to continue until (at least) 2007

© Institute for Fiscal Studies, 2005

Four anti-poverty policies for tax credits

• Increase per child element of child tax credit– Helps poor, but weakens work incentives

• Increase working tax credit– No direct help for poorest. Strengthens incentive to work in

workless families, weakens it for 2nd earners. Weakens incentives to progress for all

• Introduce “3rd child premium”– Good indicator for being poor. Minimal impact on WI.

Fertility?

• Extend baby tax credit to under 5s– Redistributes across lifecycle rather than between families.

Minimal impact on WI.

© Institute for Fiscal Studies, 2005

Distributional impact

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Poore

st 2 3 4 5 6 7 8 9

Riches

t

Deciles of family income

% c

hang

e in

net

inco

me CTC

WTC

U5

3rd child

Note: poverty line somewhere in 3rd decile

© Institute for Fiscal Studies, 2005

Distributional impactrelative to CTC

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

Poore

st 2 3 4 5 6 7 8 9

Riches

t

Deciles of family income

% c

hang

e in

net

inco

me

WTCU5s3rd child

© Institute for Fiscal Studies, 2005

Impact on incentive to work at all (replacement rate)

% whose rate rises

[weaker incentive]

% whose rate falls

[stronger incentive]

Change in mean RR

(ppt)

CTC 30 0 +0.4

WTC 19 18 +0.0

Under 5 15 <1 +0.2

3rd child 7 0 +0.1

© Institute for Fiscal Studies, 2005

Impact on incentive to progress (METR)

% whose rate rises

[weaker incentive]

% whose rate falls

[stronger incentive]

Change in mean METR

(ppt)

CTC 2 <1 +0.4

WTC 4 1 +1.0

Under 5 <1 0 +0.1

3rd child <1 0 +0.0

© Institute for Fiscal Studies, 2005

Conclusions

• No single measure can affordably cut poverty without harming work incentives

• Post-2003 tax credit changes are undoing the “good work” of previous tax and benefit reforms

• Can redistribute to families in poverty without a means-test

• Maybe time to increase WTC rather than CTC?

IFS

The end