Target tax cuts at poorest families

Last month’s unveiling of the Jobs Support Scheme (JSS) was as disappointing as it was rushed. The new scheme may be dressed up to look like a successor to the Job Retention Scheme (JRS) created last April and set to expire this month, but in substance it is an entirely different beast. While the JRS was designed in good faith to protect against mass unemployment (and even then, millions on insecure work have fallen through the gaps), the JSS is predicated on the assumption that millions of jobs are no longer ​‘viable’.

For firms trying to operate in sectors like hospitality and tourism that have been hit hardest by the ​‘rule of six’ and new national curfew, the scheme is next to useless. This is unless they are legally required to shut down under local lockdowns, in which case — in a partial resurrection of the JRS within the JSS — the government will now pay up to 66% of their workers’ salaries. But otherwise, by design it will be more expensive for these employers to reduce hours through the scheme, than it will be to cut hours and make redundancies outside the scheme. Without a change in course, unemployment can be expected to double within months.

There was, however, some small support extended to sectors hardest hit, but this largely came in the form of tax cuts. The VAT cut for hospitality was extended by six months to March 2021, and the Job Retention Bonus – effectively a cut in employer payroll taxes – was kept in place for firms that retained previously furloughed workers until January 2021.

The former adds to the £4.1bn earmarked for VAT cuts in July, while the government indicated it was prepared to spend up to £9.4bn on the latter. But even after including the new JSS and modest funds earmarked for retraining, this tax-dominated recovery package falls well short of plugging the missing stimulus in the UK economy, estimated at around £200bn over two years.

Perhaps worse still, even on their own terms the benefits of announced tax cuts are limited. The evidence that the VAT changes passed through into genuine price cuts is underwhelming. Prices in UK hospitality were affected far more by the far cheaper (from the government’s perspective) ​‘Eat Out to Help Out’ initiative in August. 

For the Job Retention Bonus, the risks of such ​‘deadweight loss‘ are even higher. In fact, it risks the worst of all worlds. Both the head of HM Revenue and Customs, and large employers themselves, have expressed concerns that billions of pounds in bonus payments are likely to be wasted on firms that would have retained jobs anyway, while at the same time not representing enough of a financial incentive to employers who will otherwise be making furloughed workers redundant.

As a rule, it’s hard to deliver tax cuts where they are most needed: for the families with the lowest incomes, who will spend rather than save an increase in disposable income, thus boosting the recovery. The priority from government should be to support people directly: to protect incomes, create new jobs and provide funded support to reskill. This doesn’t mean tax cuts should be ignored altogether, however, but they do need to be far better targeted.

Strengthening social security through tax cuts

To better target tax cuts, the agenda for tax reform should converge with that of strengthening social security. This is because the very highest marginal tax rates are experienced by those on in-work benefits. Even before earning the equivalent of £9,500 per year required to start paying national insurance contributions, many employees on Universal Credit (UC) keep just 37p in every additional £1 they earn; withdrawn benefits create an ​‘effective marginal tax rate’ of 63%, even before local support like council tax benefit is taken into account. This rises to at least 75% after National Insurance Contributions and income tax kick in, and compares to effective marginal tax rates of just 32% for those on middle incomes – or a marginal rate of just 47% for incomes above £150,000 per year.

Addressing these eye watering tax rates experienced precisely where increased hours, earnings and spending is needed most, should be an uncontroversial goal that both left and right can get behind. Fortunately, there are already quick and straightforward ways of achieving this, that could be pursued alongside a deeper reform of UC and the establishment of a new minimum income guarantee.

The ​‘taper’ in UC sets the rate at which benefits get withdrawn for every additional £1 in earnings from work, and the so-called ​‘work allowances’ give a threshold for earned income, above which the taper is applied. Simple changes to these rates and thresholds – either making them more generous or extending entitlement to a wider group of people on in-work benefits – could dramatically lower the effective tax rates for the poorest people in work, while at the same lifting working families out of poverty (see new NEF scorecard modelling below, Table 1).

Table 1: Scorecard of changes to the elements of UC that directly interact with financial work incentives, current prices, 2021/​22.

Further modelling on UC and financial work incentive

Financial work incentives are complex, varied and contingent on family circumstances just as much as the characteristics of an individual (for example whether someone is a first or second earner, and whether there are dependent children in the household). The evidence suggests that they tend to be strongest for those with lower qualifications, single parents and second earners in couples.

When thinking about financial work incentives, it’s also important to differentiate between ​‘participation tax rates’ (PTRs – the total subtraction in tax and withdrawn benefits as a proportion of gross pay, after moving into work), and the ​‘effective marginal tax rate’ (EMTR – the total amount of tax and withdrawn benefits for a given increase in gross pay). In effect, this is the difference between the financial incentives to move from unemployment into work in the first place, as distinct from the incentive to increase hours or rates of pay further once someone is already in work.

Upcoming work at NEF will consider these dynamics with respect to the current labour market as part of our work to propose a permanent replacement to UC, which not only addresses poverty, but also acts as a springboard into employment as well. For the purposes of this blog, however, we set out an illustrative package of reform to UC centred on reducing effective tax rates for the lowest paid workers (Table 2).

The overall cost of this illustrative package is set at around £9bn, similar to the total possible spend allocated to the otherwise highly wasteful Job Retention Bonus (see above). In effect, it shows the difference to people’s living standards and work incentives that could be achieved if the money for the Job Retention Bonus were invested in a first year of reform to UC instead – but in practice this investment could and should be made in addition the JRB, given the extent of missing stimulus in the UK economy right now.

Overall, this illustrative package would also see disposable income rise by £1,100 per year (or 14%) on average among working families in the poorest fifth of all households, and £1,200 per year (or 5%) for those among the next poorest 20% (Figure 1 below). In doing so, the package would also reduce the number of people in poverty by approximately 500,000 (Table 2). In Appendix 1, we also set out further possible changes in UC for comparison (see Table A1). Beyond financial work incentives, these measures focus on key reforms crucial for reducing poverty further, and will be important for wider work to establish a new minimum income guarantee.

Table 2: Illustrative package for improved work incentives, current prices, 2021/​22.

Figure 1: Even before behavioural effects, reducing effective tax rates in UC through the illustrative package above would raise living standards for the lowest income families in work.

Our main illustrative package also significantly boosts financial work incentives. For example, a 35 year old single parent with one child (and not receiving support for housing costs) currently has a Participation Tax Rate (PTR) of 20% when moving from unemployment into a part-time job (20 hours per week) at minimum wage, but this would fall to 13% under our illustrative package (Figure 2). If the same person moved into full-time work from unemployment (35 hours per week) their PTR would fall from 37% to 31%. The package also reduces the Effective Marginal Tax Rate (EMTR) for an additional hours’ work. For example, under the current system, our illustrative single parent working 20 hours per week would face an EMTR of 67p for an extra £1 in earnings. But under our illustrative package this falls to 56p for an extra £1 in earnings (Figure 3).

Figure 2: NEF’s illustrative package would allow those on in-work benefits to keep far more of what they earn from work.

Figure 3

The government should be commended for supporting millions of jobs through its furlough scheme since April. But with the Job Support Scheme set to do little to avert a tsunami of redundancies by Christmas, the UK is currently facing a severe and avoidable jobs crisis. It is time government recognised the role a reformed social security system could play in the months and years to come, not just by protecting incomes and guarding against poverty, but also by providing a system that ensures the lowest income families keep more of what they earn from work as well.

Appendix 1

This analysis includes further scorecard changes to the headline payments received by adults and children, as well as an additional package (also costed at around £9 billion) with a more balanced approach to prioritising reduced poverty and higher living standards, alongside improving financial work incentives as well. All reforms and packages modelled in this blog are for illustrative purposes only, with work forthcoming on NEF’s detailed proposals on how to replace UC with a more effective system

Table A1: Scorecard of changes to key elements of Universal Credit not directly related to financial work incentives, including an additional package of measures, current prices, 2021/​22

Photo by John Cameron on Unsplash