Universal Credit and the big labour market questions the UK needs to consider

October 22, 2017

The current debate  surrounding  the introduction of Universal Credit is an opportunity to think about the big questions in UK labour market policy and the support given to households of working age through the tax and benefit system. The context in which these questions should be considered is the huge success of the UK labour market. From being one of the least flexible labour markets, incapable of adjusting to changing circumstances and challenging economic shocks, Britain now recognised as one of the most flexible labour markets among advanced economies.

Active Labour Market Policies

In many respects Universal Credit remains the right direction of travel. It offers the simplification of a series of complex means tested benefits. It forms part of an agenda that is intended to improve further the active labour market measures that have been a distinct dimension of UK labour market reform since Lord Young introduced Restart in 1986. 

Policy Exchange has always taken an interest in labour market and welfare reform, as well as recognising the need to simplify the system and improve the help that people have in getting work. Paul Garaud and Mathew Oakley  in Slow Progress, for example, looked at active labour market measures that would not simply get people into work but would help them progress in work to raise their earnings in return for the means tested benefits that people in work receive through the tax credit system.

Market economies work better with an effective benefits system 

Advanced market economies need frameworks of tax funded transfer payments to help people tackling challenges like the loss of a job, disability or low earnings in relation to the needs of their household. Far from being incompatible with a dynamic market economy, when the structure of benefits is well calibrated it can contribute to the economy performing better.

Over the last twenty years there has been a huge expansion of targeted or means tested benefits that are withdrawn as income increases. This is essentially the tax credit system put in place by Gordon Brown in 1998. Spending on transfer payments (leaving aside housing benefit) to households with low incomes that are in work has increased from £7 billion in today’s money under the old Family Credit regime in place before 1998 to something closer £30 billion.

Tax Credits, Complex Tapers and Incentives

As a result of this expansion of transfer payments, many more households face high net rates of withdrawal that operate effectively like marginal income tax rates. When establishing social security benefits or tax credits to help households in poverty, policy makers are constrained by a series of awkward trade offs. They boil down to a choice between a large number of people having a generous benefit that is slowly withdrawn or tapered away, but at what is still a high rate of over 50 or 60 per cent, or a much smaller number of people over a narrower portion of the earning distribution experiencing a very high taper of over 90 or even 100 per cent. 

These high tapers damage work incentives. There is little point in doing overtime or getting promotion if the lion’s share of the incremental income is lost by what amounts to a high marginal tax rate. At low multiples of average income, the lost output resulting from the impact of these benefits is much less important than the central objective of helping a household on a low income in difficult circumstances. The further these high tapers travel up the earnings distribution the greater their economic damage.

Productivity in the context of a Manhattan Skyline of High Effective Marginal Tax rates

Part of the slowing of UK productivity over the last twenty years is probably explained by the expansion of the tax credit regime and its complex tapers. They damage productivity at bottom end of income distribution, but the decision to means test Child Benefit between £50,000 and £60,000 imposes a 60 per cent taper on participants in the labour market who are highly productive. Moreover in a modern economy many people in that position are able to modify the number of hours and days a week that they work to avoid being drawn into what in effect, was the top marginal income tax rate, before Nigel Lawson cut it from 60 per cent to 40 per cent in the 1988 Budget.

The UK now has a set of effective marginal income tax rates that are analogous to the US Federal Income Tax code’s Manhattan Skyline of marginal tax rates. The key feature of this dramatic skyline is that a marginal tax rate has little to do with where a person or household is in the earnings distribution and more to do with rules about where and how means tested benefits phase in and out of the system.

Lessons from the German Hertz Reforms about the importance of lowering the replacement ratio

Universal Credit has involved a very big upheaval in the framework and administration of benefits. It has many merits similar to the so called Hartz reforms made to the German labour market in the early 2000s. One central test of a structural reform of benefits is what impact it has on the replacement ratio of benefits to earning. In effect, how do benefits stack up in their generosity compared to what a claimant could realistically get in a job?  It is not clear that Universal Credit will make much difference to this important dimension of labour market policy, unlike the German reforms that significantly lowered the replacement ratio. The issue of what the appropriate replacement ratio should be is a matter that UK policy makers will have to return to.

The principal questions that go beyond the structure of Universal Credit

There are features of Universal Credit that are reasonable to examine and to consider changing. These include whether payments should be weekly or monthly, the time lag before payments are made and whether the housing component could be paid to the recipient’s landlord. Yet any serious consideration of the benefits regime swiftly leads on to wider and much bigger questions.

Transfer payments and the impact of the public sector on the working of regional economies

These turn principally on the way that the public sector interacts with regional labour markets. To promote regional economies that are economically competitive, reforming public sector pay to ensure that it takes account of local labour market conditions is an obvious direction of travel that Gordon Brown briefly explored as Chancellor. As part of that, transfer payments made to people of working age should take account of local labour market circumstances. 

There should also be a debate about the role of local authorities within their own local jobs markets. We have had years of estate regeneration where local authorities are normally central to that process. Yet in the questions that are central to local employment and business opportunities councils are broadly irrelevant. Councils control none of the main policy instruments that systematically influence local employment. The time has probably come to look afresh at these big questions, including the role that councils could play in shaping the levels of benefit and public sector pay in relation to local circumstances to improve the performance of the UK’s regional labour markets.

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