IFS

Social security reforms and incentives

Mike Brewer and Tom Clark

Institute for Fiscal Studies

May 22nd, 2002

IFSMotivation

• Reforms changed incomes and incentives• Ever-present trade off when designing tax-

and-transfer system• This talk

– Asks how we should analyse changing incentives– Describes (not judges) the impact of Labour’s

changes– Work in progress –comments welcome!

IFSWhat sort of incentives?

• Incentives...– ...to work– ...to work more or earn more– ...to save– ...to claim benefits/tax credits (?)– ...to cohabit and marry (??)– ...to have children (???)

IFSEvaluating impact of incentives: a hierarchy

• “Optimal income tax” literature– “Are Labour’s reforms optimal?”

• Estimate response to incentives, predict changes due to reforms– Not saying whether “incentives” are good or bad

• Describe change in incentives– Not saying whether “incentives” are bad– Nor predicting their impact

IFSWork incentives

• Idea: trade off paid work against money• Summarising the impact of reforms

– Marginal effective tax rates– Replacement rates– Average tax rates

• Use tax and benefit model

IFSMarginal tax rates, workers

0 5,000,000 10,000,000 15,000,000

0%0-10%

10-20%20-30%30-40%40-50%50-60%60-70%70-80%80-90%

90-100%100%+

Before

After

IFSChange in marginal tax rates, workers

0 20 40 60 80

40%+ fall30-40% fall20-30% fall10-20% fall

0-10% fallNo change0-10% rise

10-20% rise20-30% rise30-40% rise

40%+rise

% of workers by family type

Children

Nochildren

IFSHow do marginal tax rates vary with earnings?

• Split earnings distribution into equal-sized cells– Calculate average marginal tax rate in each cell– Assume away extremes– X-axis not linear!

IFSMarginal tax rates and earnings, all workers

05

10152025303540455055

0 20 40 60 80 100

% of earnings distribution

Mar

gin

al t

ax r

ate,

%

Median, 97 Median, 03

Mean, 97 Mean, 03

IFSMarginal tax rates and hourly wage, all workers

05

10152025303540455055

0 20 40 60 80 100

% of wage distribution

Mar

gin

al t

ax r

ate,

%

Median, 97 Median, 03

Mean, 97 Mean, 03

IFSMarginal tax rates, earnings and children

05

10152025303540455055

0 20 40 60 80 100

% of earnings distribution, people without children

Mar

gin

al t

ax r

ate,

%

No kids, 97 No kids, 03

IFSMarginal tax rates, earnings and children

05

10152025303540455055

0 20 40 60 80 100

% of earnings distribution, people with children

Mar

gin

al t

ax r

ate,

%

Kids, 97 Kids, 03

IFSThe new tax credits and incentives

• New tax credits will change how families with children are means-tested

• For many families, awards based on past year’s income

• Income increases of under £2,500 will be ignored in the short-run

IFSIncentive to work at all

• Replacement rate– RR = [Income out-of-work / income in work]– Include partner’s income

• Average tax rate– What proportion of gross earnings is lost in tax and foregone

benefits and tax credits?

• Results– Almost no change for those without children!– Improves for lone parents– Worsens for couples with children

IFSMarginal tax rates, over 65s

0 1,000,000 2,000,000 3,000,000 4,000,000

0%0-10%

10-20%20-30%30-40%40-50%50-60%60-70%70-80%80-90%

90-100%100%+

Before

After

IFSChange in marginal tax rates, over 65

0 5 10 15 20 25

40%+ fall30-40% fall20-30% fall10-20% fall

0-10% fallNo change0-10% rise

10-20% rise20-30% rise30-40% rise

40%+rise

% of workers by family type

IFSOther incentives

• To partner– Not possible to have progressive tax, joint

assessment and neutrality to presence of partner– Difficult to quantify impact of reforms– Change compliance or behaviour?

• To have children– Considerably increased financial support for

children

IFSSupport for children, lone parent, 1 child

£0

£20

£40

£60

£80

£100

£120

0 20 40 60 80 100% of (gross) income distribution for lone parents with 1

child

Ch

ild s

up

po

rt, £

/wk

(med

ian

)

Before After

IFSSupport for children, couples, 2 children

£0£10£20£30£40£50£60£70£80£90

£100

0 20 40 60 80 100% of (gross) income distribution for couples with 2

children

Ch

ild s

up

po

rt, £

/wk

(med

ian

)

Before

After

IFSConclusions – so far!

• Work incentives– Little changed for those without children– For those with children, depends on whether

partner present and/or working– Remember “work” also means “increase earnings”

• Incentives to save for retirement complex• Incentives to partner, have children, claim

benefits altered, but hard to quantify

IFS

End

IFSWork incentives, families with children

RR, 40 hours

RR, 40 hours, after reform

ATR, 40 hours

ATR, 40 hours, after reform

Lone parent 68% 64% 61% 52%

Couple, working

55% 59% 31% 38%