How would you like £3,166 a year of free money from the government? Sounds too good to be true? Well if you’re in a reasonably paid job that’s exactly what you’ll be getting when the new financial year starts in April. This sum is the cash value of two huge tax breaks, the income tax personal allowance, which will exempt £11,000 of taxable earnings, and its equivalent in the national insurance system.
Now, not everyone likes to think about tax reliefs as handouts from the state. On the face of it, there’s a big difference between money you’ve earned, which the government chooses not to tax, and money that’s already come from someone’s taxes, which the government chooses to give to you.
HM Revenue and Customs doesn’t necessarily see it that way, however. Each year it publishes estimates of tax reliefs and expenditures, reporting the cost of the foregone revenue as if it were public spending. And from the perspective of your family’s disposable income, it makes no difference whether you receive an extra pound through a higher tax allowance or a cash payment.
So, welcome to the world of ‘shadow welfare’, where each year the nation spends (or doesn’t raise) hundreds of billions of pounds in tax reliefs, mostly in pursuit of policy goals we normally associate with social security. Fabian Society research due out later in the year will show that, in all, the tax breaks households receive add up to more than £200bn annually, roughly the same amount we spend on welfare. That £3,166 starting allowance alone costs around £100bn.
These findings suggests that politicians should start analysing ‘spending’ on shadow welfare, just as robustly as on real welfare. Not only is each just as real when it comes to closing the deficit, but the way ministers choose between tax reliefs and social security has consequences. That’s because when we increase tax breaks only people paying sufficient tax can benefit, while benefit spending can help us all.
Take the example of those basic income tax and national insurance allowances. Each time they rise in value it is only people earning above the previous allowance who gain. Yet, George Osborne has said he will increase their cash value by over 80 per cent between 2010 and 2020, from £1,921 to more than £3,500 a year. Over the same period the value of the basic out-of-work benefit for an adult will rise just 12 per cent. The result, other things being equal, is that mid and high incomes will grow faster than low incomes, and income inequality and poverty will rise.
Even this difference in percentage growth only tells half the story. It’s the cash values of the entitlements that really raises questions. By the time of the next election the safetynet payment for a single adult without work will be £3,800 per year (excluding support for rent and council tax). That’s not even £300 more than the value of the tax allowances which most workers will receive by then, even though the former is intended to meet all subsistence costs.
For couples the picture is even more striking as we’ve already reached the point of cross-over. If you and your partner both work, in 2016/17 your basic allowances will amount to £6,331 of ‘shadow welfare’ spending. But if you are both out of work, your safety-net entitlement will be £5,972 (because couples receive less in benefits than two single people). As figure 1 shows, 2015/16 was the year when partners started to receive more if both were working than if both were not. That this has been allowed to happen says a lot about the political priorities of David Cameron, George Osborne and Iain Duncan Smith over the last six years. That it has happened with no one even noticing, is a reflection on our whole political debate.
The story gets a little more complicated if you consider social security and ‘shadow welfare’ beyond the basic allowances. Most people who are out of work and receiving benefits get more than the safety-net payment of £73 per week: they receive money to take account of children, disability, rent and council tax. But many workers also receive more than the basic tax breaks, not least through pension tax relief, where the more you earn, the more you get. And that’s just thinking about direct taxes. Middle and high income households also consume more, so they gain more from VAT exemptions, even though we think of these reliefs (for basics such as food, children’s clothes and energy) as being there to help low spending families.
Figure 2 presents new Fabian analysis which brings together all the major sources of social security and shadow welfare for non-retired households.1 Astonishingly, these calculations reveal that the UK already has a near flat system of public income support for households, once tax reliefs are taken into account. In 2013/14, on average, the poorest fifth of households received £10,200 in cash support and the richest fifth £9,400. The latter number is likely to be an under-estimate (in the calculations we ignored the higher marginal rates paid on higher earnings). It will also climb over the rest of the decade as tax breaks rise so, with safetynet benefits frozen, we could end up giving more to the top quintile than the bottom. Meanwhile, the particularly high spending on the second quintile will decline because this group mainly comprises low paid working households; for them universal credit will be much less generous than the previous tax credit system (the higher personal allowance is insufficient to bridge the gap).
These findings suggest that, by 2020, we will have something approaching a flat-rate system of cash support, at least when you look at the averages for large groups. No matter how much households earn (or don’t), on average, they will receive the same income top-up from the government.
So how should the left react? Perhaps our instinctive response should be one of moral indignation. At a time of huge financial pressure, a Conservative government has covertly targeted resources towards mid and high income groups, at the expense of those with greatest need. That would suggest that the first task for any Labour government should be to unwind this new flat-rate world: money should be diverted to boost the incomes of families without work or with low earnings, so people have the support they need to lead an acceptable life.
But pause a moment and you can see that the 2020 regime could also bring opportunities. If social security and shadow welfare could be presented as a combined entity, which provides different households with broadly similar levels of support, then it might be possible to initiate a shift in public attitudes to welfare. And since public attitudes are a key determinant of the long-term generosity of any welfare state, reducing resentment regarding spending might eventually do more to boost low incomes than an immediate uplift in the safety-net.
The aim would be to persuade the public that people without work, or with very low earnings, are not making a special claim on society, but are receiving support on similar terms to everyone else. In other words, that ‘we are all in this together’. A future Labour government could seek to ingrain this idea, using the pulpit of ministerial office and some cosmetic changes to tax and benefits. If universal credit has been successfully introduced by 2020, there will already be a single system of payments uniting people with work and without. Building on this, the main tax allowances could then be badged as ‘universal credit’ too, or as a complementary ‘universal tax credit’. Even if more than one system continued in operational terms, all the elements of support could be listed together, as cash entitlements, in a single annual statement.
There are other more radical possibilities too. The spending parity could create the conditions for a genuine integration of taxes and benefits. This is an intriguing thought in the context of the growing debate about whether Britain and other advanced economics should introduce a basic income (also called a citizen’s income). The idea is that every individual should receive a single flat-rate payment from the government, in place of tax allowances and means-tested benefits. The payment would then be gradually offset by taxation, using a single marginal rate of withdrawal.
For purists, these schemes entail actually handing over cash to every citizen, but the same financial effect can be achieved through the pay packet by redesigning the tax code. Money is then paid out only when people’s entitlements are greater than their total income tax and NI liabilities (this approach is usually referred to as ‘negative income tax’ and is popular on the libertarian right).
A basic income becomes a more practical proposition if it is conceived, not as vast new spending, but a process of integrating and rationalising existing entitlements of broadly similar generosity. For people of working-age, the task would essentially be to combine the basic tax allowances, universal credit and child benefit in a way that was broadly revenue neutral. There would be formidable obstacles, and inevitably many ‘losers’ as well as ‘winners’. For example, the RSA recently proposed a scheme which would entail tax rises for people earning over £75,000 and also a cut in the safety-net payment for children of school age (it justified this on the basis that, without means-testing, their parents would no longer face financial barriers to work).
For and against basic income
Introducing a basic income would bring political pain and the usual risks of any huge administrative reform, so years of debate are needed to determine whether the benefits really outweigh the costs. In particular, those of us on the left would need to ask whether the effort was all worthwhile, if the end result is a system where the overall income distribution and the incidence of poverty remain broadly unchanged. After all, people in the deepest poverty – those out of work for long periods of time – would be no better off after the changes.
The proponents of basic income counter that the reform would have powerful behavioural effects, by greatly improving and simplifying the incentives to enter work and earn more. But a basic income could also lead some people to reduce the hours they work, perhaps to care for children, and it might lead to more long-term unemployment, if work-search conditions were removed from recipients without a job. Ultimately these dynamic effects on employment, earnings and therefore poverty are empirical questions, which can only be determined by experimentation.
With these drawbacks in mind, some commentators have suggested that the basic income concept should be treated as the platonic ideal for a tax-benefit system, not a real-life plan of reform. They say it should be used as a thought experiment to generate principles, which should then inform gradual improvements to our messy, path-bound reality.
For now, I think the left should try and ride two horses. It should engage seriously with the idea that a basic income might be the eventual end-point after a whole series of changes. That is essentially the history of state pension reform over recent decades, with the pension morphing gradually into a flat-rate, near-universal payment. But in the meantime it should focus on practical, incremental policy changes which embody something of the spirit of the basic income idea, but make sense as reforms in themselves.
The Solidarity Society
When it comes to the future of the tax-free allowances, a good place to start is The Solidarity Society, a major Fabian report published in 2009. It proposed that tax allowances should gradually be transformed into a something akin to a small basic income, which the authors called a ‘universal tax credit’. They had at least two steps of reform in mind.
First, the allowances should be turned into credits, meaning they would be paid in full to all workers earning above some minimal amount. People working a modest number of hours would qualify for the £3,000-plus entitlement, which would instantly make the transition to low hours work pay much better. The credit would then be withdrawn through tax and NI (paid on all earnings, under this system) and higher paid workers would see no change in income. Of course, implementing this reform without leaving anyone worse off would cost money, but it would be in the same ballpark as the amount the government has spent on its personal allowance policy. It could also be introduced gradually by progressively lowering the earnings threshold that triggered eligibility.
The second, more radical step would be to extend the new tax credit to every adult below 65, in or out of work, to symbolically unify the tax and benefit systems. Public attitudes to welfare could be transformed if the new tax credit was badged as part of universal credit (in practice it could still be ‘paid’ through PAYE for those in work). This is not a conventional basic income, because it would be paid on top of means-tested universal credit. But, as a result, it would bring a huge boost in incomes for the very poorest households (as we saw earlier, tax breaks are worth almost as much as the basic universal credit payment for a single adult).
Lots of detailed work would be needed on this second phase of reform, as it would be very expensive to achieve without reducing the level of the tax credit and/or existing universal credit payments. But even if the basic adult rate of universal credit was cut in half, people out of work would still see their living standards leap, with poverty falling as a consequence. Alternatively, if the value of the existing tax credit was cut, higher income groups would see a modest fall in take-home pay and it would be necessary to compensate low and mid earners by tweaking the universal credit rules.
Pouring over the minutiae is for another day. However, as The Solidarity Society showed eight years ago, and this analysis of shadow welfare proves again, when you look at benefits and tax reliefs side by side there are plenty of promising routes forward. The left must start on a journey towards a simpler, fairer, less stigmatising system, which ultimately will change how people think and feel. It is time to reimagine a tax and welfare world where we all walk side by side.The analysis for this article was carried out as part of a research project ‘Social security in the 2020s’ kindly supported by Shelter.
1. The graph is derived from the ONS publication The Effects of Taxes and Benefits on Household Income 2013/14. We’ve estimated the additional value of the shadow welfare that each quintile receives by comparing the amount of income tax and national insurance that was actually paid with the amount that would have been, if all earnings and other similar income had been charged at the headline rate. We ignored the higher marginal rate paid on high earnings, so the calculation for the top quintile is a cautious underestimate. The calculation for shadow welfare spending also includes an estimate of the value of VAT exemptions for households in each quintile, drawing on previous IFS research prepared for the 2011 Mirrlees Review.