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Reforming the Tax and Benefit System to Reduce Unemployment

David Chapman 25 February 1998

ABSTRACT

Two reforms are proposed. In the first, referred to as the Work-Spreading Tax, the present tax system is modified so that it produces a labour subsidy, but without cost in terms of extra tax. This is done by simply making the employers responsible for paying each worker's income tax and employee's national insurance contributions, in just the same way as they now pay the employer's NI contributions. Thus the employers will in effect be receiving a subsidy per worker equal to the value of one person's allowances on income tax and national insurance, that is, a subsidy probably of about £35 per week This subsidy provides a strong incentive for employers to spread whatever work is available among a greater number of workers, that is, to employ the unemployed. Thus the reform will increase not only the total number of persons employed, but also the security of employment, for those workers who are already employed.

The other reform is a new type of Earned Income Tax Credit, referred to as the Work-Related Benefit scheme, which is designed to give a better deal to the lowest earners, but in such a way as to avoid creating more of an unemployment trap or a poverty trap. A person who earns a low amount per hour, is given a benefit per hour of work done, let us say up to 20 hours per week. The lower is the hourly wage, the greater is the amount of benefit given per hour. If the person does more than 20 hours of work, this benefit is withdrawn, but at a lower rate, the lower is the hourly wage. With a very low hourly wage, there is no withdrawal at all, and the person keeps the whole of any extra earnings which they make.

The Work-Related Benefit thus enables the low-paid to obtain both a guaranteed minimum income per hour of work, and a guaranteed minimum income per week. As compared with a standard Earned Income Tax Credit, the Work-Related Benefit allows a higher average withdrawal rate to be used, without trapping the poorest into their poverty. Because of this better targeting of benefit, and because of the saving due to its greater reduction in the number of unemployed, the Work-Related Benefit scheme is likely to be less expensive than a standard Earned Income Tax Credit, providing a greater guaranteed minimum income, for any given welfare budget.

The two reforms are independent of each other--either could be used alone, or they could be used together, for maximum impact on unemployment.

The Work-Spreading Tax

Many schemes have been put forward for the use of labour subsidies to reduce unemployment. One of the most far-reaching of these proposals is that of G. Beacon, D.R. Holden and J.K. Swales (The Employment effect of Subsidies, Report to the Directorate General Employment, Industrial Relations and Social Affairs, Commission of the European Communities, SOC 94 100018 05A01, November 1995). This puts the case for giving all employers a fixed subsidy per worker, to be financed by a 5% rise in VAT. The paper estimates that this measure would increase output by up to 2.8%, and employment by up to 4.0%, with expansion stimulated most in the low-paid low-skill sectors.

However, this proposal may not be acceptable in the present political climate, since it is clearly redistributive, benefiting the lower-paid at the expense of the higher-paid, as the authors themselves point out. I therefore put forward a similar scheme for reducing unemployment by means of a labour subsidy, which does not involve any redistribution. The basis of the scheme is to change the method of collecting all tax on the income of employees, in such a way as to use the degree of progressivity which already exists in the tax system, in order to provide a per-head labour subsidy, without cost in terms of extra tax.

The scheme is simply to convert the income tax and social security tax currently paid by employees, into an extra tranche of tax paid by the employer. Let us refer to this tax paid by the employer as the Work-Spreading Tax, or WST for short. Thus just as the employers are now responsible for paying the employer's NICs (national insurance contributions) on behalf of each worker, so under WST they will also be responsible for paying each worker's basic income tax and employee NICs.

There are some further aspects of the WST scheme which need explanation, as follows. The value of any special allowances to which the worker might be entitled, such as ones for mortgage interest, for pension premiums, or for being married, will be paid directly to the worker by the Inland Revenue, in the form of a subsidy of appropriate size. The worker will pay tax directly to the Inland Revenue on any unearned income from investments. These NICs paid by the employer under WST, will give the worker the same entitlements to pension and other benefits, as the employee NICs paid by the worker do under the present system.

What then will be the effect of this WST scheme upon the level of wages? It can be expected that, in any particular trade, employers will pay a standard wage per hour, as determined by the labour market. This standard wage per hour will be less than the present wage, by the average amount of tax which the employers will then have to pay, per hour of work in that particular trade. WST will thus make little or no difference to workers who work an average number of hours per week--they will be paid a wage about the same as their previous wage after deductions for tax and national insurance.

However, the new scheme will be very different for the employers. They will in effect be receiving a subsidy per worker equal to the value of one person's allowances. These allowances, on income tax, employee's NICs, and employer's NICs, will probably be worth about £35 per week in total, for a person paying the standard rate of income tax. (This assumes that the recently proposed reform of employer's NICs is in fact carried out). Employers will thus have an incentive to spread the available work, so as to receive more of these subsidies, employing more workers each working fewer hours, to do a given amount of work.

For example, suppose that a firm, instead of employing 33 workers each working 38 hours per week, employs 38 workers each working 33 hours per week. The firm will thus reduce the tax it has to pay, and hence its labour cost, by 5 x 35 = £175 per week.

The expected effect of the WST scheme is thus as follows. Whilever there are unemployed workers available who can do the work, it will be in the interest of each employer to reduce the hours worked per week, and to increase the number of workers employed. It might not in general be possible for a firm simply to make an immediate reduction in the standard working week, since this would create too much opposition from the workers. But in various ways the average working week can be reduced, and extra workers can be taken on. Thus if workers leave or retire, or if production needs to be expanded, the firm will seek to give jobs to unemployed workers, rather than to give its existing work force more hours of work per week. It will probably prefer to take them on as part-timers, since this will enable it to employ more new workers, and save more tax. If a pay rise is being negotiated, the firm will probably seek to include some reduction of hours per week as part of the bargain, that is, it will seek to persuade workers to take part or all of their rise as an increase in leisure, rather than as an increase in total pay. This will allow it to save tax, by taking on more workers from the unemployed.

Evaluation of the Work-Spreading Tax

What then are the advantages and disadvantages of WST, as compared with the present system?

(1) WST can be expected greatly to reduce the number of unemployed persons, by spreading the available work between more workers.

(2) Hence WST will reduce the total amount of expenditure on benefit for the unemployed.

(3) WST is likely to increase security of employment, for those workers who are already employed. Firms which at present respond to the opportunities of new technology by dismissing part of their workforce, will be more likely under WST to retain their workers, but reduce the hours of work offered to them.

(4) WST redistributes work from the fully-employed to the unemployed. Though this gives a fairer distribution of work, it might well be regarded as a disadvantage by many of the fully-employed whose income is thus reduced. On the other hand, many of them might feel amply compensated by the greater security of employment which WST can be expected to provide.

(5) WST might bring about some reduction in efficiency, due to such factors as: difficulties inherent in employing more workers to do the same amount of work; higher overheads; the possibility that the extra workers taken on will be less skilled. If this reduction in efficiency in fact occurs, then in order to maintain production, employers are likely to offer a greater total of hours of work, but at a lower wage rate per hour, which will at least increase employment. However, a countervailing factor, tending to increase efficiency, is that workers who are working fewer hours per week, being less tired or bored, might produce more per hour, and perhaps this factor will prove to be of greater importance.

(6) There might be some savings in administrative costs to the state, to the employers, or to the workers themselves, in that it is likely to be easier to collect one tax (that is, WST), instead of the two abolished taxes (income tax and NICs) which it replaces.

(7) It is reported that an increasing number of people would prefer a simpler life, in which they work fewer hours, earn less, consume less, and have more leisure. This might be difficult for them to achieve under the present system, but under WST, the employers will be eager to accommodate them.

(8) WST achieves this spreading of work by positive incentives to the employers, not by restrictive regulation, such as a ban on overtime, or a statutory reduction of the working week. Hence it is less likely to reduce efficiency.

(9) This incentive to the employers is not a new subsidy, which would be vastly expensive, but instead it is an essentially costless adjustment to the method of collecting tax on employees' income. Progressive taxation is already being used, which levies no tax or low tax on the first portion of an employee's income. WST simply makes use of this existing feature of present taxation, to provide an incentive for the employer to spread work.

(10) With WST, it is not necessary to make the tax system any more redistributive than it is now, as a very significant work-spreading effect would be achieved with a WST based on the existing levels of taxation.

(11) WST is not a radical change from the present system. It simply makes the employers responsible for paying the employees' tax. Hence it can be expected that WST can be introduced easily and without cost or disruption, to achieve this spreading of work.

The Work-Related Benefit Scheme

The Work-Related Benefit scheme (WRB for short) is a new form of Earned Income Tax Credit, designed to give a better deal to the lowest earners, but in such a way as to avoid creating more of an unemployment trap or a poverty trap. Because of its better targeting of benefit, and because of the saving due to its greater reduction in the number of unemployed, the WRB scheme is likely to be less expensive than a standard EITC, providing any given minimum guaranteed income for a smaller total expenditure, or a greater minimum income for any given expenditure.

The standard EITC provides benefit conditional upon earning, up to some level of earnings (for example, it might give £1 of benefit for every £1 earned, up to £40 per week of earnings). After this point, the benefit is withdrawn as earnings increase (for example, 60p might be withdrawn for each extra £1 earned), until at some level all benefit has been withdrawn. The benefit is paid by the employer, along with the worker's wages, just as the employer deducts PAYE tax from the worker's wages at present.

With WRB, the benefit is similarly paid by the employer. But the difference is that a person who earns a low amount per hour, is given a benefit per hour of work done, up to some fixed number of hours per week (let us say 20 hours). The lower is the hourly wage, the higher is the benefit (so that it partially compensates for the low wage, but not so much as to remove the incentive to get a higher wage). The benefit is such that, if the person does 20 hours of work, they get, in total wage and benefit, an amount equal to the "basic benefit" (the minimum guaranteed weekly income) plus some fixed percentage of earnings (let us say 30 per cent). If they do more than 20 hours of work, this benefit is withdrawn, as it is with the standard EITC above the fixed level of earnings. However, the difference with WRB is that the lower is the hourly wage, the lower is the withdrawal rate. Thus with a very low hourly wage, there is no withdrawal at all, and if the person does more than 20 hours of work, they keep their benefit from the first 20 hours, and the whole of any extra earnings which they make, above 20 hours. The WRB thus enables the low-paid to obtain a guaranteed minimum income per hour of work, and a guaranteed minimum income per week, but without creating a poverty trap.

Further details of the WRB scheme are given in the appendix.

The WRB scheme might either be used in conjunction with the Work-Spreading Tax, or it might be used alone. If WRB is used alone, without WST, income tax and national insurance contributions will still be charged, as they are now. The problem thus arises, of how the benefit and tax systems are to be combined, without producing a low or negative return for extra work, that is, a poverty trap. WRB overcomes this problem, by giving a person whichever is greater, either full benefit plus wage less that percentage of the wage specified as their withdrawal percentage, or wage less appropriate tax and national insurance. ("Full benefit" is defined as that amount which would be paid if the person did 20 hours of work at zero wage, such as voluntary work for a charity.) Thus with WRB, the return for doing extra work will never be less than the hourly wage, less the appropriate withdrawal percentage.

Another important question is that of who should receive any child benefit p aid in excess of the "universal" child benefit that all parents get, or who should receive any benefit paid in respect of a non-working partner. In this situation, the WRB scheme provides that the excess child benefit is paid directly by the state to the caring partner, and that similarly the non-working partner is paid the appropriate benefit directly by the state. The amount of these direct payments to the non-earning partner are then added to the tax bill of the earning partner. Thus the earning partner will have to pay them back to the state only if he or she can afford it, that is, has earnings which are high enough to pay tax rather than to receive benefit.

What then are the advantages of the Work-Related Benefit scheme over a standard EITC? With a standard EITC, a person with a low hourly wage is likely not to be able to earn enough to get full benefit. In the attempt to overcome this problem, it is usually proposed that along with the EITC there should also be a legally fixed minimum wage per hour. But in fact the minimum wage is likely to reduce the number of jobs on offer, so that low-skilled persons might well not get a chance of earning at all.

However, with WRB, there is no earnings requirement, and it can be expected that a person will always be able to find the 20 hours of work needed to obtain full benefit, even if it is voluntary work for a recognised charity, or temporary work provided by the state, until the person can find a better job. Thus with WRB, a legally fixed minimum hourly wage will not be needed, since the scheme already guarantees a minimum hourly income (of wage plus benefit), and indeed the minimum wage would in any case be counter-productive, since it would prevent people from pricing themselves into the jobs which they are willing to do.

Evaluation of the Proposed Tax and Benefit Reform

The proposed reform is a double one--the Work-Spreading Tax (WST), and the Work-Related Benefit scheme (WRB). What then is likely to be the combined effect of these two measures?

(1) WST will spread the available work between more workers, thus greatly reducing the number of persons who are unemployed.

(2) WRB will remove the unemployment trap, giving persons of working age a strong incentive to take up work, even if the only jobs available are very low-paid.

(3) This removal of the unemployment trap will encourage employers to create more jobs, jobs which will have become profitable at the lower wages which unemployed people will then be willing to accept. Thus the combined scheme of WRB and WST can be expected to bring about considerable expansion of employment, increasing both the total number of hours of work being done, and the number of persons in work.

(4) This expansion of employment can be expected to exert a stabilising influence on overall demand, reducing the fluctuations of the trade cycle, and stabilising the economy as a whole.

(5) Thus the new scheme will tend to increase security of employment. Firms which need to reduce the total hours worked, will tend to reduce the hours worked per week, instead of reducing the number of persons in the work force.

(6) The combined WST-WRB scheme will support and complement the present government's welfare-to-work proposals. Under the new scheme, unemployed people who do not have qualifications and experience, will be able to take jobs at low pay, in order to acquire a higher level of skill, while nevertheless getting a total income of wage and benefit which is enough to live on. Employers will have a greater incentive to provide such jobs, since under WST they will pay little or no tax on them; and similarly the unemployed will have a strong incentive to take them, in order to qualify for the Work-Related Benefit. Thus the new scheme will promote what is in effect on-the-job training, with the added advantage that it can be unofficial, not requiring the government to organise it, or pay for it.

(7) It can also be argued that the combined scheme of WST and WRB is superior in its effects to the often-proposed Citizens' Income or Basic Income scheme, in that it is likely to give a greater reduction in unemployment, in that it is likely to provide a higher minimum income for any given total expenditure, and in that it provides stronger work incentives, not only for the lowest earners, but also for the bulk of middle earners, those who are at present paying tax.

(8) The combined scheme of Work-Spreading Tax and Work-Related Benefit is not a radical change from the present system. It saves money by reducing unemployment and by better targeting of benefit, and thus it is unlikely to require the tax system to be any more redistributive than it is now. Hence this new scheme of tax and benefit reform, is put forward as an effective and politically acceptable method of relieving poverty and increasing employment.

Appendix: Further Details Of The Work-Related Benefit Scheme

The WRB scheme is intended to apply only to persons of working age, who do not have significant caring responsibilities, and are not sick or disabled. Those to whom the WRB scheme does not apply, should receive a benefit which is not conditional on working, and which is withdrawn if earnings are made, perhaps at a lower percentage rate than would apply under WRB.

Under WRB or not, these earnings on the basis of which benefit is withdrawn, should be net earnings, that is, earnings less allowable expenses incurred as a result of working, these allowable expenses including travel to work, working clothes, child care, and so on.

Under WRB, since a person's benefit is made conditional upon working, the scheme must provide that everyone is able to find work of some kind, so that it is possible for them to obtain their full benefit. Thus there must be made available to anyone who wants it, a sufficient number of hours of work for some public employer (perhaps at a very low or even zero hourly rate), to enable them to obtain their full benefit. It is expected that few people will apply for this publicly-provided work, since it is likely that most people will be able to find normal employment which pays better. (This will especially be the case if also the Work-Spreading Tax is in force, which gives each employer the incentive to employ a larger number of people to do a given amount of work, and so will provide a larger number of jobs.) Alternatively, people might prefer to do voluntary work for some recognised charity, working sufficient hours to obtain their full benefit. However, if in any area at some time not enough of this publicly-provided work can be provided, then the work requirement could temporarily be lifted for certain categories of people, or for the newly-unemployed in the first so many weeks of unemployment, so that those persons who could not find work could be given full benefit.

Further, the WRB scheme should regard persons on recognised full-time courses of study or job training, as fulfilling the work requirement, entitling them to obtain full benefit.

What then are the detailed rules of the WRB scheme, by which benefit is given conditional on work or earnings?

For convenience in exposition, let us assume (1) that the standard amount of work which the scheme requires a low-paid person to do to qualify for full benefit, is 20 hours per week, and (2) that the scheme's standard withdrawal rate, used for all except the lowest earners, is 70 per cent. These two values, of 20 hours and 70 per cent, are not put forward as necessarily the best ones, but they are plausible figures, the adoption of which makes it easier to explain the principles of the system. However, it may well be that a somewhat different number of hours, or a somewhat different withdrawal rate, would produce better results in practice.

It is also assumed in this exposition, that WRB is used in conjunction with the Work-Spreading Tax. Thus those who are earning enough not to receive benefit, will receive all their earnings, and will not be liable to income tax and national insurance contributions.

As was explained above, each person is assigned a "basic benefit", consisting of a certain sum per week, enough for them to live on, which is fixed according to such factors as their age, housing costs, etc. The amount of this benefit which a person actually receives, then depends on the magnitude of their hourly wage, measured as a percentage of their basic benefit. There are two critical magnitudes of the hourly wage, as follows:

(1) an hourly wage equal to 5% of the person's basic benefit per week, that is, one such that they could earn an amount equal to their basic benefit in the standard 20 hours;

(2) an hourly wage equal to 1.5% (that is, 30% of 5%) of the person's basic benefit per week--30% being the residue after withdrawal, that is, 100% minus the standard withdrawal rate of 70%.

Benefit recipients are thus divided into three categories as follows, according to their hourly wage, measured as a percentage of their basic benefit.

(1) Persons whose hourly wage is more than 5% of their basic benefit per week. These receive benefit essentially in the same way as in a standard EITC, that is, up to some level of earnings, they get benefit in proportion to these earnings, and for any further earnings the benefit is withdrawn at the standard rate.

(2) Those whose hourly wage is less than 5% but more than 1.5% of their basic benefit. These get benefit according to the number of hours worked, up to 20 hours per week; and for any further hours of work, the benefit is withdrawn, but at a lower rate, the lower is the person's hourly wage.

(3) Those whose hourly wage is less than 1.5% of their basic benefit. These also get benefit according to the number of hours worked, up to 20 hours per week, but for any further hours of work, the withdrawal rate is zero, and the person keeps the whole of any extra earnings which they make.

This needs to be explained in more detail, as follows. Concerning a person in category (1), with hourly wage more than 5% of their basic benefit, if the amount they are earning is less than their basic benefit, they get their earnings, plus a benefit equal to 30% of earnings. If the amount they are earning is more than their basic benefit, they get whichever is greater, either their total earnings, or an amount equal to their basic benefit plus 30% of their earnings.

For example, if a person's basic benefit is £80, and their hourly wage is £5, they will gain 130% of £5 = £6.50 for each extra hour of work, up to the point where their earnings are £80. For further work they will gain 30% of £5 = £1.50 per extra hour, until they have earned £114.29, after which they will simply get their earnings without benefit, and so will gain £5 per extra hour, that is, their hourly wage.

Concerning a person in category (2), whose hourly wage is between 5% and 1.5% of their basic benefit, if they work exactly 20 hours per week, they will be paid an amount equal to their basic benefit plus 30% of their earnings. If they work fewer than 20 hours, they will get less than this, in exact proportion to their hours worked. If they work more than 20 hours, they will be paid whichever is greater, either their total earnings, or an amount equal to: their basic benefit, plus 30% of their earnings for the first 20 hours, plus 1.5 % of their basic benefit for each hour of work in excess of 20 hours.

For example, if a person's basic benefit is £80, and their hourly wage is £3, they will gain £80/20 + 30% of £3 = £4.90 for each extra hour of work, up to 20 hours. For any further work they will gain 1.5% of £80 = £1.20 per extra hour, until they have worked 41.11 hours, after which they will simply be paid their earnings, and so will gain £3 per extra hour, that is, their hourly wage.

Concerning a person in category (3), whose hourly wage is less than 1.5% of their basic benefit, if they work exactly 20 hours per week, they will get an amount equal to their basic benefit, plus 30% of their earnings. If they work fewer than 20 hours, they will get less than this, in exact proportion to their hours worked. If they work more than 20 hours, they will get an amount equal to: their basic benefit, plus 30% of their earnings from the first 20 hours, plus 100% of their earnings from their hours of work in excess of 20 hours.

For example, if a person's basic benefit is £80, and their hourly wage is £1, they will gain £80/20 + 30% of £1 = £4.30 for each extra hour of work, up to 20 hours. For any further work they will gain £1 per extra hour, that is, their hourly wage.

What then is the effect of this WRB scheme on low-paid people's work incentives, on the unemployment trap and the poverty trap?

(1) There is a strong incentive to do the first 20 hours of work per week, since benefit is paid in proportion to how many of these first 20 hours are worked. Thus up to the 20-hour point, the return for an extra hour of work is especially high, at least 130% of the hourly wage, and at least one-twentieth of the basic weekly benefit, so that there is no unemployment trap.

(2) For a person working more than 20 hours, the return for working an extra hour is at least 30% of the hourly wage, and is 100% of the hourly wage for the very low-paid.

(3) If a person changes to a job paying a higher hourly wage, their increase in total income from earnings and benefit will never be less than 30% of the resultant increase in earnings for the first 20 hours of work.

Thus there appears to be an adequate incentive for an already-employed person to work more hours, and to move to a higher-paying job--in other words, there appears to be no poverty trap.

How far, then, is this WRB scheme administratively feasible? The benefits will be paid by the employer, along with the worker's wages, just as the employer currently deducts tax from wages under the PAYE scheme. The employer will be reimbursed by the state for the benefits paid out. The employer will of course have a record of the number of hours worked, and the hourly wage being paid, and from this information the amount of benefit can be simply calculated. Thus the WRB scheme can be expected to be no less administratively feasible than the current PAYE.

But how far is the WRB scheme susceptible to fraud? It would be possible for the employer and worker to collude in obtaining excessive benefit from the state by registering a lower hourly wage than had actually been paid out, or by claiming the worker had worked 20 hours when in fact he had worked 30. This however would be a serious offence, and one which would appear to be easy to detect. A similar fraud under PAYE would be to understate the wage in order to reduce the amount of tax to be paid by the employer to the state. Thus it appears that benefit fraud under WRB will be no more likely to occur, than is tax fraud under the present PAYE.

Please e-mail comments on this paper to David Chapman at: chapman@democdesignforum.demon.co.uk, or (if you are a member) to the Reinventing Democracy discussion group at: redemoc-L@newciv.org