Eliminating cliff edges in the tax-benefit system would help improve work incentives
Tax-benefit systems face challenges in achieving their objectives. One key challenge is to ensure people have adequate incomes without creating strong financial disincentives to work.
One element which may reduce work incentives are cliff edges. Cliff edges occur where benefit entitlements and other supports are withdrawn sharply (or entirely), or where tax and social insurance liabilities increase steeply as income rises. Research has found that people adjust their behaviour to keep their income below points such as these.
This paper examines where such cliff edges exist in the Irish tax-benefit system and outlines potential reforms. PRSI and USC both have cliff edges in their design as people under a certain income are exempt. Once this threshold is passed, however, all of a person’s income becomes liable for the charges. This results in a drop in disposable income once the threshold is passed. Removing the cliff edge is possible by introducing a 0% band with those above this level only paying USC/PRSI on the income above this band (as is the case in the income tax system). Reforming the current system is possible but would mean trade-offs if the government want such changes to be revenue neutral – either more low-income people would need to be brought into the USC/PRSI net or rates must increase.
Part-time and low-income workers are negatively impacted by current rules
The social welfare system mainly avoids cliff edges through the gradual withdrawal of benefits as incomes rise. However, two cliff edges exist. The 4-in-7 rule, whereby those working part-time can only receive a Jobseekers Allowance (JSA) payment if fully unemployed for 4 days out of 7, can disincentivise employment as it means that a person working part-time, but whose hours are spread out over the week, will have no JSA entitlement. A second cliff edge exists for lower-income workers – those working at least 38 hours a fortnight can receive the in-work support, the Working Family Payment, while those just under this cut-off cannot.
Medical Card, Housing Assistance Payment and student grant entitlements in need of access and retention reform
Finally, cliff edges exist in other benefits such as the medical card system, whereby someone just over the cut-off is not usually eligible for the card. The GP-Visit card scheme, discretionary cards and the ability to retain cards when returning to work after long-term unemployment have helped soften this cliff edge. An exception to the income limits exists for those whose income is all from social welfare sources – therefore two families on the same income where one is all from social welfare and another has some employment earnings can have different medical card entitlements. This issue is exacerbated by the fact that medical card limits have been frozen since 2005 despite sharp rises in incomes since then. Similar cliff edges exist in housing supports (i.e. someone marginally over the income cut-off cannot access social housing or the Housing Assistance Payment) and the steplike nature in student grant rates means that two students with very similar means face different rates of payments.
Dr Claire Keane, an author of the report and a Senior Research Officer at the ESRI, said:
“Cliff edges, where welfare entitlements drop or tax liabilities increase sharply as income rises, can impact the decision to take part in the labour force. A variety of such cliff edges exist in the Irish tax-benefit system, for example within the PRSI and medical card systems.”
Dr Keane added:
“The Commission on Taxation and Welfare has advised that all cliff edges should be removed from the tax and welfare system. Doing so would help improve work incentives”.