Taxes, Benefits and the Financial Incentive to Work: Evolution and Policy Impacts

Taxes, Benefits and the Financial Incentive to Work:Evolution and Policy Impacts The Employment Guidelines include a general commitment towards making the taxation system more employment friendly. Targets for reductions in the overall tax burden are called for, and where appropriate, targets for reduction of fiscal pressure on labour and non-wage labour costs, in particular on relatively unskilled and low-paid labour. A key focus in this area is on the impact of tax and welfare policy on the financial incentive to work facing an individual. A logical corollary is that the most appropriate form of analysis is one involving data on the individual and his or her family situationand a means of simulating tax liabilities and benefit entitlements for each individual in the family, under alternative labour market states (employed, unemployed and out of the labour force). Essentially, this requires a tax-benefit (simulation) model, based on nationally representative survey data. In our analysis we use SWITCH, the ESRI tax-benefit model to provide estimates of two key measures of the financial incentive to work: replacement rates (measuring the balance between income in work and income out of work) and marginal tax rates (measuring the financial incentive to increase or reduce hours of work). These measures are used to give an up-to-date estimate of the profile of work incentives for 2002, under current tax and welfare policy. We also provide estimates of the profile of work incentives in 1998. By 2002, about 12 per cent of employees faced a zero marginal tax rate, and about two-thirds faced a tax rate below 30 per cent. This compared with about one-third facing a tax rate below 30 per cent in 1998. The proportion of all those in receipt of UA or UB with a high replacement rate of 70 per cent or above halved between 1994 and 2002 falling from about 30 per cent in 1994 to around 15 per cent at 2002. However, one cannot infer policy impacts from a simple comparison of these snapshot pictures of the profile of work incentives. For this purpose, we construct alternative scenarios involving no policy change. The first of these is the one typically used in constructing the conventional opening budget: no policy change in nominal terms, as tax and welfare parameters are frozen in nominal terms. Moving beyond this, we could define no policy change in real terms as indexation of tax and welfare parameters in line with price inflation. But even under this scenario, average tax rates would rise as real income growth led to fiscal drag. For a neutral scenario, under which the average tax rate does not rise, it would be necessary to define no policy change in relative terms, as indexation in line with wage growth. Policy impacts between 1998 and 2002 are assessed against each of these scenarios. In our view, it is assessment against the only neutral scenario, involving policy indexation in line with wage growth, which is of most relevance. The impact of 2002 policy is less dramatic compared with this scenario. Over a fifth of employees saw their point marginal tax rate fall by more than 10 percentage points. About a tenth saw a fall of between 5 and 10 percentage points. The point marginal tax rate facing the majority of employees fell by between 1 and 5 percentage points. Aggregate statistics on income taxes and national income indicate only a small decline in the share of national income taken by income taxes, and the share of income taxes in total tax revenues. Evidence from macro-level and micro-level analysis confirm that tax-benefit policy has contributed to recent employment growth, but the extent of the contribution is modest, with a number of other factors playing a more dominant role.