Why wage subsidies are not the best way to help the poorest paid in Britain
BRITAIN’S tax credit regime was introduced by Gordon Brown in an attempt to boost the living standards of the low paid. But by topping up pay, this effective state wage subsidy has worrying long-term implications for the worst off and the economy.
Tax credits suppress natural market pay rises, encourage overmanning (particularly in non-growth sectors), and thus depress productivity growth. And they cost a fortune. Few employers would increase pay when the state effectively does this for them. Tax credits also discourage people from improving their skills when it makes little difference to their take-home pay.
This was precisely what happened under the “Speenhamland System” in the early nineteenth century. Agricultural workers’ incomes were topped up out of the poor rate, encouraging over-employment in the sector. When the system was abolished in 1834, a substantial movement of labour into the new industries of the day followed, leading to an economic take-off over the next 20 years.
Tax credits have had similar results. The cost has ballooned, wage increases have been suppressed, and productivity growth has been poor.
In the wake of the 2007-08 crisis, it may have been helpful that subsidies suppressed wages, and thus enabled employment levels to hold up. But to achieve greater growth in the longer term, wage increases need to be driven by market forces; there needs to be a movement of people to new higher growth sectors; and individuals need to see that, if they improve their skills, their take home pay increases.
Tax credits also require a minimum wage to put a floor under the extent to which top-up payments subsidise wages. No wonder the government is now thinking of raising the minimum wage significantly – largely motivated by reducing the ballooning cost of tax credits. But this is little more than a sticking plaster, and hiking the minimum wage will also serve to price the unskilled out of work. The tax credits regime needs to be abolished, and a minimum wage must be low enough not to harm those without skills.
The big issue is whether the new universal credits regime, which ends specific tax credits, will get rid of these labour market distortions and the negative impact on productivity growth. Universal credit merges virtually all individual benefits, with a cap on the maximum payment of £26,000 a year. It is designed to get people back into work, by reducing the “cliff edge” of withdrawal rates that disincentivises the unemployed from getting a job.
I fear, however, that universal credit will worsen the Speenhamland effects. The amounts that can be claimed up to the maximum remain essentially a function of pay for those in work, incentivising employers to hold down wages. This will continue to be bad news for productivity growth. The maximum payment of £26,000 a year, equivalent to annual taxable pay of £35,000, is significantly greater than average income. The Speenhamland effects would only be contained by raising the minimum wage, thus pricing the unskilled out of work.
The sadness is that in-work subsidies are seen as necessary to boost living standards. But their long-term effect is to reduce productivity growth and wage increases, thus withholding better living standards for the poorly paid.
Lord Flight is a Conservative peer.