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Missing: an appreciation of marginal tax rates. Reward: better growth prospects

    Today marks the implementation of changes to child benefit payments, such that for the first time the benefit will lose its universality. The Government has used the persuasive argument that, given all benefit spending has to be raised from somewhere, it makes little sense for wealthier households to receive state hand-outs. Yesterday, the Prime Minister said:

    "I think people see it as fundamentally fair that if there is someone in the household earning over £60,000 you don't get child benefit... I think it is the right approach."

    Whilst broadly supporting the overall philosophy, the implementation of the policy, by looking at individual rather than household income, has inevitably thrown up significant anomalies – reflective of having a benefit system largely focusing on family income at the same time as an individualised tax system.

    However, what it does do is introduce another spike in the effective marginal tax rate that the group of people earning between £50,000 and £60,000 will face.

    What does this mean in practice? Well, the effective marginal tax rate is essentially the proportion of an extra £ in earned income that is paid out in taxes or lost in benefits. People earning between £50,000 and £60,000 face a marginal income tax rate of 40%, a marginal employees’ National Insurance Contribution rate of 2% and now an effective child benefit loss equivalent to an income tax rate of 10.5% for their first child and 7% thereafter.  In other words, if you have no children your personal effective marginal tax rate is 42%, as now. But if you have two children, your effective marginal tax rate will now be 59.5%. If you have 4, it will be 73.5%. For every extra £1 you earn you will get to keep 58p, 40.5p and 26.5p in each case. This is before things like repayment of student loans, which add a further 9% to your tax rate, are considered.

    This matters because the effective marginal tax rate essentially measures the incentive to earn more money. It is thus the key measure of work incentives, and is the reason why supply-side economists suggest tax cuts can induce economic growth.

    And in truth, the complexity of the UK tax, benefits and tax credits system means that there are now numerous income levels which experience very high effective marginal rates. Fraser Nelson has recently written about the ‘poverty trap’ – i.e. where those on low incomes experience high levels of benefit withdrawal, in addition to tax, which dis-incentives people to earn more income because of high marginal rates. Some people face rates as high as 95%, meaning individuals get to keep just 5p of every extra £ earned. Then there is the anomaly seen for those earning over £100,000, who through the gradual loss of the personal allowance face a combined income and National Insurance tax rate of 62%.

    Essentially, as I argued when discussing giving money to the poor in a recent City AM article, there is a trade-off. Universal benefits or allowances on a universal basis are expensive, and given our current fiscal position need to be reviewed. However, means-testing and withdrawal often create perverse incentives and exceptionally high marginal tax rates at the level of incomes during which certain taxes are increased or benefits are taken away.

    But if these effects are well known (and they have been for years!) then why do we only ever hear about the direct effect? Why, after every Budget do we hear ‘how much better off/worse off’ a certain group will be as a result of the measures, on a static basis, but nothing about what the measures will do for marginal tax rates and incentives?

    Admittedly, the latter is less sexy and is less easy to squeeze into a news cycle piece. It is also more complicated to calculate. But if the effects are as important as many of us think they are, particularly for those in poverty, then is there not a case for a more robust immediate analysis of the effects of budgets on incentives to go alongside the more static distributional analyses undertaken by the Institute of Fiscal Studies?

    The status quo also highlights the importance of tax and benefit reform. Given the Chancellor has said that the tax burden should now remain around the same, the Coalition should use the next few years to embark on base broadening (through eliminating exemptions and loopholes) whilst using any additional to lower marginal rates. On benefits, specifically through the implementation of the universal credit, there should be much more focus on rewards for earned income over unearned income streams as the means of alleviating poverty.

    But mostly, it would just help if we started talking about marginal rates and incentives again.

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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