BRIEFING PAPER ADAM SMITH INSTITUTE Welfare Reform The importance of being radical By Matthew Triggs & Sam Bowman Introduction The British welfare system does not work in its current form. Although welfare spending rose by 48% in the 10 years from 1997, the number living in severe poverty (on incomes less than 40% of the median) has increased from 5% to 6% of the UK s population in the last decade. 1, 2 The system is rising in cost and increasingly failing to help those most in need. The Government seems set on reform but unsure about how to proceed. On the one hand, the Treasury is calling for piecemeal reform based on the reduction of existing benefits and stricter conditionality. On the other, the Department for Work and Pensions (DWP) prefers a radical overhaul, with the introduction of a Universal Credit to consolidate existing benefits and taper payments away at a single constant rate. The Adam Smith Institute s line is clear: Piecemeal reform will not solve the existing problems. Radical reform will. neutral approach that would implement the Department of Work and Pensions proposals in a way that benefits the poorest but does not increase the size of the budget deficit. 1. The failings of the current system An effective welfare system must provide a minimum income to the needy without damaging incentives to work. In this section, we argue that the current system fails on both counts. a) Providing a minimum income to the needy As outlined above, the number of people living in severe poverty in the UK (less than 40% of UK median income) has increased from 5% to 6% in the last ten years. Over the same period, welfare expenditure has risen in real terms by 48%. We are spending more while helping the neediest less. However, radical reform appears expensive. DWP estimates the first year cost of the Universal Credit at 3bn. Though arguably justifiable when public funds are plentiful, this expense is problematic while the UK is running a 170bn budget deficit and other departments are being asked to find savings of 25 40%. If we are to have radical reform that is also economically viable, we must adjust DWP s proposed policies to reflect our grim fiscal situation while preserving their objective of making work pay. This report will argue for radical and viable reform in four stages. First, it will outline the failings of the current system and show the need for reform. Second, it will argue that piecemeal reforms are unsuited to solving these problems. Third, it will defend the proposals of the Department of Work and Pensions whilst recognizing that they are currently too expensive. Finally, it will propose a deficit Part of this failure comes from the low take-up rates of some means tested benefits by the very poor. Among those estimated to be eligible, the Working Tax Credit has a take-up rate of 57%, the Child Tax Credit a rate of 81%, and Housing Benefit a rate of between 80% and 87%. 3 Millions of eligible households slip through the welfare net because they are either ignorant of the system or overwhelmed by its complexity. b) Preserving the incentive to work As Table 1 shows, below, many welfare recipients face high Marginal Deduction Rates (MDRs) if they increase their working hours. 4 The Marginal Deduction Rate calculates the amount of welfare money lost by recipients as they enter the workforce. Adam Smith Institute - The free-market thinktank 23 Great Smith Street, London, SW1P 3BL +44 (0)20 7222 4995 www.adamsmith.org
Table 1 Marginal Deduction Rates 2011-12 Over 90 per cent 130,000 Over 80 per cent 330,000 Over 70 per cent 1,710,000 Over 60 per cent 1,935,000 additional hour s work. Such complex interactions between benefits also cause the unpredictability of MDRs. Were they simpler, people would at least know whether or not work pays. 2. The limits of piecemeal reform At these rates, work simply does not pay: a 90% rate reduces the net income from an extra hour of work at the minimum wage ( 5.80) to 58 pence. By ensuring such meagre returns from work, the benefits system traps millions in unemployment and discourages further millions from working more hours. Furthermore, the manner in which various benefits and tax credits interact and are tapered away at different rates makes it difficult to calculate whether or not work pays in a given situation. This difficulty for individuals in calculating MDRs is an extra disincentive to work in its own right. Under the current welfare regime, MDRs damage work incentives by being both high and unpredictable. The failure of the status quo The current welfare system neither provides a minimum income to the needy nor protects work incentives. Both of these failures have a common root: the system s complexity. Receiving one s full welfare entitlement is a labyrinthine process for any claimant. Over fifty different benefits and tax credits can be claimed, each with a unique application process to navigate and eligibility criteria to digest. Some are administered locally (such as the Council Tax Credit), others centrally (such as the Employment and Support Allowance). There is no single point of contact where benefit applications can be submitted, payments organised or the total value of benefits being receiving checked. To navigate the system optimally would require an encyclopedic knowledge of the 10,150 pages of guidance published by the DWP, local authorities and HMRC. 5 The low take-up rates and subsequent failure to deliver to those most in need is no surprise in a system this complicated. Similarly, the multiplicity of benefits causes high and unpredictable Marginal Deduction Rates that damage work incentives. Because means tested benefits are tapered away at different rates with little attempt at coordination as incomes rise, the resulting MDRs are capricious and uneven. As outlined above, these deduction rates often combine to significantly reduce the income earned by an A piecemeal reform is any reform that leaves unchanged the underlying structure of the current benefits system. This section will argue that piecemeal reform cannot overcome the complexity of the welfare system and thus cannot rectify the current system s failings. As shown above, the current system s failure to provide an income to the needy is largely due to the low take-up rates caused by its complexity. If a multiplicity of benefits with diverse application processes remains the status quo, many people will continue to find applying for their full entitlement difficult. This requires a complete overhaul of the present system if it is to be addressed. This problem exists because of the difficulties that claimants have interacting with the benefits system. Unless there is either a single point of contact between claimant and benefits system or significant consolidation of benefits, people will fall through the cracks. Both require a fundamental reworking of the way we administer benefits. Recent attempts to improve work incentives have tended to make small adjustments to existing systems for instance, the transformation of the Working Family Tax Credit into the Working Tax Credit. This approach to the disincentives comes in two main forms: a) adjusting the amount of benefit paid and b) altering the benefit s taper rate. Both fail to resolve the problems of high and unpredictable Marginal Deduction Rates. a) Adjusting the amount of a benefit paid This is a very tempting option for governments to take when reducing expenditures. It is easy to implement and appears to improve work incentives. If I have less money, the thinking goes, I will be inclined to earn more. Yet this logic neglects thinking at the margin; even if I am poorer I will not significantly increase my hours of work if I lose 90 pence of every pound I earn. Again, high MDRs are the problem, which is not addressed by reducing the levels of benefits paid. Figure 1 (below) models the interactions of six benefits and two taxes on a 2 Adam Smith Institute
minimum wage earner s income as he works more hours. 6 (Note that this model is a simplification of the tax and benefits system and does not represent the full variety of benefits available.) Changes in Housing Benefit in the above graph can provide a useful hypothetical example. If the amount of money paid out is halved but the taper rate left the same, then the light blue, topmost area will shift downwards. The only change this effects is a shortening of the number of hours worked required to completely taper away Housing Benefit: it takes half the time to withdraw, say, 50 at 65 pence in the pound than to withdraw 100 at the same rate. MDRs fall after a benefit has been fully tapered away because one less deduction is being made to a person s income. In theory, smaller Housing Benefit payments should bring forward a reduction in people on lower incomes MDRs, boosting their work incentives. However, this drop in MDR doesn t materialise even after 50 hours have been worked at the minimum wage. For all practical purposes, this MDR reduction doesn t exist. Considering that Housing Benefit is one of the most generous benefits, we can conclude that reducing the amount of benefit paid rarely does anything to change MDRs, leaving them equally as high and unpredictable as before. b) Altering a benefit s taper rate Altering a benefit s taper rate directly affects the Marginal Deduction Rate because, as discussed above, MDRs are the sum of all taper rates and tax rates. Reducing the rate at which benefits are tapered away thus appears to effectively improve work incentives: reducing the taper rate of Housing Benefit from 65 to 60 pence in the pound allows me to keep an extra 5 pence out of every pound I earn. However, reducing a few benefits taper rates will not improve the work incentives of all welfare claimants because they do not all receive the same benefits. For example, reducing the taper rate of the Working Tax Credit does nothing for those working fewer than 16 hours at the minimum wage. Although it can improve the work incentives of the few, fiddling with existing benefit s taper rates is not a comprehensive strategy to reduce high MDRs. Furthermore, even with certain benefits taper rates reduced, the problem of unpredictable MDRs is not solved. If taper rates are only reduced, not standardised, claimants must still calculate whether they will be better off working more. The worry remains that an additional hour s work could cause the MDR to spike. 3 Adam Smith Institute
Conditionality a) Providing a minimum income to the needy Increased welfare conditionality is sometimes given as another simple benefit reform. This approach attaches conditions to the receipt of benefits in order to promote positive behaviour. For example, attaching a time limit as a condition to the receipt of Job Seekers Allowance would promote jobseeking among those receiving the benefit. Though good at creating new work incentives to counter the disincentives created by high and unpredictable MDRs, when applied across the board conditionality exacerbates the benefit system s failure to provide an income to the needy. Were the receipt of all benefits conditional, those failing to satisfy the conditions would receive no income from the state at all. Some may argue that such people are getting what they deserve. However, if the welfare system is to provide an income to the needy, a minimum amount of benefit needs to be paid unconditionally. If we are to encourage people to move off this unconditional benefit, it is important to taper it away at a reasonable and predictable rate. Fixing the British welfare system requires more radical reform than simply the greater use of conditionality. Because the UC would replace all working-age benefits and tax credits, it would reduce to one the number of applications required to receive benefits; the number of agencies administering benefits; and the points of contact with the benefits system. For the first time, claimants could potentially receive a single statement detailing their earnings, entitlement and the relationship between the two. Following the UC s adoption, the system would become comprehensible to the layman. Take-up among those eligible would surge as a result. Those who do not apply for all of the benefits they are entitled to, because they are uninformed or too busy to apply through the maze of bureaucracy, would receive their full entitlement with a single application. A minimum income would be provided to the needy far more effectively than at present, and the trend of growing deprivation reversed. In the long-term, the consolidation of benefits would allow for a more informed approach to benefit reduction, as the impact of reductions would be easier to see in advance. b) Preserving the incentive to work The need to be radical As this section has argued, piecemeal reform of the welfare system is unsuited to overcoming its two chief failings failing to provide a safety net for the needy and doing so in a way that incentivizes work. Structural change is needed simplification of the complexity that deters claimants from applying for their full entitlement, and creates high and unpredictable Marginal Deduction Rates. We need to be radical. The DWP s proposed changes are just that. In the next section we turn to explaining why adopting the Universal Credit, the most fundamental of the DWP s proposed reforms, would overcome the current system s problems. 3. Why the Universal Credit solves the welfare crisis The Universal Credit (UC) massively simplifies the benefit system by replacing all existing working-age benefits and tax credits with a single payment that is withdrawn at a single, constant rate. This section will argue that such a simplification of the present system would fix the current problems in the welfare system. As argued above, complex interactions of many benefits, tax credits and taxes produce high and unpredictable Marginal Deduction Rates that serve as strong disincentives to work. By contrast, the UC has a single and predictable withdrawal rate that can be set lower than the MDRs presently observed by the most disincentivized members of the workforce. As put forward in the DWP s report 21st Century Welfare, the UC has an earnings disregard: a low income threshold within which the credit is not withdrawn as earnings increase. In other words, the credit does not harm work incentives until a certain income is reached. This makes work significantly more attractive to the worst off and particularly incentivizes the long-term unemployed to start working in part-time jobs. Getting people into work is the most sustainable way of helping them quit poverty; it is easier to work more hours once one is in work than it is to move from unemployment into work. An earnings disregard seems to recognise this fact and should be praised for doing so. After this earnings disregard, the benefit should be tapered away at a constant rate. If a person s MDR is higher under the present system than the sum of the UC s taper rate and the income and national insurance tax rates, they would 4 Adam Smith Institute
be better off were the UC adopted. If this is not the case, they would be worse off. The lower the UC s taper rate, the more people s work incentives will be improved. In any realistic implementation of the system, MDRs in excess of 80% would no longer exist and the incentives of the most deterred would be fixed. Furthermore, the UC does away with the uncertainty problem. Because the UC s taper rate is constant, recipients know how much an extra hour s work will pay. The threat of benefits being withdrawn sharply disappears under this system. As outlined in this section, the Universal Credit would fix the present welfare system s failings by removing complexity and minimizing damage to work incentives. However, these improvements would be expensive. Rearranging the system to accommodate a single point of contact between recipient and administrator of benefit requires an upfront cost. Any taper rate below 70%, all other things being equal, will increase the total amount of benefits paid out (at least in the short term). 7 Given the size of the current budget deficit, replacing the current system with a more expensive one seems irresponsible. To have both effective and viable welfare reform we must demonstrate how the DWP s proposed policies could be adjusted to better reflect fiscal reality. 4. Adjusting the Department of Work and Pensions proposed policies to reflect fiscal reality Cost projections of the DWP s Universal Credit vary. The DWP estimates that it will add around 3.5bn to the annual welfare bill, using a static model that does not attempt to project the long-term savings of the measure. 8 On the other hand, the Institute for Fiscal Studies puts it significantly higher at 9bn. 9 There are economic and political difficulties of increasing welfare expenditure when the nation grapples its largest ever peace-time deficit the only way to avoid these is to determine how the Universal Credit can be made at least deficit neutral. The main savings can be made by reducing the total amount of benefit paid, as this accounts for most of the system s costs. There are two effective ways to do this: increasing the taper rate and reducing the level of benefit paid. Table 2, below, gives a matrix of the costs (in bn) of a similar system to the UC (a negative income tax) at different combinations of benefit levels and taper rates in 2007-08 prices: 10 Table 2 50% poverty line 55% poverty line 60% poverty line 50% taper 72.3bn 87.6bn 104.1bn 55% taper 62.0bn 74.9bn 89.2bn 60% taper 54.7bn 65.8bn 78.1bn 70% taper 45.2bn 54.0bn 63.6bn At 2007-08 prices, the existing system costs 63.7bn. To maintain deficit neutrality, only five of the twelve options are affordable. At the moment, we use the 60% poverty line as a guideline to determine the level of benefit payments. Keeping this, our options narrow to one: a UC with a 70% taper rate is just affordable. However, this is not politically feasible. A 70% taper rate is only just affordable and requires the assumption that the moneys for working benefits remain uncut. Furthermore, despite reducing the MDRs of those currently facing the worst disincentives, a 70% taper rate is still quite a disincentive to work. Indeed, it would worsen 2 million people s incentives to work (see table 1 above). In the absence of a recognized standard of absolute poverty, we support recalibrating the welfare system to provide at the 50% poverty as recommended by the Taxpayers Alliance in their Welfare reform in tough fiscal times. At present, the welfare system fails to even provide incomes at a 40% poverty line. If dropping the line to 50% makes affordable a replacement of this system by one that can better help the poor, then we support it. We recommend a Universal Credit that pays initial benefits at 50% of the median income (adjusted for familial circumstances etc) tapered away at 55%. Such a UC would be both deficit neutral and retain the features that allow the reform to overcome the present system s problems. This would net a 1.7bn upfront saving. However, if welfare faces cuts similar to those expected in other departments, a 1.7bn saving is too small. In such a case, we would urge the government to stick close to the 50% poverty line and 55% taper rate model. A poverty line lower than this risks hurting the poor, while a higher taper rate lessens the improvement to work incentives. Potential savings exist in lowering the earnings disregard and attaching conditionality to receipt of the UC. A two- 5 Adam Smith Institute
tier system with a full and partial Universal Credit where receipt of the first is contingent upon the satisfaction of conditions, such as active job seeking, is an idea worth exploring. It would both boost incentives to work whilst saving money by lessening the payments to those who simply refuse to engage in gainful activity. Furthermore, we should not forget that, whatever its form, the UC s implementation, will yield some impressive savings. As the Centre for Social Justice has argued: broader savings would also come from reducing the indirect cost of unemployment reduced expenditure on health, crime, policing, and other social costs. We estimate that the total cost savings that could be achieved by these reforms would be 3.4 billion per year. 11 This 3.4bn stands in addition to the 1.7bn saved by switching to the 50% poverty line and 55% taper rate model. Combined, these savings already amount to 8% of the present system s cost (in 2007-08 prices). Endnotes 1 E. Butler, The Rotten State of Britain, Gibson Square, 2009, page 227 2 TaxPayers Alliance, Welfare reform in tough fiscal times 3 Centre for Social Justice, Dynamic Benefits: Towards welfare that works, page 5. 4 D epartment of Work and Pensions, 21st Century Welfare, page 11 5 David Martin, Benefit Simplification: How, and why, it must be done, page 5 6 Centre for Social Justice, Dynamic Benefits: Towards welfare that works, page 12 7 TaxPayers Alliance, Welfare reform in tough fiscal times, page 36 8 Centre for Social Justice, Dynamic Benefits, page 16 9 Institute for Fiscal Studies, Means-testing and tax rates on earnings 10 Taxpayers Alliance, Welfare reform in tough fiscal times, page 36 11 Centre for Social Justice, Dynamic Benefits, page 16 6 Adam Smith Institute