IFS Social security reforms and incentives Mike Brewer and Tom Clark Institute for Fiscal Studies May 22 nd, 2002

IFS Motivation Reforms changed incomes and incentives Ever-present trade off when designing tax- and-transfer system This talk –Asks how we should analyse changing incentives –Describes (not judges) the impact of Labour’s changes –Work in progress –comments welcome!

IFS What sort of incentives? Incentives... –...to work –...to work more or earn more –...to save –...to claim benefits/tax credits (?) –...to cohabit and marry (??) –...to have children (???)

IFS Evaluating impact of incentives: a hierarchy “Optimal income tax” literature –“Are Labour’s reforms optimal?” Estimate response to incentives, predict changes due to reforms –Not saying whether “incentives” are good or bad Describe change in incentives –Not saying whether “incentives” are bad –Nor predicting their impact

IFS Work incentives Idea: trade off paid work against money Summarising the impact of reforms –Marginal effective tax rates –Replacement rates –Average tax rates Use tax and benefit model

IFS Marginal tax rates, workers

IFS Change in marginal tax rates, workers

IFS How do marginal tax rates vary with earnings? Split earnings distribution into equal-sized cells –Calculate average marginal tax rate in each cell –Assume away extremes –X-axis not linear!

IFS Marginal tax rates and earnings, all workers

IFS Marginal tax rates and hourly wage, all workers

IFS Marginal tax rates, earnings and children

IFS Marginal tax rates, earnings and children

IFS The new tax credits and incentives New tax credits will change how families with children are means-tested For many families, awards based on past year’s income Income increases of under £2,500 will be ignored in the short-run

IFS Incentive to work at all Replacement rate –RR = [Income out-of-work / income in work] –Include partner’s income Average tax rate –What proportion of gross earnings is lost in tax and foregone benefits and tax credits? Results –Almost no change for those without children! –Improves for lone parents –Worsens for couples with children

IFS Marginal tax rates, over 65s

IFS Change in marginal tax rates, over 65

IFS Other incentives To partner –Not possible to have progressive tax, joint assessment and neutrality to presence of partner –Difficult to quantify impact of reforms –Change compliance or behaviour? To have children –Considerably increased financial support for children

IFS Support for children, lone parent, 1 child

IFS Support for children, couples, 2 children

IFS Conclusions – so far! Work incentives –Little changed for those without children –For those with children, depends on whether partner present and/or working –Remember “work” also means “increase earnings” Incentives to save for retirement complex Incentives to partner, have children, claim benefits altered, but hard to quantify

IFS End

IFS Work incentives, families with children RR, 40 hours RR, 40 hours, after reform ATR, 40 hours ATR, 40 hours, after reform Lone parent68%64%61%52% Couple, working 55%59%31%38%