Cutting tax credits is the wrong way to reform the benefits system, argues Doug Bamford. Earnings subsidies will reduce the incentive to work in the shadow economy, he explains.
Recent government plans to reduce tax credits have generated a lot of interest and controversy. I propose a further reason to think that the proposals are going in the wrong direction: earnings subsidies such as tax credits discourage people from engaging in the shadow economy.
Like many I was surprised by George Osborne’s decision to commit to a new and increased minimum wage for over 25s, while reducing tax credits. I think this is a bad move as the increased labour costs will probably hit small businesses and consumers, while not compensating most of those who lose out in tax credits. Furthermore, some less skilled people might end up losing—or failing to get—jobs because of the higher wage floor.
The rationale is no doubt to shift support for working people from the government to consumers and thus enable a shrinking of the role of the state in the economy. To add to the controversy and potential unpopularity of the proposal I wonder if it will make the introduction of the Universal Credit more difficult. People are given a greater incentive to work longer and take higher paid work if they will continue to get tax credits (albeit tapered-off).
My own blue sky proposals involve a new form of earnings subsidy that would replace tax credits with a much more expansive alternative—tax credits on steroids. I’m therefore doubly disappointed in the government’s direction of travel.
Earnings subsidies can be expensive and the beneficiaries are not always clear. The vagaries of tax and benefit incidence are such that they can have one or more of several effects. Payments to workers will sometimes enable businesses to pay less than they would otherwise. In this case the benefits should be passed on to consumers in lower prices, though (in the short term) business owners will be able to generate higher profits. If prices are cheaper this can help local businesses compete with those from elsewhere and if companies can pay less gross while workers receive a decent net wage then there should be higher employment overall. However, most of the benefit should go to the low wage workers who will get more money in their pockets than they would have otherwise.
I want to suggest a further advantage of earnings subsidies that is little discussed. They encourage businesses and individuals to engage in legitimate and open activities and thereby discourage criminal and black market activity. If legitimate businesses and jobs are eligible for subsidy and illegitimate ones are not, then criminal activities and the shadow economy will be less attractive. Legitimate activities receive a subsidy that illegitimate activity would not and legitimate businesses would have an advantage over illegitimate ones.
In order to qualify for the subsidy businesses and workers will need to make themselves known to the authorities and thereby open their activities up to scrutiny. In reality, public agencies do not always work together closely at present – so businesses are not always as inspected as they should be. Even so, we can hope for better inter-agency co-operation in the future, enabling inspectors to catch out those traders making illegitimate claims.
If enterprises engaging in illegal activities want to qualify their workers for tax credits they will have to go to the trouble of making themselves appear legitimate, for example by filing accounts. This would add a further expense to their enterprise which would make the illegitimate aspect of the enterprise less lucrative. It would open up more scrutiny on their activities. Again, accountants have often failed to uncover or alert authorities to questionable businesses, but we can hope that they will play the part they really should in ensuring that the market economy works as it should.
A high minimum wage may have the opposite effect and inadvertently encourage illicit activity. One possible consequence of a high minimum wage is that less skilled workers may find it difficult to obtain work as employers will not want to hire them for the minimum hourly wage. Some of the involuntarily unemployed might decide in their desperation to work in the shadow economy for less than the minimum wage in order to get some income. The employers and workers will want to keep their activities out of the view of the authorities. Some workers may then be tempted to claim unemployment assistance at the same time as working below the radar.
The more earnings support given to low paid workers in legitimate businesses, the less attractive it will be for people to engage in criminal enterprises or black market activity. A stronger economy should result.
This is an entirely theoretical argument, of course, and I imagine it would be very difficult to verify. It is very difficult to know the size of the shadow economy, let alone how small (or even large) changes in earnings subsidies would affect this. But if anyone has any thoughts on the plausibility of this argument and how to verify it I would be interested to learn about them.
