Three steps to making work pay

The minimum wage, 10p tax band and reform of National Insurance will help spring the poverty and unemployment traps

MAKING WORK PAY is critical to the Government's strategy of tackling the root causes of poverty and disadvantage in our society. As we described in our Social Justice Commission pamphlet in 1993, the last 20 years have seen the rise of a two-tier labour market in Britain: a growing number of two-earner households alongside a record number of working-age households with no-one in work - either officially unemployed or trapped in "non- employment" (without work but outside the official unemployment count).

Today around 3 million households - nearly one in five - have no one in work, double the number in 1979. For many, the gains to work have simply been too low. The combined effects of paying tax and losing benefit meant they were little or no better off working than on welfare, locking people into the poverty and unemployment traps. This is the main reason for the tripling of the number of children living in poverty over the past two decades.

Some doubted, before the 1997 election, whether tax reform to improve work incentives would make a difference to the number of people moving into work. Their mistake was to take an overly static view of the labour market. New research by Paul Gregg, Paul Johnson and Howard Reed - co- ordinated by the Institute for Fiscal Studies (IFS) - suggests it will. If the IFS study is right, the combined effect of the Chancellor's reforms could spring the unemployment trap for up to 290,000 people who are estimated to move into work.

The test starts now. April is delivery month for the Government's Make Work Pay agenda. A year ago the New Deal for Young People was rolled out as a national programme to get the under 25s back to work, matching new opportunities with new responsibilities. This month sees the introduction of the national minimum wage, the 10p starting rate of tax and the first wave of reforms to the National Insurance system designed to make work pay. From October, the Working Families Tax Credit (WFTC) will be boosting the pay packets of 1.4 million low-paid workers.

Over 1.8 million low-paid people will see their income tax bills halved by the 10p rate, and a further 900,000 people will be removed from tax altogether by the second wave of National Insurance reforms announced in the Budget. Add to this the Working Families Tax Credit, and the minimum wage, and the gain from work for a one-earner couple on pounds 200 per week with two children under 11 will have increased by an average of 25 per cent from before the 1998 Budget - equivalent to an extra pounds 25 per week.

The traditional approach to modelling the effects of these policies has been to look at the wages of people currently in work, and assume that these are the wages that people currently out of work would command if they moved into work. For the first time, Gregg, Johnson and Reed model the effect of policy by making use of the actual wages earned by those who move into work.

These new "dynamic" findings show that people who move into work do so at wages considerably below those of current employees with otherwise similar characteristics. Work pays less well for those who move from worklessness to work. The effect is that policies to increase the rewards of work have a correspondingly greater effect.

The study uses data from the Quarterly Labour Force Survey (LFS), which samples 12,000 people five times over a period of 15 months. This makes it possible to track working-age people who start off out of work, but subsequently make the move into work, and see what wages they obtain. On average, these are only two-thirds of the wages of working people as a whole.

By modelling the tax and benefits system using data from the Family Resources Survey (FRS), it is then possible to calculate how much better off people would be if they took jobs paying those wages rather than staying on benefits. Putting together this information from the LFS and the FRS, it is possible to estimate the effect of changes to in-work income on the numbers of people who move into work.

The financial returns to working do affect the probability of entering work for both men and women, with the effects slightly larger for women. A pounds 10 increase in the amount of income someone can earn is estimated to increase the likelihood of moving into work by just under 1 percentage point for men, and just under 2 percentage points for women. This relationship between the gains to work and movement into work seems to be strongest where the initial financial returns are lowest.

The authors simulate the effect of three of the Government's headline policies to make work pay: the Working Families Tax Credit, National Insurance reforms, and the 10p income-tax rate. The WFTC will provide more generous in-work payments to working families than the current system of Family Credit, which it replaces in October. And because the taper - the rate at which WFTC is reduced as income rises - is lower, recipients will be able to keep more of what they earn, increasing their work incentives.

From April 2000, WFTC will also be paid through the wage packet, eliminating the stigma of claiming benefit for families in work, but the effects of this cannot be picked up in the IFS model. Nor are the effects of more generous childcare support in WFTC modelled. Both the 10p rate and National Insurance reforms give the greatest tax cut to those on low incomes.

The WFTC alone is estimated to increase the number of people moving into work by over 90,000. The effects are very different across different types of people. For married women whose partners are out of work, and lone parents, the effects are substantial. Almost 7 per cent of lone mothers are estimated to move into work as a result of the WFTC (there are also likely to be large effects for lone fathers, but there are too few in the sample to model effects on them separately). And there are significant effects for married men with non-working partners.

Of course, the WFTC is only one element within the broader Make Work Pay strategy. The 10p tax rate and national insurance reforms will help to make work pay for all low-income earners, including second earners and the childless. Looking across the package, the employment effects are positive for all groups.

The table above shows the overall increase in the likelihood of finding work for different family types. While single men are only 3 per cent more likely to be in work, this probability rises to nearly 10 per cent for lone parents and married women in workless households.

Of course, the effects of the Government's reforms cannot be measured just by their impact on helping people to move into work. The 10p rate, WFTC and national insurance reforms all also deliver tax cuts to hard- working low and middle-income families. The cut in the basic rate of income tax, which the authors do not model, will also reward work and ensure that working families are better off. The overall effect of this package, before any increase in employment is taken into account, is to make working families with children better off by an average pounds 740 a year, and more for low-paid working families. The net effect will be to reduce child poverty by 700,000.

The report's findings show that making work pay will also have a significant effect on people moving into work, cutting the bills of economic failure, and so helping even more people to become better off and more independent. Tackling unemployment and persistent poverty in the modern labour market demands new policies based on state-of-the-art research and analysis. That is what this Government is now delivering.

Work and Welfare: tackling the jobs deficit, by Edward Balls and Paul Gregg. Institute for Public Policy Research, 1993.

Entering Work and the British Tax and Benefit System, by Paul Gregg, Paul Johnson and Howard Reed. Institute for Fiscal Studies, pounds 20.

Ed Balls is the Chancellor's Economic Adviser. Paul Gregg is a member of the Treasury's Council of Economic Advisers.