Will wages fill the tax credit gap? Don’t Budget for it

Recent high-profile converts are bringing headlines and new vim to the debate on working poverty. Good. But with this comes a cacophony of confusion about the National Minimum Wage (NMW), Living Wage, the role of tax credits and the likelihood that a recovery in earnings will compensate for cuts to in-work support. And this risks obscuring both the implications of what the Budget might mean for working poverty as well as alternative, practical, policy solutions.

The first muddle concerns the idea that in one bold gesture we could merge the NMW and Living Wage. From its conception, the NMW has acted as a wage floor that takes account of potential risks to employment. In contrast, the Living Wage is unencumbered by any job considerations: it is driven by changes in the cost of living (and the public’s perception of what a minimum standard of living looks like). That’s a big difference. It’s for this reason that the Living Wage Foundation opposes making it mandatory as many firms, particularly small ones, would struggle to adapt. Equally, those who’d like to see a more ambitious remit for the Low Pay Commission don’t propose making it chase the Living Wage. The NMW and Living Wage are, and will remain, distinct.

Nor – contrary to endless media repetition – is the Living Wage set at a level that would permit households to cope without in-work support. Its calculation is predicated on full take-up of tax credits, housing benefit and so on. If in-work support is cut then, as night follows day, the Living Wage will rise. For example, if we exclude in-work support then the level of the London Living Wage leaps from £9.15 to £11.65; 80 per cent higher than the current minimum wage. Anyone thinking that something like this might happen anytime soon needs to take a long walk.

Bear in mind, too, that the Living Wage is itself a composite of different wage rates that, together with in-work support, are required to ensure a minimum living standard for a variety of household types. The rate for a lone parent with two kids would need to be over £14, while for a childless couple it falls to well below the NMW at under £5.  Even in the unlikely event that the ‘official’ Living Wage (£7.85) was mandatory – and let’s not forget that over 5 million workers still get less than it – it wouldn’t guarantee families a decent standard of living.

Perhaps the biggest misconception is the voguish notion that if tax credits are cut, employers will somehow decide to offer pay rises to fill the gap. This is saloon-bar economics espoused by some on both left and right. The available evidence suggests that the great majority of the gains from tax credits flow through to employees, not employers.

What about the claim that those working families should be able to absorb cuts in tax credits and other benefits by securing a commensurate pay rise? It doesn’t wash either. To illustrate, consider the idea that’s been floated of cutting Child Tax Credit by £5 billion (accounting for under half of the proposed welfare cuts). A single parent with one child, working 16 hours a week on the NMW could experience a cut in annual income of £845. To prevent this income fall they would need to boost their earnings by nearly £1,500 (due to high effective tax rates) ­– equivalent to a 26 per cent pay rise. Alternatively, it would take 12 years of incremental 2 per cent real pay rises (well above the pre-downturn trend) simply for this family to recover their position. If the family had two children then we can practically double the figures in this particular example.

We should also bear in mind that under Universal Credit it will become harder, not easier, for this sort of family to claw their way back to today’s position as the effective tax rate they face will rise. And are tax cuts going to fill the gap? No. As we’ve often pointed out, a higher personal tax allowance (PTA) won’t give a penny to almost 6 million of the lowest earners. Only about 1 per cent of the cost of the planned increases in the PTA will actually be spent lifting the lowest earners out of income tax (the rest is spread between all tax-payers). The measure that would be most useful – raising the National Insurance threshold – has hitherto been shunned.

So as we head into the Budget week, let’s be clear-eyed about quite how severe the consequences could be for the working poor. But let’s do so while also acknowledging that the status quo needs changing. It’s true that in some important respects our policy architecture has worked well: several decades of blending steady welfare reform, in-work support and the NMW have left our labour market in a far stronger position than some of our key competitors (notably the US). Yet there are big shortcomings to be tackled not least on low pay, work incentives and training. New ideas capable of courting support across the political spectrum are needed.

First, we could prioritise progress on poverty-pay in those sectors that are largely in the government’s gift and that will clear the path to a higher NMW. For instance, a move towards a Living Wage for care workers would offer a pay rise to almost a million of the worst-paid, most overlooked workers in the country and remove one of the biggest road-blocks to a higher wage floor for all workers. Year after year the Low Pay Commission highlights that the care sector works as an anchor on the NMW. Action here would also give the government much greater moral authority to lean on other key low-paying sectors like retail and hospitality, and would cost less than many realise due to the scale of savings from in-work support. Good policy, good politics.

Second, Universal Credit needs to be overhauled so it becomes a significant part of the solution to persistent low pay rather than reinforcing the problem – encouraging people to work more hours and making earning more worthwhile. This is eminently achievable and fully in keeping with the government’s rhetoric. Political will from the Treasury, and an open mind from DWP, are what’s needed.

Third, as part of the push on productivity, it’s high time that the state demanded more from employers on training. Debates on training levies and employer contributions are as old as the hills – all governments examine them only to shy away – but they now have real urgency due to the perilious decline of the adult skills budget. The new government should use its mandate, and its strong hand vis-à-vis employers, to act. It would be a meaningful sign that, amidst the hardship, it is seeking to inch the economy towards shared and sustainable wage growth over the medium term.

It seems that working poverty is about to be made worse. Let’s hope that there is also some clear thinking about long-term improvements too.