‘In-work benefits’ like the UK’s Working Families Tax Credit (WFTC), which target the
working poor, are much more effective than traditional anti-poverty measures. In
maintaining, and even strengthening, people’s incentives to work, they make transferring
money from rich to poor far less costly. These are among the central findings of a new
study by Herwig Immervoll, Henrik Kleven, Claus Kreiner and Emmanuel Saez, which
uses EUROMOD, a new simulation tool, managed by the Institute for Social and Economic
Research.
Writing in the January 2007 Economic Journal, the researchers conclude that in-work
benefits – sometimes referred to as ‘Kombilohn’ in German – represent a valuable policy
option for enhancing the economic situation of many low-income families, especially in
continental European countries where taxes are high and up to a third of the population
draw most of their incomes from government transfers.
Reducing income inequality without increasing unemployment is tricky. Redistribution from
rich to poor requires taxation but taxes cut into the payoff from work and tend to reduce
work incentives, causing what economists call efficiency losses. The new study sheds light
on this trade-off in 15 European Union countries. It turns out that the cost of redistribution
varies both between policy instruments and between countries. Getting policy right is
therefore of crucial importance. The authors start by asking how much it costs to
redistribute a given amount, say one euro, from the rich to the poor. They use EUROMOD
to calculate tax burdens and benefit entitlements for a representative set of households in
each country, showing people’s financial incentives to work as well as the cost of different
types of social transfers.
The study finds that the design of redistributive policies matters hugely. Traditional antipoverty
programmes can be very expensive, with the rich paying far more than the poor
receive. In contrast, in-work benefits, which target transfer payments to the working poor,
are much more efficient. A one euro transfer delivered through in-work benefits costs the
rich little more than one euro (and sometimes less).
In Nordic countries, for example, work incentives are already rather weak (many
unemployed people lose as much as 70-80% of their gross earnings to higher taxes and
reduced benefits if they move into work). Any further transfers to the poor make work even
less attractive and are therefore very expensive: an additional one euro transfer would cost
six euros and more.
In Belgium, France and Germany, the same transfer would cost the rich four to five euros.
Hence, only 20-25% of the taxes paid by higher income Germans would actually reach the
intended beneficiaries – the rest is lost in the process because higher taxes and benefits
reduce work effort leaving fewer resources for redistribution.
Extending existing anti-poverty policies would therefore seem undesirable in these latter
countries – unless the population is particularly committed to redistribution to the poor. This
would be the case if, say, income gains of the poor in the Nordic countries were valued
more than six times as much as losses suffered by the rich.
What, then, can governments do to make redistribution less costly? The study shows that
‘rolling back the welfare state’ is not the only possible response. Carefully designed
redistribution policies can maintain, or even strengthen, work incentives. And such policies
already exist. The best-known examples are the Earned Income Tax Credit in the United
States and the UK’s WFTC. A number of continental European countries have recently
introduced similar measures, although on a much smaller scale.
Like traditional anti-poverty programmes, these in-work benefits also redistribute from highto
low-income people and tax workers to finance the transfers. But importantly, benefit
payments are conditional on having a job. In-work benefits therefore improve the incomes
of the working poor and strengthen incentives to take up employment. As low-skilled people
are particularly responsive to this type of incentive, in-work benefits can have large positive
effects on employment, boosting people’s incomes and reducing government expenditures
on welfare benefits.
Of course, support for the poorest households, those without a job, is still required. Indeed,
in Southern Europe, where many poor currently receive little support, anti-poverty transfers
could be introduced at a relatively modest cost. But in high-tax countries where welfare
benefits are already more generous, rebalancing the existing benefit system towards
support for the working poor would make it more effective and less costly.
Would in-work benefits receive the necessary political support? The authors calculate that,
in most countries, a majority would gain from increasing support to the working poor. So
this is a policy that makes economic sense and is politically attractive.
ENDS
Notes for editors: ‘Welfare Reform in European Countries: A Microsimulation Analysis’ by
Herwig Immervoll, Henrik Jacobsen Kleven, Claus Thustrup Kreiner and Emmanuel Saez is
published in the January 2007 issue of the Economic Journal. Immervoll is at the OECD in
Paris; Kleven and Kreiner are at the University of Copenhagen; and Saez is at the
University of California, Berkeley.
For further information: contact Herwig Immervoll on +33-1-4524-9214 (email:
herwig.immervoll@oecd.org); Henrik Jacobsen Kleven on +45-35-32-44-15
(email:henrik.kleven@econ.ku.dk); Claus Thustrup Kreiner on +45-35-32-30-20 (email:
claus.thustrup.kreiner@econ.ku.dk); Emmanuel Saez on +1-510-642-4631 (email:
saez@econ.berkeley.edu); or Romesh Vaitilingam on +44-7768-661095 (email:
romesh@compuserve.com).