STRENGTHENING WORK INCENTIVES FOR LONE PARENTS
01 Feb 2009
The current tax and benefit systems for lone parents in the UK and Germany are difficult to make sense of unless the governments in the two countries care a lot about the poorest lone parents and hardly at all about those with low levels of earnings. That is the conclusion of new research by Mike Brewer, Professor Richard Blundell, Dr Peter Haan and Andrew Shephard, published in the February 2009 issue of the&##160;Economic Journal.
Their findings are directly relevant to current debates about how to design welfare benefits, in-work tax credits and income tax rates for low-skilled groups. They indicate that work incentives for lone parents could be strengthened in the UK and Germany, but only if the governments cared less about the poorest.
The UK government is currently implementing policies that will make it harder for those with children aged 7 or over to receive state support if they do not look for work and accept suitable job offers. The authors suggest that a more efficient tax and benefit system could indeed take account of children''s ages, but not by the extreme measure of denying state support to lone parents with older children.
For example, in the UK, it might make economic sense to reduce slightly the support given to lone parents with school-age children who do not work and increase it for low-earning lone parents with school-age children.
In the UK and Germany, substantial cash transfers are made to lone parents with no income of their own. But as lone parents'' earnings rise, the value of these payments falls, weakening their incentives to earn more or to work at all.
In Germany, this arises because welfare benefits fall nearly euro for euro as earnings rise. In the UK, although the Working Tax Credit provides a generous subsidy to part-time work, it is often offset by aggressive means testing in programmes to subsidise rent and local tax bills. For
those with higher earnings, income tax and social insurance contributions have a similar impact.
Less harsh means tests do less to weaken incentives to work at all, but mean lower tax revenue for the government; steeper means tests raise more taxes, but may lead some people to work less or not at all.
How the overall personal tax and benefit system should be designed to balance this trade-off depends on three factors: how generous overall the&##160;government wants to be; how responsive people are to financial incentives to work; and how much the government cares about redistribution.
Using existing information on the extent to which lone parents respond to financial incentives to work more or to work at all, the authors use recent developments in optimal tax analysis to examine the tax and benefit system for lone parents in the UK and Germany.
Their main finding is that the existing tax and benefit systems for lone parents are optimal only if the governments in the two countries care a lot about the poorest lone parents and hardly at all about those with low&##160;levels of earnings. This conclusion is driven by existing evidence that lone parents do respond to financial incentives when deciding whether or not&##160;to work.
The argument runs as follows. A small cut in benefits for lone parents who are not working would encourage some to start work. This would increase their income and save the government money; the drawback is that it would leave those lone parents who did not move into work a little worse off.
The fact that the UK and German governments have designed tax and benefit systems where the incentive to take low-earning or part-time jobs is so weak can only be explained, then, if those governments care a great deal about those poorest lone parents.
The model used by the authors can be reversed to design a tax and benefit system that makes a trade-off between these competing demands if one knows, or assumes, how much the government cares about the poor.
The authors find that, with weak preferences for redistribution, levels of support for low-earning lone parents should be similar to those for non- working lone parents in both countries, leading to average tax rates close to zero at low earnings. But they also suggest that a more efficient system could be designed if taxes and benefits took into account the age of children in the family.
In the UK, the authors estimate that it might make economic sense to reduce slightly the support given to lone parents with school-age children who do not work, and increase it for low-earning lone parents with school- age children, even if the UK government cared a great deal about the incomes of the poorest lone parents.
In Germany, the authors estimate that a similar reform would be sensible for those with pre-school-age children, but for those with school-age&##160;children, taxes should be raised on high earners to pay for extra support for low earners.
In the UK, the government is currently implementing policies that give more encouragement to lone parents who are on welfare to find a job, and make it harder for those with children aged 7 or over to receive state support if they do not look for work and accept suitable job offers.
The approach suggested by the authors can be seen as an alternative to this. Rather than, at the extreme, denying state support to lone parents with older children, they suggest that a reshaping of the existing benefits and tax credits might help bring about similar outcomes.
''Optimal Income Taxation of Lone Mothers: An Empirical Comparison for the UK and Germany'' by Mike Brewer, Richard Blundell, Peter Haan and Andrew Shephard is published in the February issue of the Economic Journal.
Richard is a professor of political economy at UCL and the director of the ESRC Centre for the Microeconomic Analysis of Public Policy (CPP) at the IFS.
Institute for Fiscal Studies (IFS) and University College London | email@example.com
German Institute for Economic Research, Berlin