An investigation of the effects of taxes on work decisions on the example of the WFTC in the UK

This essay deals with the Working Families Tax Credit (WFTC) which was introduced by the UK government in 1999. The WFTC is a wage subsidy for low income workers that is withdrawn above a certain level of income. To evaluate the impact and outcome of the imposition of this tax credit I will first of all use budget line analysis to predict the likely effects of the reform on labour supply. Doing this it is important to take into account both the hours worked and the labour force participation. In the second part I am going to search for empirical evidence about the effect of this reform. Using the articles by Blundell (2000)TP F 1 FPT and Blundell et al (2005)T PF 2 I will highlight the problems faced by Blundell et al in applying FPT the difference- in-differences approach.

Working Families Tax Credit (WFTC) was as a replacement to Family Credit (FC). Eligibility for the programme depended on hours of paid employment, the number of children, income, capital and formal childcare costs. Couples were assessed jointly. Families fulfilling the work condition (an adult in the family unit must work 16 or more hours a week) were immediately eligible for the maximum credit, but earnings above a threshold reduced the credit at a rate of 55% of net income. Support for childcare was paid in addition.

Starting with the theoretical analysis I like to make a general comment on policy intervention by the government. In general we have to see every intervention – especially in form of taxes or subsidy – as a disturbance added to the economy. However, the world of today and especially the welfare state make intervention unavoidable. By intervening, governments should not forget about the purpose and the effectiveness of policies they drive. An intervention mostly bares a burden – one exemption is of course a lump-sum tax – in addition to the direct costs. In evaluating policies one should therefore have a good look on who bares the burden. Governments should try to formulate policies in such a way that a change in behaviour of citizens due to the policy is minimal. Though, this essay is about the evaluation of the influences of the Working Families Tax Credit whose effects I am going to estimate by budget line analysis. Using budget line analysis we can make use of its three important aspects. We can estimate at the effects of tax system and its reforms. In our case the slope of the budget line will be changed in a way that we have to add extra kinks to it due to extra allo wances made by the government.

1 R Blundell (2000), “Work Incentives and `In-work' Benefit Reforms: A Review”, Oxford Review of Economic Policy, 16:1 , 27-44. TP PT

2 R Blundell, M Brewer and A Shepherd (2005) “Evaluating the impact of the Working Families Tax Credit using difference-in - TP PT differences”, HMRC Working paper no. 4, (pp. 1-7, 24-27) Page 1 of 7

Furthermore we can depict the effects on individual behaviour in terms of labour supply and we can analyse the impact of income and substitution effects. In addition we are able to describe the heterogeneity of effects on different groups of individuals.

My analysis will focus on the behaviour of families eligible for the credit; it will not deal with the influence of the restriction the WFTC - like the incentive for couples to get married or the influence on the birth rate.

Graph 1 shows the budget set which includes in the absence of the WFTC the budget set: the point the individual is non-working (E), the initial line segment with slope –w starting from (but not including) the point E-F, representing earnings falling within the personal allowance that are exempt from tax, the second line segment with slope –w (1-0.22) representing earnings subject to the 22% rate (“Basic rate”) of tax (I ignore the 10% tax bracket for simplicity) and finally the third line segment with slope –w (1-0.04) representing earnings falling into the top tax bracket of 40% (the “Higher rate”).

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In the presence of the WFTC: the non-working point (E) remains the same, if one individual of the family is working 16 hours families become eligible for the full amount of WFTC, thus the budget line now shifts up vertically as represented by the vertical dashed line segment, the second dashed line segment has slope -w indicating the region of earnings where no subsidy is paid for additional hours worked but the credit is not being withdrawn. Finally the third dashed line segment has slope –w(1-0.37), since the credit paid on previous earnings is being withdrawn over this region of earnings - £90 a week in October 1999 - (the taper under the WTC is 37% of gross income).

We can identify six groups of individuals for whom the effects of the WTC are different:

Case (a): individuals who were not working prior to the reform and whose reservation wage is sufficiently high (indifference curve sufficiently steep) that they do not choose to work after the WTC is introduced either. The labour force participation of these individuals is unchanged (? LFP = 0) and they are unaffected by the reform as shown in graph 2.

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