I'm feeling compelled to write this post, because I don't see any evidence that the current Chancellor understands this trap, and I see otherwise intelligent friends not understanding just why this is a dangerous trap for a government to fall into; often, they're letting themselves be blinded by an ideological view.
The trap in question is one where increasing my taxable income decreases my net income; there are two ways for this to happen. The first is obvious - if the tax rate applicable (once you combine income tax, national insurance, and any other taxes paid on income) is above 100%, increasing your pay decreases your net income. The second is more subtle; if you are paid income-linked benefits, and the increase in net pay is offset by a greater decrease in your income-linked benefits, you lose out.
Why is this so bad? There are two reasons:
- You set things up such that I could pay more tax, but I'll be worse off than if I pay less tax. This results in things like someone refusing a pay rise that takes them into higher-rate tax, until it's enough to make up for the loss of child benefit; the government is thus losing out on tax revenue, and paying out in benefits.
- You encourage people to depend on benefits rather than earned income, because they're better off that way - this is bad enough when people are depending on benefits because they value their free time above their possible earnings, but becomes utterly crazy when they're doing it because they could get off benefits, but then they'd work as hard for less money in the bank.
I have set up an example spreadsheet on Google Documents to illustrate this. My hypothetical benefit is £1,000/month (housing costs, say), paid to people who earn £12,000 per annum or less. To set up the trap, we've excluded people who earn £24,000 per annum from claiming the benefit at all, and we've decided that you'll lose benefit linearly as you earn more (e.g. people on £18,000pa get £500/month benefit). I've also simplified taxation - instead of multiple taxes on income, I've got a single rate, and a personal allowance. We could add higher rate tax, and more personal taxes, but it doesn't seem worthwhile for a simple example.
You will notice that in my simple example, anyone who earns between £12,000 and £28,000/year is worse off than someone earning less than them. A rational actor will handle this by refusing to accept any job where they're paid in that range; the result is that (for example), instead of taking a job at £24,000, and paying a net £354.17/month in tax, someone sane will take a job at £12,000, and receive a net £895.83/month in benefits after tax is allowed for. It's obvious how this is bad for the government.
It's also not all doom-and-gloom; in this case, by increasing the upper threshold for £24,000 a year to £28,000 a year, people earning between £12k and £28k simply don't take home more; increase the upper benefit threshold a bit further (say to £30k), and although you don't take home much more as you increase your pay, you do take home more money, and thus escape the trap. You can also escape the trap by limiting benefits; this has other, deeper, social implications, as it can result in the benefit not helping the people it's supposed to assist.
So, how do governments end up in this trap accidentally? The usual route is to link the level of a benefit to something different to the thresholds for being permitted to claim the benefit; for example, in the example, I could have tied the benefit level to rents in London. When it started, I was paying £300/month maximum benefit; at that point, there is no trap. As rents rise, I don't review my thresholds, nor do I limit the benefit level; once rents exceed a certain threshold (around £750/month in my example), the trap appears. Capping the benefit just forces people out of an area completely, and creates "ghettos" of poor people kept out of the way of the rich, making it easier for the genuinely rich to be ignorant of what it's like living in a world where £10,000 isn't just the cost of a good night out, but is a sigificant sum of money.