A dangerous "benefits trap"

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:

1. 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.
2. 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.

On freeloaders in the benefits system, and reducing the offence they cause

One complaint that appears in the popular press from time to time is that the welfare state is too generous to undeserving people, while not being generous enough to hard-working citizens.

It's an unfortunate reality that no matter how careful you are in designing your welfare state, you're guaranteed one of three outcomes:

1. Some people freeload and get away with it, because there's nothing in the system to stop them.
2. Some deserving people don't get the help they need, because the system says no.
3. The system costs a huge amount to administer, and is much more expensive overall than a system that permits freeloading - you can easily end up spending hundreds of pounds on administration for each pound of freeloading prevented.

I hope that people would agree with me that the third option is absolutely insane - there comes a point where pragmatism says that you shouldn't spend hundreds of pounds just to guarantee that a few pennies don't get given to people who don't need them. This leaves us with just two choices; I would personally prefer that deserving people don't miss out, which means that I have to tolerate freeloaders.

Given this state of affairs, what can be done to ensure that freeloaders don't upset people? First, we need an understanding of why freeloaders upset people; I believe that, in large part, people get upset because they work hard "for what they have", while freeloaders appear to get more by not working at all. We therefore need to ensure that freeloading isn't going to leave you better off than working.

Of course, I have an idea to solve this; simply put, we have plenty of benefits that could easily be paid to everyone, regardless of need, with those who don't need them paying them back in taxes. For example, the highest rate of Jobseeker's Allowance is £65.45 per week per person (around £3,500 per year). The basic rate of income tax is currently 20%, but by removing the personal allowance completely (replacing it with what used to be JSA), you claim back £1,500 from basic rate tax payers; you could then increase the basic rate to claim back the remaining £2,000, or accept that by pushing more people into the higher rate tax band, you're getting more income tax. Further, because people continue to get the same rate of benefits whether they work or not, you encourage people who don't work because they're scared of losing their benefits, or who can't stick out a job for more than a few months at a time to work, and thus pay taxes.

As a second upside, you reduce the amount of administration needed; if you look at all means-tested benefits, and remove those that can fairly be paid to everyone and reclaimed via tax, you reduce the number of people you need to administer the benefits system. There will still be exceptional cases (disability benefits for one), but they're fewer and further between.

There are, of course, downsides. For one, you need to be good at catching out tax dodgers; if people hide from the tax system in the black market, the maths stops working out. You still have a social problem; while you're now always better off working for a living, people will still resent carrying people who don't work, even though they should. I do, however, believe that this system will lead to less resentment, and even, possibly, more employment overall (it becomes possible to work for a couple of hours a week, without losing out on your "bennies").