Do Welfare Benefits and Tax Credits Affect Work Incentives in the Uk?

Introduction

This report aims to discuss the effects of welfare benefits and tax credits to labour supply in UK. It is divided into three sections. Section 1 focuses on the theoretical relationship between welfare and labour supply. According to Borjas (2009, p.83),welfare programs would weaken the work incentives if they provide cash grants as well as tax to participants in the labour market. In contrast, credits on earned income will inspire many workless people entering the labour force. Empirically, based on several papers, section 2 generalised the welfare policies implemented after 1997 in UK in terms of affecting the work incentives. Three key policies and their effects would be mentioned in this section, they are (1) New Deal programs, (2) Pathways to Work , (3) Working Families' Tax Credits.Section 3 concludes.

1. Theoretical analysis

In the neoclassical model of labour supply, we assume that people always want to maximize their utility, which is determined by the trade-off between consumption and leisure. The optimal allocation locates on the tangent point of people's indifference curve with the budget constraint, i.e., point P in figure 1.

Take welfare program into consideration, using the example mentioned by Borjas (2009, p.57), under the assumption that leisure is a normal good, a welfare program that gives the worker a cash grant of $500 and imposes a 50% tax on labour earnings decreases the hours of work, by moving point P to point R in figure 2. In this case, from point P to point Q is the income effect which caused by the cash grant while from Q to R is the substitution effect induced by the tax. Both of the income effect and substitution effects result in reduction in labour supply under this welfare program.

On the other hand, by tax credits, the government provide income subsidies to welfare recipients. The subsidies are refundable taxes can be considered either as reductions in taxes which they need to pay or as cash grants paid regularly by the government. As a result, tax credits will hopefully reinforce the employment in targeting groups. For example, the workless people will be strongly motivated by this program and more likely be drawn into labour market. However, it might be the case that creates work disincentives for some workers that already in the labour market.

2. Evidence in UK

The Labour Government of UK has developed its welfare program since 1997.For the sake of activating the labour market, a number of policies such as New Deals and Pathways to Work were carried out.

Specifically, under the compulsion of the New Deal for Young People (NDYP), all the young aged from 18 to 24 who have been unemployed for 6 months are involved to get extensive support of job seeking. According to De Giorgi(2005)'s study, which estimated flows off unemployed to jobs during the first 12 months of its starting, we can find that the NDYP draws 6-7% in the proportion of unemployed men moved into work ,and that the impact is relatively stable in this 12 months.

Moreover, the 'Pathways to Work' reforms provide greater support and impose greater obligations to encourage claimants of incapacity benefits to move into paid work. Evident results got from Brewer(2007,p.24)indicate that the flows off incapacity benefits in the pilot areas were around 8% higher than that of the non-pilot areas in the six months after its starting (from