Tuesday, April 10, 2007

Neill Harvey-Smith's Scheme for Reforming Tax Credits

Neill Harvey-Smith has a plan for reforming the tax credit system. Creating such a plan is noble work as the scheme is an absolute travesty at present and more and more is being asked of it. Essentially he argues that we should use an abolition of parts of the tax credit, principally those not involving children, to pay for a reduction in business taxes. We should then raise the minimum wage. By these means business pays the money we currently pay as tax credits as wages instead of through corporate taxation which is used to pay for tax credits. His argument is that this improves simplicity, is better for a worker's feeling of self-actualisation as it shows up as money they have earned and creates fewer discincentives for a worker to endeavour to improve their condition. I don't think he has properly analysed the costs of the minimum wage and he has also aggregated 'business' in a way which glosses over his proposal's true business harms.

In discussing the efficiency of his new system Neill considers all of the costs of a tax credit system but none of the inefficiencies associated with the minimum wage. There are a number of ways the minimum wage can be avoided by businesses who do not wish to face increased costs. Undocumented immigrants who do not need to be paid this wage yield an increased return which will outweigh the costs of possible legal sanction in more and more cases. Applying the minimum wage to piece work is fraught with difficulty as there is not a clear hourly rate. This can be exploited. Finally, many businesses can simply fire a portion of their workers to keep costs the same. Workers pay for the minimum wage in the greater effort that is necessary to complete the same workload with fewer people.

Like most prohibitions of a mutually consenting activity the minimum wage is hard to enforce. Any business that wishes to remain honest and pay the new, higher than market, wages risks being put out of business by less law-abiding or foreign rivals. Restrictions like the minimum wage pervert market mechanisms. Creative destruction turns from an imperative to increase efficiency into an imperative to become a criminal. Every penny added to the minimum wage increases this effect as the advantage accorded to the criminal increases. Despite all these problems a rise in the minimum wage could still be worthwhile if it has particularly massive benefits. However, Neill has not made this case as his analysis is based upon considering the costs and failures of the tax credit system but not the costs and failures of the minimum wage. Without a proper cost-benefit analysis he cannot claim that his system is the less costly means of distributing benefits to the low paid.

His other big problem is that he aggregates 'business' in a very misleading way. A minimum wage means that businesses pay increased wages if they employ the poor. The more people you employ on the minimum wage right now the more you will pay with any increase in the minimum wage. By contrast, a cut in corporation tax will go to all businesses. This means that some firms are going to be taking a kicking from this measure while others take close to a pure tax cut.

Some employers of low-wage workers, particularly those in less competitive markets, will internalise the new costs or find that higher wages are actually better for them but the number of these cases will be limited in a relatively open economy like the UK's. Many other firms will try one of the tactics described above to avoid paying the new wages. However, a great many firms will prove unable to pay the new wages and will not have the nous or moral 'flexibility' to avoid paying. These firms will exit through bankruptcy or outsourcing. Their workers will be made unemployed. This is the classic problem created by the minimum wage.

We have an obvious objective. Put more money in the hands of those working but whose low productivity justifies only low wages. We can pay for this in a way which spreads the cost across the economy, either tax credits or something else like a citizens basic income, or we can pay for it through a minimum wage. By focussing the costs onto companies that employ the poor we would distort our economy. We would hurt our competitive position in any business that employs the low skilled. This would increase the pace of the shift in our comparative advantage towards high-skilled work. With the weaknesses in our education system this is likely to feed into further increases in income inequality.

Neill's idea addresses a serious problem but I am unconvinced he has found the first question to which 'increase the minimum wage' is the answer.


James Higham said...

The more people you employ on the minimum wage right now the more you will pay with any increase in the minimum wage. By contrast, a cut in corporation tax will go to all businesses.

And your feeling about that, Matthew?

Matthew Sinclair said...

I'm not sure I follow you James. By penalising employers of those with low productivity you risk hurting the very people you're trying to help. I think I've set out why in the section on the potential for creating unemployment and the bit on comparative advantage.

If you're getting at something else I apologise.

Communication consultant said...

That's an excellent analysis of the shortcomings. On the first objection, I haven't seen research to predict where the tipping point of the minimum wage might be in promoting widespread avoidance. So far, the level has gone from £3.60 to over £5/h without all the predicted problems. However, the fact that Brown doubled funds for enforcement in the Budget does suggest that might be changing. The second objection, lumping together "business" was indeed a simplification, intended to establish the principle that employers required greater incentives to offset taking a hit on the minimum wage. Wages are important, but only one factor in deciding whether to employ British workers - a significant cut in corporation tax would be very welcome to employers.

My first problem is "how can we boost work incentives by supporting in-work incomes?" - I don't consider cutting welfare benefits or introducing workfare, for example. Focusing resources on creating a gap between unemployment and employment, rather than giving taxpayers' money to people on decent incomes, is a better approach in my humble opinion.

Matthew Sinclair said...

I'm not sure we have escaped the problems with the minimum wage so far. As an illegal or quasi-illegal activity such as avoiding the minimum wage isn't an easy thing to study. However, I am aware that even fairly major and respectable employers have tried the 'have fewer workers do the same job' strategy. I wouldn't be surprised if that turned out to be the main corporate response to the minimum wage.

Employers may require an incentive to accept a hit on the minimum wage but you can't target corporation tax cut at firms employing the low skilled. That mismatch is a serious problem. It distorts your economy to the detriment of those you're trying to help.

While a cut in corporation tax would help 'employers' you'd see the city and other businesses that employ very few poor people running off with great piles of money and employers of the poor getting creamed. That might make your scheme politically quite successful as you would defuse business lobby objection. However, it could significantly increase the pace of changes already underway in our economy by hurting the sectors which are suffering most in international competition. The social effects of this could be dire.

I do see your objective and certainly see the problems with solutions currently being proposed. A Citizens Basic Income or increasing tax allowances could help with the incentives problem but are hideously expensive as they have to be paid to all. However, I think your solution could be counterproductive.

You do create a bigger gap between employment and unemployment under your system. The question is whether you'll have made that gap too wide for most unskilled people to cross.