The money-go-round

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As the Spending Review approaches the Government has put its proposals for welfare reform at centre stage. This is not surprising since the size of the welfare budget 218 billion in 2010 (if departmental spending is included), or 15.8 per cent of GDP dwarfs any other area of spending. This Reform report publishes new evidence to inform the debate on each of the Governments key welfare proposals: reducing spending on middle class welfare, making work pay and reforming the delivery of welfare (including introducing the Work Programme).

Middle class welfare the money-go-round

Benefits (cash and in-kind) paid to middle and high income families have increased to the tune of 41.4 billion over the last decade. But this has been matched by extra payments in taxation. The middle classes have been on a money-go-round where higher benefits are funded by higher taxes. This has come at the cost of expanded bureaucracy and the harmful effects of higher taxes on the economy. The apparent benefit to the middle classes from extra spending on welfare is largely a fiscal illusion.

This spending has also done little to help the poorest families. Experience shows that poorly targeted spending leads to less generous support for poor families. Even a small increase in the generosity of a universal programme comes at a very large fiscal cost, meaning resources have to be spread thinly and less is available for families in need. Political incentives mean that the wrong support tends to increase so that programmes that are not needed (but that are widely received) become more generous while those that are needed become more residual. The view that universal welfare may constitute an unaffordable luxury has recently been echoed by Martin Narey, Chief Executive of the childrens charity Barnardos.

The scale of this money-go-round suggests that the Government is right to target middle class welfare such as Child Benefit as areas for making savings. Some critics have argued that middle class benefits should only be removed if taxes are reduced at the same time. But this report suggests that the situation is the reverse. The abolition of middle class welfare will make it possible to reduce taxes once the deficit is eliminated.

That said the Governments approach to means-testing the Child Benefit is so badly designed that it risks bringing the whole idea of means-testing into disrepute. The much better way to achieve the same goal would be to abolish Child Benefit and increase the value of the Child Tax Credit for poorer families. There is no need to create a new administrative system and take-up of the Child Tax Credit is already high (around 97 per cent, the same as take-up of the Child Benefit) among lower income families. Unlike the approach of basing eligibility on a familys income tax position, combining the Child Benefit and the Child Tax Credit would more closely retain the principle of payments varying with household characteristics (large families facing the 40p tax rate may retain some eligibility).

The means-testing of the Child Benefit must also only be the start of a process of cutting spending on middle class welfare. Other areas of spending, especially gimmicks paid to pensioners such as the Winter Fuel Allowance, free bus passes and free TV licences, are also in need of reform.

Making work pay

The Government is committed to allowing people on in-work benefits to retain more of their income as they earn more. At the Conservative Party conference in October 2010 the Chancellor of the Exchequer, Rt Hon George Osborne MP, said that the Government would create a system in which it always pays to work. Yet the complexity of many families living arrangements, and how these arrangements change over time, mean that no government ever has managed to achieve the goal of ensuring that work pays more than benefits for everyone and at every time. Further, improving financial rewards for work at lower income levels discourages work for people earning higher incomes. It also brings more people into the receipt of benefit, which contrasts with the ambition of making people independent from state support.

The Coalition is considering trying to make work pay through increasing the amount that people can earn before they start to lose their benefit (the earnings disregard) and decreasing the amount that is lost in benefit as they earn more. Yet the economic benefits of this approach are questionable. Some of the likely outcomes of this policy would be, for example:

Low wage, low status, part time work would be encouraged. Increasing wage rates would be discouraged. Many families would be encouraged to reduce their incomes and second earners would be encouraged to withdraw from the labour market

An increased financial penalty for marriage, since a lone parent and a single person would together enjoy larger earnings disregards than the disregard for a couple

The costs of in-work benefits would increase without any certainty of the savings achieved.

At a cost in the order of 2.7 billion these proposals represent poor value for money. While they would provide some benefits through simplification, other options for simplification could be pursued at a much lower cost.

Delivering welfare

The principle of simplification is important given the complexity of the current system. The Department of Work and Pensions Decision Makers Guide is no less than 8,370 pages long. But the Governments current approach, based on a major central administrative and IT effort, is not the right way to go about this. There needs to be a greater focus on employing local initiative and allowing benefit rules to vary at a local level to suit local circumstances.

It could be argued that the difficulty of reconciling trade-offs between criteria could be reduced through smart automation. Yet while improving the automation of the welfare system is important, smart automation is limited in the benefits that it could provide. There are several important criteria that cannot be automated without incurring significant administration and compliance costs (such as the length of time that the child stays with one parent in a joint custody arrangement). This is aside from the poor record of implementing national information technology programmes in the United Kingdom.

The Work Programme is a good idea, given the success of similar programmes in other countries. But developing the Work Programme is likely to take years to get right. Some commentators have recommended a discovery phase of around twelve months for companies and the Government to deliver together a form of contracts that actually works. A discovery phase would also allow the development of greater understanding of which segments of the population are most likely to face poor labour market outcomes due to fiscal consolidation and the costs of getting different population groups back into work (the risk profile of the population).

Conclusion and recommendations

Welfare reform should be one of the most important achievements of this Parliament. This would not only help to eliminate of the deficit but also contribute to a supply side reform agenda of encouraging economic growth. However, the evidence in this report shows that the Government needs to recast its priorities if it is to achieve the benefits of welfare reform. In particular, the Government needs to:

Means-test the Child Benefit in a simple and fair way. Rather than basing means-testing of the Child Benefit on the presence of any earner in the household facing the 40p tax rate, the best way to means-test the Child Benefit would be to combine this support with the Child Tax Credit

Remove more benefits from middle and higher income earners. This includes abolishing benefits such as the Winter Fuel Allowance. Undertaken properly these reforms will increase the fairness of the welfare system. The potential savings from these reforms (including changes to the Child Benefit but not to the core State Pension) is around 10 billion

Not go ahead with plans to introduce a Universal Credit with more generous earnings disregards and a single uniform rate of abatement. There needs to be an honest debate on the trade-offs in the design of policies designed to make work pay and more cost effective opportunities for simplification should be employed

Introduce a discovery phase for the Work Programme to allow the implementation of a form of contracts and market structure that would actually work. This will require a greater understanding of the risk profile of the population and the costs of getting different population groups back into work.