7.3 Government policies to alleviate poverty and to influence the distribution of income and wealth

What is poverty and the tax and benefits system?

Poverty is seldom caused directly and immediately by taxation and the benefits system. However, through a process known as fiscal drag and through in welfare benefits, poverty can increase. Making taxation more progressive and increasing welfare benefits reduce poverty and inequalities in the distribution of income, at least in the short run. However, pro-free-market economists believe that, in the drive to reduce inequality, these changes worsen labour market incentives, competitiveness and economic growth. They may lead to a culture of welfare dependency where some people are long term unemployed and are reluctant to look for work. According to this view, in the long run, low incomes may fail to grow, and poverty may increase. If trues, government intervention in labour markets in an attempt to reduce poverty results in government failure.

What are the five stages through which taxes and benefits affect the distribution of income?

1. Household members begin with income from employment, private pensions, investments such as shares they own and other non government sources. This is referred as 'original income'.

2. Households then receive income from cash benefits. The sum of cash benefits and ordinal income is referred to as 'gross income'

3. Households then pay direct taxes. Income after direct taxes have been subtracted from gross income is called disposable income

4. Indirect taxes are then paid on spending on goods and services. Disposable income minus indirect taxes is referred to as post tax income.

5. Households finally receive a benefit from services provided by the government (benefits in kind). Post tax income plus benefits in kind is referred to as 'final income'.

What is fiscal drag?

The UK tax system has affected poverty partly through a process known as fiscal drag. Fiscal drag occurs in a progressive income tax system when the government fails to raise tax thresholds to keep pace with inflation.

Define marginal tax rates

The tax rate levied on the last pound of income received. The term can be applied solely to income taxes or to all the taxers that a person or business pays.

What is the poverty trap (or earnings trap)?

Fiscal drag is one of the causes of the poverty trap. As there are a number of ways in which the poor can be trapped in poverty, this particular trap, which traps the low waged in relative poverty, is perhaps better called 'the earnings trap'. It affects people in employment in low rates of pay rather than the unemployed who are unwaged. Another causes of poverty affecting the homeless stems from the fact that to get a job they need a home, but to get a home they first need a job.

The immediate cause of the earnings trap is the overlap between the income tax threshold and the means tested welfare benefits ceiling (the level of income at which means tested benefits cease to be paid). When welfare benefits are mean tested, a person's right to claim the benefit is reduced and eventually tapers away or disappears completely, as income rises. By contrast, a universal benefit is claimed as of right and is not dependent on income, although the state may decide to 'claw back' universal benefits that are taxable.

Low paid workers caught within the zone of overlap not only pay income tax and national insurance contributions on each extra pound earned; they also lose part of all of the right to claim benefits. Thus low paid workers and their families whose income falls within this zone of overlap become trapped in relative poverty, since ant increase in their pay results in little or no increase in their disposable income.

How can the poverty trap be eliminated?

The poverty trap can be eliminated by getting rid of the zone of overlap in the income pyramid. The income tax threshold could be raised to take low waged households out of the tax net. Means tested benefits could be completely replaced by universal benefits, though this is unlikely to happen. The national living wage might also reduce poverty by being raised to a higher rate than is currently planned in an attempt to prevent employers paying 'poverty wages'. However, raising the NLW could be counterproductive if unemployment increases as a result. At the time of its introduction, the Conservative government said the NLW might lead to a loss of 60,000 jobs which implies that a higher NLW might lead to even more job losses. However, the government also said that continuing economic growth would create many more jobs.

What is the unemployment trap?

The poverty trap affects the low wages in jobs rather than the employed who are unwaged. It is important not to confuse the poverty trap or earnings trap with unemployment trap. The unemployment trap is closely related to the earnings trap, since both affect the poor and result from the nature of tax and benefits system. But people caught in the unemployment trap are out of work - at least in terms of officially declared employment. The unemployment trap contains unwaged social security claimants who choose unemployment. This is because they decide they are better off out of work, living on benefits, than in low paid jobs paying income tax and national insurance, and losing some or all of their rights to claim means tested benefits.

What is the link between the earnings trap and the unemployment trap?

One link between the two is the underground economy - the hidden or informal economy in which people work, usually for cash payments, while failing to declare income and sometimes fraudulently claiming social security benefits. Low paid workers in employment can escape the earnings trap by giving up declared work in order to claim unemployment benefits, while receiving income from undeclared work in the underground economy, sometimes known as the 'black economy'.

What are the consequences of government policies which affect poverty and the distribution of income?

- Restributive policies can make the distributions of income and wealth more equal and reduce relative poverty. Many would argue that such policies are equitable. However, by reduce incentives to work hard and to be entrepreneurial, redistributive policies may have adverse unintended consequences, such as slower economic growth and loss of international competitiveness.

- Redistributive policies can alleviate child poverty, old age poverty and fuel poverty, but these aims have only been partially achieved

- Arguably, faster economic growth provides the main avenue for reducing absolute poverty, and perhaps also relative poverty, but according to pro free market economists, wider inequalities in the distributions of income and wealth may be necessary if fast growth is to be achieved and sustained

- Some fiscal measures, used to try to reduce poverty and narrow inequalities in the distribution of income, have resulted in the development of poverty and unemployment traps