There is an alternative to the tax credit cuts saga and it's a negative income tax

Ben Southwood
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Nobel prize laureate Milton Friedman was an early proponent of a negative income tax (Source: Getty)

Chancellor George Osborne's tax credits cuts have seen him come under a lot of fire from surprising quarters. So far, every welfare cut, no matter the extent, has brought him approval from centre-right think tanks, his backbenchers, The Sun newspaper, and the public via polling. But there seems to be rising opposition to this new retrenchment, particularly because it stands in rude opposition to the government's repeated mantra of making work pay.

All welfare benefits can distort labour markets, but tax credits, which are paid out conditional on having a job and earning above a certain threshold, are one of the least inefficient ways of topping up incomes. Since they are conditional on being in work, they don't disincentivise employment, and since they do not affect a worker's productivity, they don't simply subsidise employers by lowering wages—a logical argument that is held up by the empirical work.

Politicians always find U-turning unappealing, probably because they rightly believe that voters judge it weak, which implies that Osborne will try his best to find a solution that allows him to at least appear to stick with his plans for cuts. But he will also be eager to try and head off the makeshift coalition that seems to be building against him around these plans.

Read more: Osborne's "rhetoric on tax credits is just empty words"

It may seem panglossian to say so, but I believe such a policy exists: the negative income tax. The negative income tax (NIT) is a policy which replaces all major means-tested cash benefits and instead guarantees a universal basic income, or minimum income floor, paying money directly to individuals. As a person earns more through wages or other sources, the benefit is steadily withdrawn, like it is being taxed.

For example, it might guarantee a monthly income of £700. For each extra £100 a person earns a month in the labour market, they lose £50 of their initial £700 benefit. When their wages hit £700 they're getting £350 from the state, for a total of £1,050—when their wages hit £1,400, they no longer get anything.

The negative income tax has a long heritage, but its most prominent support has come from an unlikely base: free marketeers. Economists like Milton Friedman and Friedrich Hayek, both Nobel prizewinners, saw the negative income tax as a way of shredding administrative costs and freeing up recipients to make their own decisions instead of being given things they might not themselves judge that they want or need.

Read more: Poll: Tax credit cuts are unfair but necessary

Aside from the potential to slash something like £5bn off government costs (the Department of Welfare and Pensions spent £5.3bn on administration, according to a 2011 freedom of information request), the NIT has huge additional benefits.

The current system requires costly and complicated applications, leaving many eligible recipients in the lurch. It also disincentivises moving to find work, since many benefits require reapplication. And even after the implementation of Universal Credit (UC), which has cost hundreds of millions already and reached very few people, withdrawal rates are often near 75 per cent.

When we cut taxes on top earners from 83 per cent to 60 per cent and then to 40 per cent, we saw them do a lot more work, earn a lot more income, and pay a lot more in taxes. Why should we expect different results when it comes to the effective tax rates on the badly-off?

The NIT offers George Osborne an opportunity to snuff out many of his political problems: he can end the nightmare of UC implementation; he can save billions in administration to make up for the cost of scrapping the planned cuts to support for worse-off workers; he can make good on his pledge to make work pay through an even better system; and he can do it all without appearing to U-turn.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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