The welfare trade-off: Why raising benefits doesn’t boost the economy

Ryan Bourne
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DAVID Cameron often says that growth is the coalition’s priority. Yet the 2010 Comprehensive Spending Review stated its priorities included aid, the NHS, fairness and social mobility. Clearly, some of these will directly conflict with the growth agenda. Public policy inevitably entails trade-offs.

We should therefore be suspicious about policies that supposedly produce the “double dividend” of satisfying two different social and economic ends at once. Take redistribution programmes. Many claim that transferring funds from rich Peter to poor Paul stimulates the economy and creates jobs. After all, poorer people are more likely to consume, so the transfers raise “aggregate demand”. Increasing state benefits is therefore not only morally right, but economically beneficial.

But what if the exact reverse is true? What if increasing people’s income streams through transfers actually increases unemployment?

Redistribution Recession, a recent book by professor Casey Mulligan, concluded that redistributive interventions in 2008-09 account for half of the large fall in the US’s labour participation rate. As eligibility for programmes like food stamps and unemployment insurance increased, the annual average payoff for not working rose from $10,000 (£6,172) in 2007 to $16,000 in 2009, falling back to $14,000 in 2011. This was inversely related to the path of working hours. And the fall in working hours was only partly a demand issue – many industries maintained output, but simply substituted away from labour to other production inputs.

By discouraging work, hand-outs make labour more expensive by reducing its supply. The unemployed, or those in low paid jobs, face higher marginal tax rates when deciding whether to work more. They have to weigh up the benefit of any extra income against the costs of paying taxes and losing benefits. Mulligan finds many examples of Americans who’d now be worse off in work.

Iain Duncan Smith is grappling with similar issues in the UK. The present welfare system can lead to marginal deduction rates as high as 96 per cent, meaning that some keep just 4p of every extra £1 earned. 500,000 families see rates of well over 80 per cent.

The introduction of the universal credit next year aims to streamline the myriad of different benefits. It will provide significant incentives for the unemployed to find jobs, by treating in and out of work benefits the same. But those already in work could still face marginal tax rates, including benefit withdrawal, of well over 70 per cent.

It’s important to understand, therefore, that welfare entails a trade-off. Providing a more generous safety net for a decent standard of living for the poor may be the right thing to do. This, of course, raises their static living standards and affects the composition of goods demanded. But we shouldn’t forget that the same policy harms incentives and makes it harder for poor families to earn more money in the future.

Ryan Bourne is head of economic research at the Centre for Policy Studies.