Is welfare dependence optimal for whom – part 4: In-work tax credits and labour supply

In-work tax credits were introduced in many countries including New Zealand to encourage movement into employment by breadwinners. By linking a large payment with full-time and semi-full-time work, the rewards for working are increased for single parents and families. These in work tax credits combined child tax credit with an in work tax credit for the sole mother or couple.

These in-work benefits can phase-in when a minimum income level is reach such as with the Earned Income Tax Credit (EITC) in the USA, or a paid in full when a minimum number of hours are worked. The Working for Families in-work tax credit in New Zealand and the UK family tax credit are two examples where there is a large cash payment with no phasing-in:

  • Working for Families in New Zealand is paid if 30 hours are worked by New Zealand families or 20 hours are worked by sole parents; and
  • The British family tax credit was paid if 16 hours are worked, initially 24 hours per week.

Figure 1 shows the impact of the introduction of an in-work tax credit paid in full to families and sole parents if a minimum number of hours per week are worked by a family or sole parent. There is no phase-in region such as with the earned income tax credit (EITC) in the USA.

Figure 1: In work tax credits and labour supply

in-work tax credits and labour supply

The in-work tax credit phases-out after once the family’s income increases past an income threshold. This income threshold is usually linked to the number of children as well.

An in-work family tax credit linked to a high number of minimum number of hours worked provides an incentive for those not in work to increase their hours worked by a large amount and leave welfare, as is shown by arrow 1 in Figure 1.

For those already work, the income and substitution effect cut against each other and their net effect depend on the number of hours currently worked.

  • Those working a low number of hours, hours less per week than the minimum to qualify for the in-work tax-credit have an incentive to increase their hours to the minimum to qualify and leave welfare is shown by arrow 2 in Figure 1.
  • Arrows 3 and 4 in Figure 1 both represent reduction in hours worked.
  • Some workers can take-home more pay and work fewer hours per week or per year as shown by arrow 3.
  • Other high working hours worker can enjoy more leisure time at the expense of a slightly reduced take-home pay as shown by arrow 4.

The net labour supply effects of an in-work tax credit are therefore ambiguous because of these multiplicity of labour supply effects with some people working more another’s work in letters.

There will also be a bunching of hours worked at around the eligibility point for paying the in-work tax credit. The eligibility point is usually grouped around working a minimum of three or four days per week part or full-time that sum to 30 hours for families and 20 hours for sole parents.

Workers working less that the weekly working hour minimums will increase to the minimum to qualify for the family tax credit. Workers working more than the minimum required to qualify for the family tax credit might cut back to the working hours minimum because of the superior labour leisure trade-off. The number of people on welfare will fall because workers leave part and full benefit dependence to qualify for the in-work tax credit.

Whether labour supply on net actually increases or decreases depends on the relative numbers of individuals at different points on the budget constraint working full-time, not working and working part-time and on the magnitudes of their responses. Some will stay as they are working full-time, not working and working part-time.

To summarise, the static labour–leisure trade-off model of labour supply suggests that increases in either benefit abatement thresholds or a reduction in benefit abatement rates will increase the numbers entering the benefit and see none leave. No one will leave.

A hours worked per week based in-work tax credit will move people who are not working and working a low number of hours to work and into a higher number of work hours respectively, with bunching around the eligibility point. An in-work tax credit will also cause some to cut back their hours so the net labour supply effect is ambiguous.

The net fiscal cost of an in-work tax credit depends on the phase-in and phased out particulars of the tax credit programme and the increase in paid employment and the number of taxpaying workers as a result of the in-work tax credit. The Working for Families tax credits in New Zealand and the United Kingdom are famous for clustering of labour supply around the eligibility point for the in work tax credit.

single mum graphic

For example, in the UK, a lot of people used to work exactly 24 hours week. When the eligibility point was reduced to 16 per week, a new word had to be invented. This new word was mini-jobs to describe the large number of part-time workers in the UK who cut-back to exactly 16 hours per week. The family tax credit for workers is twice as generous in the UK as in New Zealand.

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3 thoughts on “Is welfare dependence optimal for whom – part 4: In-work tax credits and labour supply

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