Rationale on Tax Reforms and Benefit System Undertaken since Labour Come to Power in 1997 - Research Paper Example

Rationale on Tax Reforms and Benefit System undertaken since Labour come to power in 1997 Table of Contents I. Introduction ………………………………………………………… 3 II. Changes in Tax Reform and Benefit System ………………………. 5 a. Raising the Living Standards of the Lowest-Income Households ………………………………………………….. 5 b. Income-Leisure Choice Theory …………………………….. 8 c. Tax Credit …………………………………………………… 10 d. National Minimum Wage …………………………………… 11 e. Taxes in UK ……………………………….…………………. 11 III. Conclusion ………………………………………………………….. 15 References …………………………………………………………………… 16 Short Introduction Under the leadership of Tony Blair, the ‘labour party’i in UK won in the 1997 general election since its last victory in October 1974.1 The labour party shifted to describing itself as a party of democratic socialism from its original trade union movement and socialist political parties of the 19th century. Under the leadership of Blair, ‘thatcherite’ii policy was adopted by the labour party. Because of the continuous failure in the general elections of 1979, 1983, 1987 and 1992, the Labour Party observers began describing the labour party as ‘social democratic’iii or ‘neo-liberal’iv more than a democratic socialist. Blair’s described the new labour party’s political position as a ‘Third Way.’v Since the May 1997 general election, tax reforms were very active. The restructuring of taxes and benefit systems were implemented for the benefit of the lower income UK citizens including those who are employed. The Labour government uses the IFS tax and benefit model (TAXBEN) in assessing the impact of reforms that will be directly assigned to individual households.2 (See Table 1 on page 4) Changes in Tax Reform and Benefit System Raising the Living Standards of the Lowest-Income Households The UK government aims to increase the living standards of the lowest-income households by increasing the benefit levels for those who are unemployed and to introduce the working families’ tax credit in those that are employed. On the other hand, those families who belong to the top decile will be associated with an increase in the national insurance taxes while taking away the mortgage tax relief and married couple’s allowances. (See Graph 1 below; Table 2 on page 6) Figure 1 - Distributional Impact of Major Fiscal Reforms - Announced since July 1997 by Decile -     11           9                 7                   5                       3                                         1                                                                                 -2                                                         Poorest Decile 2 Decile 3 Decile 4 Decile 5 Decile 6 Decile 7 Decile 8 Decile 9 Richest   Sources: Institute of Fiscal Studies (IFS), 2000 Table 2 - Changes in post-tax incomes within deciles       Percentage of households within a given decile whose income changes by: Total   –£10 or more –£9.99 to –£1 –£0.99 to £1 £1.01 to £10 Over £10 Poorest 2.90% 23.30% 16.00% 27.00% 30.80% 100.00% Decile 2 2.00% 17.30% 12.10% 32.10% 36.50% 100.00% Decile 3 2.90% 16.20% 9.60% 45.20% 26.20% 100.00% Decile 4 3.20% 18.10% 7.90% 52.30% 18.50% 100.00% Decile 5 4.40% 24.20% 10.60% 46.70% 14.20% 100.00% Decile 6 5.00% 23.30% 9.70% 51.50% 10.60% 100.00% Decile 7 8.70% 29.20% 10.10% 44.30% 7.70% 100.00% Decile 8 8.20% 34.60% 8.90% 42.90% 5.50% 100.00% Decile 9 12.30% 36.90% 8.50% 38.70% 3.60% 100.00% Richest 20.10% 49.30% 8.60% 20.40% 1.70% 100.00% Source: IFS, 2000           The specified tax rate was actually based on the level of income each family is earning, the type of family – whether the couple has kids, or is a single parent, or never been married, etc. The tax rate distribution according to decile is very beneficial to the UK unemployed citizens. This concept of tax rate actually narrows down the gap on unequal distribution of wealth among the people residing in UK. It actually releases the tax burden on those who belongs to the lower income earning families. For example, Cathy is earning £5,000 a month working as a manager in a five-star hotel while Cindy earns only around £500 working on a part-time job as a waitress because she is taking care of her child as a single mother in the morning. Assuming that the government issues a fixed tax rate of 10% per month, Cathy and Cindy will be earning £4,500 [£5,000 - (£5,000 x 10%)] and £450 [£500 - (£500 x 10%)] respectively. In this situation, Cindy will have a serious problem raising her child with such a limited income per month. Let us take a look given that the tax rate for each individual is bracketed depending on the amount of income each individual or family is earning in a month. For example, the tax rate for those individuals earning more than £5,000 a month is 10% while the tax rate for those earning £500 and less is only 2.5%. Considering the examples on earning income we have mentioned above, Cathy and Cindy will be earning £4,500 [£5,000 - (£5,000 x 10%)] and £487.50 [£500 - (£500 x 2.5%)] respectively. The nominal value Cathy paid for tax is £500 while Cindy paid only £12.50. It means that this type of tax method is more beneficial for those who belong to the lower income class. (See Figure 2 – Tax Effects below) The point of equilibrium (Qe and Pe) is the point where the supply and demand curve meets. In this graph, it shows that the more goods a person buy, or more salary a person earns, the amount of tax charged to the person will also be higher than those who earns less. Also, this type of taxation scheme follows the free-market.3 It is not dictated by the government as to how much tax each individual should pay. It merely depends on the amount of salary each person earns in a given period of time. (See Figure 3 – Free Market below) This chart represents anything in a free market. For instance, the price of a computer is dictated by the supply of computers. Whatever profit is earned from selling those computers will be the basis on how much tax each UK citizens are obliged to pay. Income-Leisure Choice Theory There is a wide leisure gap between the high-skilled and low-skilled workers.4 Over time, the leisure gap is growing bigger than before. Back in 1960s when there is less competition in the market, the leisure time between people who belong to the same age bracket, sex and family size are almost the same. Socioeconomic status was never a factor which contributes to the gap on time for leisure and sources of income. Today, unemployment is the major cause of widening the gap between the income distribution and the available leisure time. Also, the increased standard of living is causing many people to work over time just to cover their daily expenses. For those who are working, they tend to spend more time at work that relaxing, going to parities / bars, reading the newspaper, surfing the web, or even visiting friends. Demographic changes also affect the income-leisure of each individual. The more children married couple has, the more time they spend working to sustain their daily expenses. Educational attainment is also a factor. The more educated a person is, the higher the chances that he/she is going to get a job. Because of the competition in the market, those who are less educated are the ones who are left behind in terms of job searching. Income and leisure should always be balanced in order to have a healthy life since our happiness would depends partly on the salary we get from working and the time we spend with our loved ones, watching our favorite TV shows, or even doing our hobbies. For example, let us compare the difference between earning £5 and £10 per hour.5 Assuming that Jeffrey is working for £5 per hour and Benjie for £10 per hour, if both are expected to work for 12 hours per week, how income would Jeffrey and Benjie receive each week? Jeffrey and Benjie should receive £60 [12 hours per week X £5 per hour] and £120 [12 hours per week / £10 per hour] each week respectively. The time outside work will then be used for leisure. (See Figure 4 – Income and Leisure below) This curve above shows that as wage rises, the number of hours spent on working decreases. This gives an individual more time spent on leisure. Redistributive taxation such as the one that UK have since 1997 (taxation based on Decile) is one example which can balance the income-leisure time in each individual. To those belonging to the poorest of the poor or is earning minimal wage, paying tax based on decile will not hurt their pocket more than what fixed income taxes can do. Tax Credit Back in 1971, tax credit in UK is known as the Family Income Supplement (FIS) to address family financial problems especially the single parents. FIS is payable to families with a dependent child with parents working at least 30 hours a week; 24 hours a week for single parent. FIS lasted until 1988 and was changed to Family Credit (FC) – a more generous version of FIS by reducing the required number of working hours per week. FC remained until 1999 when it was changed into Working Families Tax Credit (WFTC).6 The Working Family Tax Credit (WFTC) was redesigned in a way that it draws a distinctive line between the working support and non-working support. Under WFTC, the working group will be rewarded while the non-working group will be supported. Based on the IRS internal analysis including some external research shows that WFTC did help make work pay. 6 Back in April 1999, a family with one child working for 35 hours a week is equivalent to a guarantee income of £182 per week. In October 2004, £182 per week was increased up to £252 per week. Whereas a family with one child working for 16 hours receives a guarantee income of £136 per week and was increased up to £195 per week in October 2004. This system is successful in helping people by motivating them to work. At the same time, the system is also helping those working parents with children to help fight child poverty. National Minimum Wage In May 1997, the new Labour Government introduced a new legislation on the National Minimum Wage.7 The National Minimum Wage is beneficial to all workers. It acts as a protection against business people who hires workers way below the minimum level needed in order to survive. The government has the right to increase the National minimum wage depending on the economic status of the country. In October 2004, due to the continuous increase in the prices of goods and the purchasing power of pounds, the UK government decided to increase the national minimum wage rates up to 8%. In the adult wage rate, the increase was made from £4.50 to £4.85; while the wage rate for the young adults under the age bracket of 18 to 21 y/o from £3.80 to £4.10.8 Without the National Minimum Wage, the UK workforce will be exploited by the advantageous business people. Without the wage protection, the workforce will be exploited which result to the decrease in the national production output because of unmotivated workforce. Indirectly, without the National Minimum Wage protection, the UK economy will suffer. Taxes in UK In UK Labour governments since 1997; the government deficit was kept under control until 2004 when the government decided to follow the Chancellor’s ‘golden rules.’ The Chancellor’s golden rule states that the budget should be balanced throughout the whole economic cycle and that borrowing should be used only to finance capital spending.9 It means the budget does not cover the current gaps between current spending and tax revenues. (See Figure 4 – Yields on Government Bonds and the UK Budget Balance below; Figure 5 – UK Government Fiscal Balance on page 10) Notice that the budget balance of UK has been negative since 2002. So far, there is still no evidence that the country’s budget decifit would improve. The pension and unemployment benefit that United Kingdom government being offered to the UK citizens is limited.10 The state pension scheme is being financed mainly through tax and national insurance contributions. The real level of benefits for the pension scheme is declining since the Conservative government untied annual increases in pension levels from the growth of earnings each year and pegged them to price inflation. Lowering the external tariffs in UK combined with a low spending and tax levels plus a more flexible labour market makes the country able to cope with the increasing global competition.11 Reducing the public spending and making the labour force more flexible is one of UK’s strategies in balancing the government funds despite the new tax reform and benefit system the country is using. The unemployment benefits have been cut down as well while the pensions are being delayed until such time these people are much older to work. Financial deficit should be financed every day. In many cases, new government debt is the main cause of financial deficit. Sometimes, overseas investors can also be a factor of a deficit. It is inevitable for a country to not to have a budget deficit. Even the most highly developed country has a financial deficit. The only difference is how much the deficit is. It is a rule that a bigger government financial deficit would also means loaning some money from the central bank at a higher interest rates in case when emergency arises. The government financial deficit has something to do with taxation. In case the country’s deficit growths up to a certain degree, the government can take the option of get money from the local citizens through taxing the businesses and households. Another option the government can take is to cut down on government spending in order to balance the government funds with the budget deficit. This is actually what UK government is doing right now. (See Figure 6 – UK Government Spending and Taxation below) The chart above shows the 2005 government spending of UK versus the total tax the country has been receiving from the people. The possible factor that affects the low level of UK’s total tax return is because of the slow growth in UK’s economy right now. This is mainly because of the globalization. United Kingdom is an open country. Therefore, its economy is also greatly affected by the demand or supply shock coming from other countries. Conclusion Since 1997, there are a lot of factors which affects the tax and benefit system in UK. Despite the slow economic growth in UK, the country still manages to keep its unemployment rate low by proving the unemployed with employment benefits while searching for a potential job. Once an individual has found a job, UK government could start taxing these people. The taxation based on decile is a good option since the new tax reform and benefit system is designed to unload some tax burden to individuals who does not even have a job due to the present economic condition. It is important to consider that not all the people who are unemployed; are not looking for employment. Not all unemployed people are uneducated or personally do not want to look for a job. Issues such as globalization, tight competition and economic down trend should be considered. Taxation based on decile also has an impact in balancing the income-leisure choice. Those people belonging to the minimum or lower income level need not work double time and pay a fixed tax in order to survive. The National Minimum Wage also protects the lower-income earners from abusive employers. Factors such as globalization, tight competition in the market; and others has contributed to the negative financial deficit of UK government. It is also a good thing that despite the fact that the UK government’s fiscal policy is on a negative side, the government still manage to keep a low unemployment rate. It is a positive point that the government could maintain a low level of government spending during the past few years. If not, there is a possibility that this type of financial issues could be transferred to the UK citizens via taxation. *** End *** References: 1 Wikipedia Encyclopedia (2007) ‘Labour Party’ Retrieved: March 26, 2007 < http://en.wikipedia.org/ > 2 Myck, M. (2002) ‘Fiscal Reforms Since May 1997’ Institute for Fiscal Studies October 2002. Briefing Note No. 14. ISBN 1-903274-15-X. Retrieved: March 26, 2007 < http://www.ifs.org.uk/ > 3 Wikipedia Encyclopedia (2007) ‘Tax’ Retrieved: March 26, 2007 < http://en.wikipedia.org/ > 4 Landsburg, S. (2007) ‘The Theory of the Leisure Class – An Economic Mystery: Why Do the Poor seem to have More Free Time than the Rich?’ Posted: March 9, 2007 on slate Retrieved: March 27, 2007 < http://www.slate.com/ > 5 Friedman, D. ‘Chapter 5: Production’ Retrieved: March 27, 2007 < http://www.daviddfriedman.com/ > 6 Hussain, M. (2004) ‘Tax Credits: The UK Perspective’ IRS Retrieved: March 27, 2007 < http://www.irs.gov/ > 7 DTI (2007) ‘History of National Minimum Wage’ Retrieved: March 27, 2007 < http://www.dti.gov.uk/ > 8 HRM Guide (2007) ‘National Minimum Wage Increase’ Retrieved: March 27, 2007 < http://www.hrmguide.co.uk/ > 9 IFS Press Release (2007) ‘IFS Green Budget 2007’ Dated: 31st January 2007 Retrieved: March 26, 2007 < http://www.ifs.org.uk/ > 10 Flynn, N. ‘Social Policy, Fiscal Problems & Economic Performance in France, United Kingdom & Germany’ Department of Financial & Management Studies, University of London. Retrieved: March 26, 2007 < http://www.cefims.ac.uk/ > 11 A2 Macroeconomics / International Economy: Fiscal Policy Effects’ tutor2u Retrieved: March 26, 2007 < http://www.tutor2u.net/ > Read More