Why tax credits can be the wrong type of incentive


November 23, 2015 by Paul Goldsmith


Tax credits can remove the incentive to improve your skills and productivity so you earn a higher wage on your own merits. A long term ‘higher wage, lower welfare’ economy should thus cut tax credits. 

First of all – read the whole of this before you make a judgement. I owe this blog to three students in one of my Politics classes. I challenged the class to help me find an argument for the tax credit cuts that George Osborne has been proposing. I was frustrated that my attempt to always present a politically balanced view of every issue was not possible on the issue of tax credits as I just couldn’t think of a proper argument for them (but I have thought of many arguments against – click here to read). Then the three students spoke up and between them gave me this thought – tax credits can be the wrong sort of incentive.

So here’s how the argument goes. I have been saying that tax credits give people who are on low incomes an incentive to not live off benefits and to work instead, as even though they might earn low wages their incomes get bumped up by the government to a level they can live off. They are part of a coordinated strategy to “make work pay” – put together a higher minimum wage, a higher minimum income tax threshold – the amount you earn before you pay tax and add tax credits and someone earning a small wage can put food on the table. So, I thought it was a no-brainer to say that tax credits provided an important incentive to work and they shouldn’t be lowered because the recipients might as well live on benefits.

I had banged on about this for a few weeks and then finally three students spoke up. What they said and did was a fine example of the “judo debating” technique I had always said could be most effective in winning an argument. They took my argument’s biggest strength – that tax credits provide an incentive to work, and turned it into a weakness – pointing out that tax credits also provide an incentive not to improve your productivity.

To understand the significance of this point – I should explain a little bit of Labour market economics: To employ a new worker, a company thinks about the additional revenue (money) that worker will bring into the company. This is a mixture of their productivity (how many units they can make/sell) and the price those units can be sold at. The economic concept here is ‘marginal revenue productivity’ (MRP) – which is the additional revenue to the company of hiring an extra worker. Put simply, if MRP of that worker is higher than the wage, a company should hire them – if it isn’t, they shouldn’t. In some professions, the MRP could be represented by the quality of the work they do, but the concept remains the same.

What tax credits do is to take the worker’s marginal revenue productivity out of the equation when a firm hires a worker. Tax credits mean that a firm can pay minimum wage to the worker as they know a government will top up that pay with tax credits, regardless of the worker’s productivity. Lowering tax credits removes that safety net for firms but in turn it also lowers the safety net for workers – which, until my students spoke up, I thought was an economically nonsensical policy.

But, think about what tax credits say to many workers. They say that whatever your productivity, however hard you work in your hours employed, whatever skills you have, you can get a certain minimum income. The reality of economics is that if you want to get a higher wage, you should increase your MRP. Take a training course, increase your skills, work out how to do your job better. But if doing that doesn’t change your income, because of tax credits, then why do it? We are, after all, dealing with humans here, and humans are generally motivated by certain incentives.

This is why, and the Tories have been terrible at explaining this, if they want a ‘high wage, low welfare’ economy, it possibly DOES make sense to raise the minimum wage (which could also force companies to invest in training workers as well as they will want them to be more productive) AND to cut tax credits (incentivizing the workers to improve their productivity so they can get paid a higher wage).

This point makes economic sense. It is difficult in this political environment to explain it, and I certainly think that raising Aid by £3.5bn by raiding the incomes of the working poor because you have ringfenced so many areas of spending whilst committing to producing a budget surplus was politically naive. BUT, it does make economic sense.

What do you think?



3 thoughts on “Why tax credits can be the wrong type of incentive

  1. Tristan Pahl says:

    I do understand your point about extra investment in training that could happen, raising the productivity and wages of low-wage workers. Is there a limit to the extent to which this is true?ie would the ultimate repeal of tax credits make economic sense( despite possible political suicide). Despite voting against the introduction of a minimum wage because it might be higher than the MRP for some workers, the then Shadow Chancellor Michael Portillo explicitly stated that the next Conservative government would not repeal it. My question is and I respect that you went out of your way to represent the other side, what economic effect do tax credits have on those people who don’t claim them( at the lower and middle end of the income spectrum).


  2. kirstwrites says:

    I think this is really interesting and a well thought out post, but it raises a couple of questions for me. How do you define productivity? It’s easy enough in a shop or factory (make more stuff, sell more things) but if you’re a teaching assistant or care worker or any other job which is about the quality of human interaction rather than making money, how do you measure it or increase it? Secondly, what about the many people for whom “increasing their productivity” simply isn’t an option (because they are ill or have learning difficulties or caring responsibilities and are already working at the best of their abilities) or if they were able to increase their productivity it wouldn’t bring about a pay rise because of the nature of their job? Thirdly – and this is not an economic point, merely a human observation – talking about taking away money as an incentive to make people more productive feels a bit dehumanising, like the working poor are nothing more than lab rats in an economic experiment. I’m not saying that’s what you believe personally, but it’s something that’s always troubled me about purely ‘economic’ arguments. Sorry. Rant over!


  3. swiveleyed says:

    The vast majority of jobs that are affected by the tax credit cuts are not going to see pay rises that offset or beat what they will lose, no matter how productive they are. We are mostly talking about the lowest skilled jobs in the economy. Current immigration levels ensure a steady stream of available labour for these roles. No company is going to introduce pay rises for these jobs whilst that’s the case.

    I was fervently in favour of slashing the welfare bill in 2010 that’s why the Tories got my vote, to their credit its the one thing they did stick to. But the idea of tax credits is to promote work over pure benefits. Tax Credit cuts are a step too far, I strongly believe its counter productive.

    We need to start looking at other revenue. Looking at the tax avoidance of corporates would be a good start.


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