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How (and how not) to tax wages

George Kerevan…on real wages, minimum wages, living wages and no wages at all.

As a rule, we (‘society’) tax stuff that we would prefer there is less of, or at least, we tax stuff in which we would like to see some moderation in consumption.

And vice versa.

So we tax consumption rather than capital, and do our damnedest to ensure taxes on income don’t blunt incentives.

Curiously, there is one exception to this rule – employment. In the UK we levy substantial, regressive taxes on both hiring and on taking a job. These taxes are called (erroneously) ‘national insurance’ taxes, though they are a straight levy on income and profits which goes straight to the Exchequer.

At best, employee NI contributions provide necessary revenues while keeping down the headline rate of income tax, so bamboozling the worker into thinking their incentive to perform has not been affected. Again, the employer’s NI contributions enrich the Treasury and help pay for an education system that supports industry. But the cost is levied regardless of business efficiency or worker productivity.

This raises the obvious question: why not reform the tax system to encourage hiring? 

Chancellor Osborne is already on the case. His March budget introduced a significant incentive: an employment allowance that removes the first £2,000 off employers' NI contributions. Osborne called this move “the largest tax cut in the budget”. It will cost almost £6bn over five years, and in theory means that a third of all employers in the UK will pay "no jobs tax at all", according to the Chancellor.

(Note: this is £2,000 off the total employer’s bill – not for each worker.  Thus if you are setting up your own business, you can hire your first employee on £22,000, or four people on the minimum wage, and pay no employer NI contribution. The measure should prevent 450,000 SMEs from paying any employer NI at all.)

Credit where credit is due, this reform has had scant media attention. However, what chancellors give with one hand, they have a habit of snatching back surreptitiously with the other.

The NI allowance does not come into effect till next year, so there is no great urgency behind the reform. Also, the 2013 budget cut corporation tax for big companies but not for SMEs. By 2015, there will be a common rate of corporation tax for all firms regardless of size, for the first time since 1973. That effectively shifts the relative burden of corporation tax on to the SME sector.

It is also worth remembering that previous Treasury attempts to vary NI as a hiring incentive have backfired spectacularly. In 2010, the new Coalition Government introduced a plan for a ‘holiday’ in employer NI for SMEs in a number of specified regions, who took on ‘new labour’. Chancellor Osborne claimed that 400,000 businesses would benefit. Unfortunately, each firm had to apply for the reduction and the application process – surprise, surprise! – proved complicated and onerous. Result: far fewer businesses applied than had been anticipated.

So the general media and business silence that has followed the March announcement of the NI change may suggest it is a reform that has still to prove its worth

Not to be outdone, the Labour opposition has also come up with labour market incentives. Firms that pay staff the so-called living wage (£7.45p per hour) will be given a tax rebate of up to £1,000 for every worker by the next Labour government – though only for 12 months.

This will be funded from savings made in tax credits and benefit payments (lower because more people would be lifted out of in-work welfare) and …the extra National Insurance revenues received by the Treasury!

I do think low wages are a drag on consumption and produce costly social ills that have to be picked up by the taxpayer. However, Labour’s plan seems a bit gimmicky and too complicated to produce substantial benefits, though it is a good election wheeze. It could also have unexpected consequences: employers are likely to stop giving salary increases to workers on the minimum wage in the year before the election, knowing they could get it all rebated by the taxpayer.

Interestingly, a recent study by the Federation of Small Businesses has indicated that fully 29 per cent of its members intend to use the Chancellor’s new £2,000 NI employment allowance to give a pay rise to their employees. In other words, the cut in employer NI actually benefited wages directly.

This finding suggests a different model of wage and labour market reform: namely, formally linking progressive cuts in employer NI to wage increases. Higher wages both incentivise workers and reduce the Treasury bill for tax credits and in-work welfare payments. Banding the NI cuts would ensure the Treasury does not lose out from unnecessary cuts in NI from higher-paid workers.   

One obvious problem in implementing such a strategy is that (thanks to the Lib Dems) lower-paid workers are increasingly exempt from paying any income tax. Indeed, Nick Clegg now wants to raise the income tax threshold to £10,500. Meaning, of course, that raising the wages of the low paid does not benefit the Exchequer.

Personally, I’ve always been leery of exempting the low paid from any income tax, on the moral ground that each and every working citizen should bear some responsibility for paying for the upkeep of the community. Also, it is much better to let the tax burden fall (to an extent) on incomes rather than penalise the working poor by clawing lost income tax through high VAT or NI contributions.

Differentiating between the minimum wage and a ‘living’ wage is a form of political sophistry. If the minimum wage is too low to live off, then have the Balls (capital intended) to raise it. However, there is a problem in doing this.  Because real incomes have declined sharply since 2009, the adult minimum wage rate is now at its highest ever level relative to average earnings. That could act as a disincentive on employers to hire, especially as low wage jobs are the least productive in a conventional sense.

There’s also the fact that a disproportionate number of low wage jobs are in the public sector – and there’s no way Ed Balls wants to up the public sector pay bill!

That said, I incline to raising the minimum wage progressively (I’m a fan of signalling) while cutting employer NI, and adjusting income tax to recoup some of the NI cut. 

However, all this is tinkering compared with the existential (for capitalism) problem that wages as a share of national income are falling significantly.  The share of UK national income going to wages is now 5.5 percentage points lower than it was in the 1970s - a fall from 59.2 per cent to 53.7 per cent. This ‘wage gap’ is equivalent to around £85 billion in today’s prices. Just imagine if another £85 billion was injected into consumer spending?

Note: there is a countervailing argument that is worth examining. On the surface, growth in average earnings is falling behind growth in productivity, in the US and UK. That explains the falling share of wages in GDP. But if we track productivity against total compensation (including pensions and other benefits) and we also view it against the median wage not the average, then there seems to be no pronounced de-coupling over the long term - though it gets more visible after 1994.

(If you’re interested, see “Decoupling of Wage Growth and Productivity Growth – Myth and Reality”, by Joao Pessoa and John Van Reenan, Centre for Economic Performance, LSE.) 

What this means is that a greater share of GDP is being grabbed by the higher paid (the ‘salary-iat’) rather than by hedge fund capitalists, leaving the low paid and the younger generation at an increasing disadvantage. 

There is room for a lot of debate over the data here, but it means we should not be too quick to dismiss the notion that raising productivity is the best way of raising incomes. Equally, it means there is a stratum of workers in labour-intensive jobs, particularly in the public sector, where productivity can’t be raised (easily or at all) meaning their real incomes are effectively frozen.

Which brings us back to how we can use fiscal reforms to boost their real wages, without impairing labour market efficiency.