In yesterday's post, I referred to New Zealand's tax and transfer system, and its impact on inequality. One aspect I didn't refer to was the incentive effects of the system. These incentive effects are bound up in the effective marginal tax rate (EMTR), which is the amount of the next dollar of income a taxpayer earns that would be lost to taxation, decreases in rebates or subsidies, and decreases in government transfers (such as benefits, allowances, pensions, etc.) or other entitlements. A high EMTR creates a disincentive to earn more.
This is beautifully illustrated by this Financial Times article from March this year (paywalled):
How could a £1 pay rise leave you tens of thousands of pounds worse off? The answer is the childcare cliff edge in the UK tax system, which will get considerably steeper for higher-earning families from September.
The government’s expansion of free childcare provision in England this autumn means that working families with children aged under three will be able to claim 30 hours of government-funded childcare a week on top of the tax-free childcare scheme. Valuable benefits, but the bulk of this entitlement is lost if one parent’s adjusted net income is more than £100,000 per year.
In other words, earning more than £100,000 per year leads to a high EMTR. This is shown in the following figure from the article:
Notice how income after childcare expenses decreases markedly at £100,000 per year, and doesn't get back to the same level until income rises to nearly £150,000 per year. This creates a lot of negative incentives. The article gives several examples, one of which is:
Rob* works in tech. Since his daughter was born five years ago, he has turned down two promotions that would have taken his pay over £100,000 as he could not negotiate a high enough pay rise to compensate for the loss of childcare hours. Eventually, he quit his job and became a contractor. “This is riskier, but my earnings have jumped to the point where it is worth it,” he says. “My wife and I have decided to have no more children to maintain the quality of life we have with the one.”
The high EMTR causes people to avoid being promoted or take pay rises, to work less, change jobs, make riskier decisions, and avoid having more children. And all of that from a single example of one taxpayer.
The dumb thing is that this is not a new problem. The article notes that this threshold has been in place since 2017! That's more than long enough for the government to notice the negative incentive effects. The reason it has come to media attention now is that the threshold hasn't been changed in some time, and more and more families are being affected.
Governments need to be very cautious in setting up the tax and transfer system. While the system does generally reduce inequality, as yesterday's post showed for New Zealand, it can nevertheless create unintended consequences. Governments typically want people to work more and receive less assistance from the government. However, high EMTRs can create traps that keep people working less. The UK's childcare tax trap is unfortunately not unique in this.
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