Government Policies Tackling Poverty (AQA A-Level Economics): Revision Notes

Government Policies Tackling Poverty

Introduction

Governments can use various policies to reduce poverty and influence the distribution of income and wealth in society. These policies work primarily through the tax and benefits system, which redistributes income from richer households to poorer ones. However, these interventions can have both intended and unintended consequences that affect work incentives, economic growth and poverty levels.

Poverty and the tax and benefits system

How taxes and benefits redistribute income

The tax and benefits system is the main tool governments use to make the distribution of income more equal. This system takes money from those with higher incomes through taxation and transfers it to those with lower incomes through welfare benefits. Making taxation more progressive and increasing welfare benefits can reduce poverty and inequality in the distribution of income, at least in the short term.

The five stages of income transformation

The tax and benefits system transforms household income through five distinct stages. Understanding these stages helps explain how government policy affects income distribution.

1. Original income

This is the starting point before any government intervention. Original income includes earnings from employment, private pensions, investment income (such as dividends from shares), and other non-government sources. This represents what households earn from market activities.

2. Gross income

Gross income equals original income plus cash benefits received from the government. Cash benefits include state pensions, unemployment benefits, and other direct payments to households. This stage shows the first government intervention to support household incomes.

3. Disposable income

Disposable income is what households have available to spend after paying direct taxes. Direct taxes include income tax, National Insurance contributions, and council tax. This is the income households can use for consumption and saving after the government has taken its share through direct taxation.

4. Post-tax income

Post-tax income accounts for the impact of indirect taxes on purchasing power. When households spend their disposable income, they pay indirect taxes such as VAT (Value Added Tax) and duties on petrol, alcohol and tobacco. Post-tax income equals disposable income minus these indirect taxes.

5. Final income

Final income is the most complete measure of household living standards. It equals post-tax income plus the value of benefits in kind provided by the government. Benefits in kind include services such as state education, healthcare through the NHS (National Health Service), and subsidised housing. These services increase household welfare even though no cash changes hands.

Universal benefits versus means-tested benefits

Government welfare benefits can be divided into two main categories: universal benefits and means-tested benefits. Understanding the difference between these is crucial for evaluating poverty reduction policies.

Universal benefits

Universal benefits are paid to all eligible people regardless of their household income. These benefits are based on entitlement rather than financial need. Examples include:

• National insurance benefits such as state pensions
• Universal benefits for specific groups (though these have been reduced over time)
• Winter fuel payment, which provides financial assistance for heating bills

Advantages of universal benefits:

• Simple to administer with low bureaucratic costs
• No stigma attached to claiming them
• Everyone who qualifies receives them automatically
• Encourages take-up as there are no complex forms to complete

Disadvantages of universal benefits:

• Taxpayers' money goes to people who do not need the benefit
• Less efficient use of government resources
• May need to be paid for by cutting benefits that go to those who genuinely need help

Some economists argue that rich pensioners who currently claim universal benefits should be 'nudged' or encouraged to opt out of receiving the benefit on the grounds they do not need it.

Means-tested benefits

Means-tested benefits depend on a person's income and circumstances. With means testing, people who need a benefit must prove their eligibility, particularly if they are poor or elderly. The benefit amount may be determined by income and other financial circumstances (their 'means'). Examples include:

• Housing Benefit
• Income Support
• Universal Credit (which is replacing several means-tested benefits)
• Free school meals (income-related)

Advantages of means-tested benefits:

• More efficient as taxpayers' money is less likely to go to people who do not need it
• Better targeting of resources to those in genuine need
• Prevents waste of government spending

Disadvantages of means-tested benefits:

• Complex and expensive to administer
• May discourage take-up due to stigma or pride
• Requires form-filling and proof of eligibility
• Can create unintended disincentive effects (poverty traps)
• May prevent low-waged workers from working harder
• May discourage unemployed people from seeking employment

Fiscal drag, poverty and low pay

What is fiscal drag?

Fiscal drag is an important concept that helps explain how poverty can increase even without deliberate policy changes. It occurs in a progressive income tax system when the government fails to raise tax thresholds (or personal tax allowances) to keep pace with inflation.

The diagram shows two income pyramids. In pyramid (a), before inflation, the person earning £9,900 is below the £10,000 threshold (shown by the green line) and pays no tax. In pyramid (b), after inflation has doubled incomes, the person now earns £19,800 but the threshold remains at £10,000. The person has been 'dragged' across the tax threshold and must now pay income tax, making them worse off in real terms.

Marginal tax rates

A key concept related to fiscal drag is the marginal tax rate. This is the tax rate levied on the last pound of income received. The term can be applied to income taxes or to the taxes a person or business pays.

Understanding marginal tax rates is crucial because they determine the incentive effects of taxation. If someone faces a very high marginal tax rate, they keep only a small portion of any additional income earned, which may discourage them from working harder or seeking promotion.

Recent UK government policy

In recent years, the Conservative government attempted to reduce relative poverty among the low-paid by raising income tax thresholds faster than inflation. The basic tax threshold was raised to £12,570 in 2022. These increases in the personal tax allowance (the income level at which people start paying tax) took a significant number of low-paid workers out of the income tax net entirely. This helped 'claw back' some of the fiscal drag that had occurred in earlier years.

The earnings trap or poverty trap

Understanding the poverty trap

Fiscal drag contributes to the existence of the poverty trap. However, there are multiple ways in which poor people can become trapped in poverty. One particular mechanism, which traps the low-waged in relative poverty, is better described as the 'earnings trap'. This trap affects people in employment on low rates of pay, distinct from the unemployment trap which affects unwaged people.

The immediate cause of the earnings trap is the overlap between the income tax threshold and the means-tested benefits ceiling. This overlap is illustrated in the diagram below.

The poverty trap diagram shows an income pyramid with three layers:

• The rich at the top (purple triangle)
• A middle zone of overlap (beige section)
• The poor at the bottom (yellow trapezoid)

Two horizontal lines cross the pyramid:

• The income tax threshold (the level of income at which income tax starts to be paid)
• The means-tested benefits ceiling (the level of income at which means-tested benefits cease to be paid)

How the earnings trap works

When welfare benefits are means-tested, a person's right to claim the benefit is reduced and eventually tapers away or disappears completely as income rises. By contrast, a universal benefit is claimed as of right and does not depend on income, although the government may decide to 'claw back' universal benefits by making them taxable.

Low-paid workers caught within the zone of overlap face a particularly difficult situation. They must:

• Pay income tax and National Insurance contributions on each extra pound earned
• Lose part or all of their right to claim means-tested benefits

This creates an extremely high effective marginal tax rate. Thus, low-paid workers and their families whose income falls within this zone of overlap become trapped in relative poverty. Any increase in their pay results in little or no increase (and in extreme cases, even a fall) in their disposable income.

Effective marginal tax rates

Solutions to the poverty trap

The poverty trap could be eliminated by removing the zone of overlap in the income pyramid. Several policy options exist:

1. Raise the income tax threshold

Taking low-waged households out of the income tax net entirely would help, but this is expensive for government finances.

2. Replace means-tested benefits with universal benefits

This would remove the problem of benefits being withdrawn as income rises. However, it is unlikely to happen because:

• Universal benefits are very expensive to provide
• Money must also go to people who do not need support
• Government budgets are constrained

3. Raise the National Living Wage

Raising the NLW to a higher rate might reduce poverty. However, this could be counterproductive if unemployment increases as a result. When the NLW was introduced, the Conservative government acknowledged it might lead to a loss of 60,000 jobs. A higher NLW rate could lead to even more job losses, though the government argued that continuing economic growth would create many more jobs to compensate.

4. Use behavioural economics 'nudges'

Some economists suggest using insights from behavioural economics to 'nudge' rich pensioners to opt out of claiming universal benefits they do not need. This could free up resources for means-tested benefits.

Working poverty data

Data shows that poverty affects people in work as well as the unemployed. The number of workers in poverty increased from around 3 million in 2008/09 to approximately 3.8 million in 2016/17.

The stacked bar chart shows workers in poverty by employment type from 2008/09 to 2016/17. The data reveals:

• Full-time employed workers (purple, top section) form the largest group in poverty
• Full-time self-employed workers (green, middle section) also experience poverty
• Part-time employed or self-employed workers (pink, bottom section) make up a significant portion

The unemployment trap

Difference from the poverty trap

It is important not to confuse the poverty trap (or earnings trap) with the unemployment trap. While related, they affect different groups:

• Poverty trap: Affects people in employment on low rates of pay
• Unemployment trap: Affects people who are unwaged and out of work

How the unemployment trap works

The unemployment trap contains unwaged social security claimants who choose unemployment. These are people who decide they are better off out of work, living on benefits rather than working in low-paid jobs that pay income tax and National Insurance contributions. They also lose some or all of their right to claim means-tested benefits when they take work.

People caught in the unemployment trap are not officially in employment – at least in terms of officially declared work. They have chosen unemployment as their declared status.

Link to the underground economy

Case study: Universal Credit and the cliff edge problem

Background to Universal Credit

When Universal Credit was announced in 2013, the UK government argued that changes to the tax and benefits system would reduce penalties on almost 2 million low earners. However, a report by the Joseph Rowntree Foundation suggested that many households would struggle to deal with a more complex benefits system than before. The report stated that while 'making work pay' was the key aim of Universal Credit, many households risked being worse off in work and struggling to manage their finances.

The government claimed that in monetary terms, 3.1 million households would be entitled to more benefits as a result of Universal Credit's introduction, while 2.8 million would be entitled to less.

The free school meals cliff edge

One of the principal goals of Universal Credit was to ensure that additional earnings would always leave families better off and to avoid 'cliff edges' in incomes. However, the government's own White Paper acknowledged that Universal Credit created new cliff edges.

The diagram shows effective earnings after deductions and school meal costs. Key points:

• Families earning below the £7,400 threshold receive free school meals
• When a family crosses this threshold, they lose free school meals worth £1,311 annually (for three children)
• The family must increase earnings by an additional £3,543 (to £10,943 total) to recoup the cost of meals
• Due to the Universal Credit taper rate (families retain only 37p for each £1 earned above the threshold), there is a significant cliff edge

Evaluation of Universal Credit

Universal Credit demonstrates how well-intentioned government policies can have unintended consequences. While designed to:

• Simplify the benefits system
• Ensure work always pays
• Remove disincentives to employment

In practice, it has:

• Created new cliff edges that increase poverty
• Placed more families in the poverty trap
• Generated complex IT problems delaying implementation
• Left some families worse off despite working

Other government policies

Workplace pension schemes

Governments can use insights from behavioural economics to design policies that help reduce poverty. One example is automatic enrolment in workplace pension schemes.

The problem

Before automatic enrolment, many workers, particularly low-paid and young workers, did not join private pension schemes. This occurred for two main reasons:

1. Immediate costs outweighed future benefits: Contributing to a pension meant having less income to spend on everyday living expenses. Many low-paid workers felt they could not afford to save, preferring to "live now, pay later" rather than "save now and spend later".

2. Lethargy and inertia: Private pension schemes were often based on 'opt-in' principles. Few workers bothered to join because it required effort and initiative to sign up.

The solution: automatic enrolment

Drawing on behavioural economics insights, the UK government introduced automatic enrolment between 2012 and 2018. Under this system:

• Workers are automatically enrolled in workplace pension schemes
• Employers must contribute to the scheme
• The government adds tax relief
• Workers can opt out if they choose

This 'opt-out' rather than 'opt-in' system uses a behavioural 'nudge'. Most workers do not opt out, partly due to lethargy, but also because opting out means losing employers' contributions.

The consequences of government policies affecting poverty

Government policies to tackle poverty and influence income distribution have various consequences, both intended and unintended:

Positive consequences

Reduced inequality: Redistributive policies through progressive taxation and welfare benefits make the distributions of income and wealth more equal. This reduces relative poverty. Many argue such policies are equitable (fair) as they help those most in need.

Alleviating specific poverty types: Redistributive policies can help alleviate:

• Child poverty
• Old-age poverty
• Fuel poverty

However, these aims have often been only partially achieved. Poverty among these groups persists despite government intervention.

Economic growth as a poverty reducer: Arguably, faster economic growth provides the main avenue for reducing absolute poverty, and perhaps also relative poverty. A growing economy creates more jobs, raises incomes, and generates tax revenue that can fund anti-poverty programs.

Negative consequences and trade-offs

Disincentive effects: Redistributive policies may have adverse unintended consequences by reducing incentives to:

• Work hard
• Be entrepreneurial
• Be competitive

Poverty and unemployment traps: Some fiscal measures used to reduce poverty and narrow inequalities in income distribution have resulted in the development of poverty traps and unemployment traps. These traps can:

• Discourage people from working harder
• Discourage people from seeking employment
• Keep people trapped in poverty
• Reduce overall economic efficiency

The need for balance: Policymakers must balance the goal of reducing poverty and inequality against the potential costs of:

• Reduced work incentives
• Slower economic growth
• Lower competitiveness
• Government failure

Different economic perspectives