The fairness testMarch 2011
Fairness is at the heart of this Parliament's policy debate. In May the Coalition Government defined fairness as one of its three core values (together with freedom and responsibility). In October the Coalition based the Spending Review on reform, growth and fairness. The Leader of the Opposition, Ed Miliband, has also rooted his economic arguments on fairness (specifically "unfairness" towards "middle and low incomes").
Fairness is a difficult concept to define. It is often based on economic ideas that are difficult (if not impossible) to define, such as individual aversion to income inequality and marginal utility of income. It is also limited by the quality of the available data. For this reason policy proposals based on fairness need close examination.
This Reform report finds a number of key arguments on fairness have been presented since May 2010. Some arguments seek to punish particular groups or ideas in the name of fairness; others seek to help groups in particular disadvantage. This report presents evidence on each.
1. Target top earners. Ed Miliband has spoken of a "fairness divide" between "the richest at the top who have been doing well" and the "majority - lower and middle-income." Coalition politicians have spoken in similar terms and campaigns are running to limit top rates of pay.
But this does not take account of the wider economic effects of high (productive) pay. This report presents new analysis. For example, the immediate effect of a maximum income cap of £1 million per year would be to reduce inequality. The Gini coefficient would fall from around 38 per cent to 32 per cent, i.e., back to the level of the mid-1980s. But tax revenues would fall (based on a static analysis) by £7 billion per year, equivalent to an increase in the basic rate of income tax of over 1p in the pound.
High pay is not a problem per se. The problem is when high pay does not reflect productivity. Rather than simply clamping down on high pay reform should focus on ensuring that governance and accountability structures ensure high pay reflects high productivity.
2. Help the "squeezed middle." Concern has been expressed that middle income families' living standards could fall over the next few years. But these concerns over the squeezed middle are often so broad that, in practice, they would prevent any economic adjustment at all. In reality many families' real incomes should fall as the economy adjusts to a more sustainable level of consumption and debt.
Many families' living standards were artificially inflated by high levels of debt and poor quality government spending. Poor government spending was of little benefit to middle income families because, as Reform research has shown, the increase in this spending was largely matched by increasing tax burdens. These families were on a wasteful money-go-round that led to the welfare system losing sight of its priorities, with data from the British Social Attitudes Survey showing that as this spending increased support for out of work benefits fell.
Unsustainably high levels of debt and the money-go-round meant that the economy was particularly vulnerable when the global financial crisis hit. Inflating incomes through borrowing (for consumption) is a short sighted way to increase living standards. The "borrow now, pay later" culture must end with belt tightening.
3. Cut taxes for low earners. One of the Coalition's key policies to help low earners is to increase the income tax threshold to £10,000. But this report presents new evidence that of the £14.2 billion reduction in tax from this policy, £13.2 billion would go to people above the £10,000 threshold. The policy would encourage tax avoidance (through families splitting their incomes for tax purposes) and reduce incentives to work for most earners (by reducing their average tax rate while leaving marginal rates unchanged or higher). Tax burdens should be reduced over time - but this is not the way to do it.
4. Make 'big business' pay tax. Some commentators have argued that the right way to reduce the deficit is to reduce tax avoidance from large companies rather than to reduce public spending. In fact three-quarters of the £40 billion tax gap is due to VAT, Income tax, National Insurance and Capital Gains Tax, i.e., the taxes paid by individuals and small companies. Reducing the tax gap not only requires a focus on the big end of town but on the activities of small to medium enterprises and many families. The entire tax system needs to be simpler and less open to abuse and a culture where people take opportunities to have "cheated and fiddled things" must end.
5. Reduce costs facing future generations. Senior members of the Coalition are right to argue that high government deficits today impose a burden on future generations. Moving quickly on deficit reduction is important as, given the fast growing numbers of people approaching state pension age, delay will make change harder. Yet intergenerational fairness also requires reducing the costs of benefits to the elderly, through removing pensioner gimmicks such as free bus passes and TV licences and reversing the policy of linking the basic state pension to earnings. These poor spending decisions can no longer be justified and any taxes or National Insurance Contributions paid by these people have largely been spent on a pay as you go basis.
6. Promote equality over growth. The Spirit Level was widely discussed at the beginning of this Parliament. This work sought to argue that in developed countries equality of income is more socially beneficial than economic growth. But, aside from the debate on whether this work is robust or not, the financial crisis has shone new light on the importance of growth to developed nations. Growth will be crucial in financing pensions and other entitlements as the population ages and the ratio of dependants to workers rises.
7. Make welfare more active. The Coalition is right to reform welfare to make the system as a whole more active (encouraging people to make the right decisions rather than providing a lifestyle choice). The Coalition has argued that it will "make work pay for everyone" through a new Universal Credit costing several billions of pounds per year. In fact improvements in work incentives for some will be matched by reduced work incentives for others. Too little thought has been given to how these changes will work in practice and whether the required IT system can be delivered. Improvement will come when benefits are conditional on effort and when families take greater responsibility for work, regardless of the intricacies of benefit design.
8. Help disadvantaged school children. Improving the outcomes of the school system is essential for improving social mobility. The Coalition aims to spend £12 billion over the Spending Review period to school children in need (the pupil premium). But previous research has found that there is no simple correlation between funding levels and the performance of school children. The Coalition's ideas on greater choice of schools should bear greater fruit.
Conclusions and recommendations
What this analysis reveals is that the current debate on fairness is flawed and in danger of leading policy astray:
- It is dominated by measures that emphasise existing spending through the tax and benefit system.
- It assumes that more government spending is synonymous with fairness.
- Many arguments around progressivity and inequality are based on little more than assertion.
- The role of economic growth in providing resources for redistribution is often ignored.
- The actual nature of tax avoidance and evasion (the tax gap) is poorly understood.
If debate continues in this way it will create two problems.
First, debate will be increasingly precise but miss the point. Too much emphasis will be placed on static estimates of measures like poverty, which fail to capture the importance of behavioural changes and a wider range of variables, such as food and fuel prices, in influencing the living standards of low income families.
Second, the debate on fairness will descend into vested interests lobbying for concessions. Fairness does not mean that only other people should pay. Fairness requires being honest about what the government can do and the living standards that people should expect. It should not be used as a cover for narrow self interest.
To avoid these problems clearer thinking on fairness is needed. While there is no one single agreed view on fairness most people would accept that the extent to which government actions combat disadvantage should be central to any definition. This supports a focus on education and welfare reform. This does not support encouraging high-earners' migration, maintaining the middle class money-go-round, increasing personal tax allowances or postponing difficult decisions.