How to reduce the reliance on benefits: cut welfare or raise the minimum wage?

I wrote last week about the way in which the UK benefits system affects productivity. The basic case is that tax credits encourage those in low-income jobs to work part time rather than full time, and that this has an impact on the efficiency of the economy.

This isn’t going unnoticed – David Cameron has spoken about how keen he is to sort out the tax credit system – but I was interested to see that in this week’s Sunday Times, David Smith noted that there is “plenty of evidence that benefit and tax credit rules do affect the hours that people are willing to work, and their willingness to receive bonuses.”

He also referred to a Low Pay Commission report out earlier this year – which I hadn’t seen. The report “found that over half of employers found that employees did not [work] more hours, because it would affect their entitlement to in-work benefits. This was particularly the case among lone parents at 16 hours, and single adults at 30 hours, in each case the threshold for receiving tax credits and other benefits.”

Those still in any doubt about how our welfare system distorts our economy should look to a new report out from the Centre for Policy Studies. It claims that 51.5% of UK households still receive more in welfare (cash and ‘in kind’, which includes education and the NHS) than they pay in tax (direct and indirect). That’s up from around 45% at the turn of the century but, on the plus side, down from a peak of just over 53%.

The report makes the case very clearly for two things. First cutting taxes on the low paid (despite getting 57% of their gross income in cash benefits, the lowest-paid quintile in the UK still end up paying an average of some £4,900 in tax over the year) and for “the urgent need for more profound supply-side reforms which raise productivity and real earnings.”

The problem, of course, is knowing which bit to start with. Less welfare in the form of tax credits might mean greater productivity and hence higher wages. But might a sharp rise in the minimum wage work faster? Higher wages might drive higher productivity, which might drive even higher wages. Then the welfare bill would fall automatically and hence less welfare would be considered to be needed. Tricky one isn’t it?