The National Party went into the 2005 election with a promise to ditch Working for Families and replace it with tax cuts.  But the current National-led government has largely left the policy alone so far.  With widespread concern over the government’s finances at present, Working for Families no longer seems untouchable. But figuring out what to do with the costly scheme is no simple task.

In a word, Working for Families is huge. Around 400,000 families received some form of assistance in 2009, and the average entitlement was $6,600.  The scheme reaches high up into the income distribution.  Most households with children with a household income of up to $70,000 are eligible, as are many households earning up to $100,000.  While the scheme has undoubtedly been a boost to many low-income families, it casts a very wide net.  Why should other tax payers, including low-income taxpayers without children, be funding welfare for families earning $70,000 a year or more?

There have been suggestions recently that the rate of abetment of Working for Families payments should rise.  An abetment rate is the rate at which welfare payments fall as income rises.  This approach sounds like an easy fix as low income families would still receive most or all of their current entitlement, while higher income families would receive much less or nothing at all.  The problem is that abatement rates are already fairly steep because the scheme is so generous.

The higher the abetment rate, the higher the welfare recipients effective marginal tax rate.  An effective marginal tax rate is the actual rate of tax on any extra dollar earned, including the base tax rate, ACC and other levies, and the abatement rate of any welfare payments.  Effective marginal tax rates are very important when making employment decisions, because they determine how much of any extra money earned is kept by the individual or household and how much goes to the government.

Take the example of a single income household not receiving any kind of assistance from the government with an income of $45,000 a year.  They would pay a marginal rate of 19.5% including ACC.  At their present income level, they will get to keep just over 80 cents out of every extra dollar they earn through overtime, promotion, or changing jobs.  Now if this household has two children, they would typically be eligible for just under $6,000 in Working for Families payments each year.  This sounds great if you are in their shoes, but the flip side is that they would now only get to keep just over 60 cents in the dollar from any extra income they earn as their Working for Families payment would fall with a rise in income.

The problem with generous welfare systems like working for families is that they create poverty traps.  Although someone on a modest income becomes better off when they receive the welfare payments, their prospects for increasing their income further in the future greatly diminish.  Recipients of this kind of welfare are much less likely to invest in education, take on extra work, or aim for a promotion.  The example above uses fairly conservative assumptions.  It is possible for some households to be almost the same or even worse off after a rise in income under the current scheme.

The government’s best chance of solving the Working for Families problem is by incorporating it into a broader overhaul of the tax and welfare system.  To date the government’s approach to reform in these areas has been to set up separate working groups on the issues.  But because of the interaction between tax and welfare, a unified approach is needed.

Further separate tinkering with tax and welfare could lead to a more complicated system while potentially hurting those who are most vulnerable.  The fiscal gains from kicking a few more solo mums off the Domestic Purposes Benefit seem small compared to what could be achieved by going back to the drawing board to designing an integrated tax and welfare system that balances fairness and efficiency with social goals like poverty reduction.  The guaranteed minimum income concept, recently championed by my colleagues Adolf Stroombergen and Gareth Morgan, is one option the government could consider.

Government welfare assistance usually has very noble aims, including alleviation of poverty and providing a safety net for those in need.  But if we think that those who are able to work should by and large support their own households, then the high effective marginal tax rates that schemes like Working for Families create cannot be ignored.  As the government continues to run deficits over the next few years, political will for a major overhaul of tax, welfare, and spending could reach tipping point.