The Poverty Trap and the Equity-Efficiency Trade-Off in Redistribution
The poverty trap describes a situation in which a low-income household gains very little extra net income from working more hours or earning a higher wage, because the extra earnings are largely cancelled out by higher tax and the withdrawal of means-tested benefits.
Before you start
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Method
- Define the poverty trap precisely: it is not simply being poor, it is facing a high effective marginal tax rate that removes the financial reward from working more.
- Learn the three components of the effective marginal tax rate: income tax, employee National Insurance contributions, and the withdrawal (taper) rate of means-tested benefits.
- Learn the distinction between equity (a fairer distribution of income) and efficiency (resources being used to produce the maximum possible output), and that a policy can improve one while worsening the other.
- Learn Arthur Okun's 'leaky bucket' idea: some income is always lost in transit when it is redistributed through the tax and benefit system, due to administration costs and the incentive effects of taxation.
- For a calculation question, add together the tax rate, the National Insurance rate and the benefit taper rate that apply to the same pound of extra earnings to find the effective marginal tax rate.
- For an evaluation question, plan a chain in favour of redistribution (reduces poverty, raises aggregate demand from the higher marginal propensity to consume of poor households) and a chain against it (weakens work incentives, may reduce saving and enterprise), then reach a judgement based on the size of the taper rate and the elasticity of labour supply.
Worked example
A worker earns an extra 100 pounds a week. She pays 20 pounds in income tax and 8 pounds in employee National Insurance on this extra income. Her Universal Credit is also withdrawn at a taper rate of 55 percent of net earnings above her work allowance. Calculate how much of the extra 100 pounds she actually keeps, and state her effective marginal tax rate.
- Find income tax and National Insurance taken from the 100 pounds: 20 + 8 = 28 pounds, leaving net earnings of 100 - 28 = 72 pounds.
- Apply the Universal Credit taper to these net earnings: 55 percent of 72 = 39.60 pounds is withdrawn from her benefit.
- Add the total amount lost: 28 pounds in tax and National Insurance plus 39.60 pounds in withdrawn benefit = 67.60 pounds.
- Subtract this from the original 100 pounds: 100 - 67.60 = 32.40 pounds is what she actually keeps.
- Express the amount lost as a percentage of the extra earnings: 67.60 / 100 x 100 = 67.6 percent, so her effective marginal tax rate is 67.6 percent.
Practice questions
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Q1Define the poverty trap in your own words.Show answer
Answer: A situation in which extra earnings are largely offset by higher tax and National Insurance payments and the withdrawal of means-tested benefits, leaving a worker very little better off for working more.
Q2What is the 'effective marginal tax rate'?Show answer
Answer: The proportion of an extra pound of earnings that is lost through income tax, National Insurance and the withdrawal of means-tested benefits.
Q3In October 2021 the UK government cut the Universal Credit taper rate. State the direction of this change.Show answer
Answer: It was reduced, from 63 percent to 55 percent, so claimants kept more of each extra pound earned.
Q4Distinguish between equity and efficiency in economics.Show answer
Answer: Equity concerns whether the distribution of income or resources is fair; efficiency concerns whether resources are being used to produce the maximum possible output from given inputs, with no waste.
Q5Give one cost that a very high effective marginal tax rate can create, other than reduced work incentives.Show answer
Answer: It can discourage saving or training for a better-paid job, since the extra income from doing so would mostly be clawed back, or it can discourage claiming benefits at all due to complexity (non-take-up).
Q6What did Arthur Okun mean by the 'leaky bucket' of redistribution?Show answer
Answer: That transferring money from richer to poorer households is never perfectly efficient: some of it is lost in transit through administrative costs and the incentive effects of higher taxes and benefit withdrawal.
Q7A worker's effective marginal tax rate is 90 percent. How much of an extra 50 pounds earned would she keep?Show answer
Answer: 5 pounds (10 percent of 50), since 90 percent of the extra earnings are lost to tax, National Insurance and benefit withdrawal.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain how a high benefit withdrawal (taper) rate can contribute to a poverty trap.
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'Reducing the Universal Credit taper rate is the most effective way to reduce the poverty trap without creating a large equity-efficiency trade-off.' Evaluate this statement.
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