Interesting research was released earlier this week by the Resolution Foundation and IPPR looking into the opportunities and challenges of the Living Wage (see here). It notes that from a local scheme launched in East London some 11 years ago, the Living Wage has now become a major part of the national tax and benefits debate. Indeed, individuals and organisations from across the political spectrum have called for the introduction of this policy (the wage being currently set at £8.55 for London and £7.45 for the rest of the UK – see here).

Mindful of the increasing influence of the notion of the Living Wage, it begs the question: in the current system of Tax Credits (which will exist in some form until 2017), how much better off will those on the minimum wage (currently £6.12 per hour) be if they were to take on a living wage? Additionally, is this set to improve under the Universal Credit? In truth, what we’re really interested in here is the Marginal Effective Tax Rate (METR), something which is quite rightly raised in the Resolution Foundation/IPPR report (see p.40).

METRs (which are comprised of Income Tax and National Insurance increases and benefit withdrawal rates) tell us how much an individual or household will gain from any increase in their income. For example, if someone was to gain an extra £10 in their income from working overtime, and they experienced an METR of 50%, they would see £5 come into the household.

Unfortunately, under the current Tax Credits system, it is in earning additional income that things start to go rather wrong for many families. For example, a one-earner family with two children on the minimum wage that experiences an increase in their hourly rate up to the London living wage would perhaps expect to see all of the £2.43 increase come into the household. However, according to ‘The Taxation of Families 2011’ – a research paper published by CARE in December – one-earner families would face an extraordinary METR of 73%, meaning they would take home just 27 pence from every additional pound earned. It is the same story for many other family types too, with lone parents with two children, married couples with no children and single people with no children all facing this sky high rate. It may well be true for more family types, but the Taxing Wages data released by the OECD only analyses the families noted above.

To put this into some context, these METRs for one-earners at 75% average wage in particular are the highest in the OECD (as the graph below demonstrates). METRs of this nature are certainly not the norm!

Given the relevance of this to the issues of worklessness and poverty (which organisations such as the OECD and the Joseph Rowntree Foundation have duly noted) it is absolutely imperative that the METRs millions of families on low wages in the UK face is tackled as a matter of urgency. If high METRs for low income families can be addressed, this could have a profoundly positive effect on UK poverty rates.

Thus, whilst the Living Wage has much to commend it, many families under Tax Credits will continue to face METRs of up to 73%, with this rate increasing still further to 76% under Universal Credit, meaning that much of the benefit of any wage increase will go to the Treasury rather than the household. However, it is not too late for the Universal Credit to be amended in order to remedy the problem of excessive METRs and ensure more money enters households.

What can be done? Do look out for more on this blog in the coming weeks as we outline how to address this problem.