The Department of Work and Pensions released a report (warning, large .pdf) last week which showed that our current system of benefits and taxation is quite clearly absurd, if not actually insane. Strong words, yes, but as Chris Dillow points out:

Here’s a question: Take a married couple with two children under 11 and pre-tax earnings of £200 a week. If they get a better job, raising their earnings to £300 a week, by how much does their net income rise? £60? £50? £40? Nope. £8.52. Yes. £8.52. That’s a marginal deduction rate of 91.5 per cent. The extra £100 this couple earns before taxes are swallowed up by higher income tax and National Insurance Contributions (£33); lower Working Tax Credits (£37) and less Housing Benefit (£19.50).

One of the two things you need to know about economics is that incentives matter (the other being that admonition about free lunches), it generally being assumed that it is marginal tax rates that influence people's working habits. For someone facing 91.5% such marginal rates why work the extra hours? Why invest in education or training? Why, in fact, do anything at all to try and better one's economic situation? It doesn’t appear rational to make the extra effort.

Yes, other groups and people in slightly different situations face lower rates but the highest disincentives, when combining the tax and benefit systems, are faced by the lowest paid, precisely those we actually want to encourage to work their way out of poverty and benefit dependency. Is lunacy too strong a description of this situation?

The problem comes from the fact that the levels of income where one receives benefits overlap with those where one enters the tax system. The imposition of the latter combined with the withdrawal of the former is what causes such extraordinarily high effective marginal tax rates.

The first step to a solution would be to raise the personal allowances significantly, as happens, entirely fortuitously of course, in the ASI’s flat tax proposal, to 12,000 pounds. The next step would be to do the same with the National Insurance thresholds so that our sample family would only be facing a 55% marginal rate. Still absurdly high, more, indeed, than many higher rate income tax payers, but at least not completely insane.