Does the UK tax system make income inequality worse?

23 September 2015

George Bull

The highly respected Institute for Fiscal Studies (IFS) has this week published an informative report looking at the way the UK tax and benefits system distributes income across individuals’ lifetimes.

While recognising that excluding business taxes and the benefits from public service spending inevitably produces an incomplete picture, the IFS has reached some interesting conclusions: 

  • Taking adult life as a whole, only 7 per cent of individuals receive more in benefits than they pay in taxes. 
  • This compares with 36 per cent of individuals who receive more in benefits than they pay in taxes on a single year 'snapshot' basis. 
  • The poor are not always poor and, to a lesser extent, the rich are not always rich. The IFS suggests that, at any particular point in time, those in the bottom lifetime decile will spend only 22 per cent of life in the bottom decile. Those in the richest lifetime decile are in the top decile for an average of 35 per cent of life. 
  • Income inequality across the whole of life is much less than previously thought. A lot of the inequality between individuals is temporary in nature, reflecting either the stage in life they are at or the transitory shocks they have experienced. 
  • On average across individuals, total lifetime (direct and indirect) taxes amount to £776,000 in 2015 present value (PV) terms or 45.4 per cent of gross lifetime income. The corresponding figure for benefits is £281,000 or 16.5 per cent of gross lifetime income. Taking the difference between taxes and benefits gives an average net contribution of £494,000. This is the average revenue raised per individual across life in PV 2015 terms. 

The IFS goes on to conclude that the tax and benefits system is less effective at reducing inequality over the lifetime than might be thought. This probably reflects politicians’ assessments of the impact of taxes and benefits over short time scales. Benefits are less effective at reducing lifetime inequality than might be thought although state pensions come out as relatively effective in reducing inequality.

The impact of VAT is considered in some detail, especially as it has such a large impact on low-income groups who spend much of their income. The IFS draws the surprising conclusion that VAT could be reformed in way which eliminated zero and reduced rates whilst remaining distributionally neutral. Interestingly, in-work benefits are found to be just as good at helping the lifetime poor as out-of-work benefits, but do so without worsening working incentives by nearly so much. 

There is much to be commended in the IFS report, and much to think about. For me, I am left with four entirely different impressions: 

  • The IFS paper concentrates on redistribution via the tax and benefits system. It would be unfair to criticize the existing UK tax system for historic failings because it was never set up as a redistributive mechanism. Indeed, in its 2011 report 'Tax By Design', the IFS makes no mention whatsoever of using the tax system for redistribution. Perhaps this is something which should be addressed now. 
  • Going back to the question of short term policies and quick wins, let’s hope the Treasury does not seize on the IFS comments regarding VAT to further restrict or even scrap the zero and reduced rates of VAT. 
  • The IFS uses the baby boomer generation as a model - probably the most fortunate generation in the UK on any historical analysis given the access to free education, social benefits and (for many) final salary pensions. It would be interesting to know how this would compare with the generation before and the generation after.