Work and Pay

The minimum wage, taxes and benefits

Commissioned by: Low Pay Commission

  • Published 18th Mar 2015
  • Authors: , , Peter Kenway, , Tom MacInnes, , Adam Tinson,
  • Category: Work and Pay

This report assesses how the tax and benefits system affects people on the minimum wage and their families. It analyses the incomes and their marginal deduction rates of such families, assessing both the current position and the impact of recent changes. Our analysis further extends to how employers' decisions on setting pay and hours might be affected by the current benefits and tax system.

Key points

1. The number of hours worked at the minimum wage is more important for determining net income in relation to the tax benefit system than the hourly rate of pay. This is because entitlement to benefits under the current system is often determined by the number of hours worked, for instance, a single adult must work at least 30 hours to qualify for Working Tax Credits.

2. There are circumstances in which working more at the minimum wage is not financially worthwhile. This is generally at small numbers of hours (when each extra pound of earnings leads to an equivalent loss in benefits) and for owner-occupiers.

3. Our interviews with employers showed that these limitations were understood, up to a point, by low paid employees. Over half said they had received staff feedback relating to a pay rise reducing an employee’s in-work benefits and affecting their decisions regarding the number of hours they wanted to work. Employers reported that working mothers in particular expressed a strong preference for working 16 hours and no more.

4. This sets challenges for employers when it comes to designing rotas or providing cover for staff on leave or absent through sickness and staff training, or even increasing hours when demand is high.

5. A specific example of this would be couples with children in rented accommodation. For minimum wage earners working between 25 and 50 hours (between the couple), the Marginal Effective Tax Rate (METR) is close to 100%, meaning additional hours bring in almost no additional income.

6. In some circumstances, the marginal effective tax rate can rise above 100% - that is, people are financially worse off working slightly more. At the other extreme, the marginal deduction rate can fall below zero, meaning an extra hour of earnings increases income by more than the pay received for that hour. Such circumstances are very limited, though, and would be avoided by, for instance, working an extra five hours per week (i.e. one per day) rather than a single extra hour.

7. Just under half of employers reported that staff have asked not to receive bonuses due to the knock-on effect on their benefits. Some employers withhold this money, others continue to pay it regardless. Most feedback from staff on these issues has been from part-time working mothers.

8. Importantly just one employer said changes in the tax system had an influence on pay-setting, as opposed to rota setting, and none said that changes in the benefits system had any effect. None of the employers in the sample take net pay into account when setting pay levels.

9. Under Universal Credit, net income progression as hours at the minimum wage increase is much more even, due to the removal of hours conditions and a smoothing of taper rates.

10. One of the big differences between the current and proposed systems is the treatment of owner occupiers. Under Universal Credit, support for renters is more generous, and support for owner occupiers markedly less so.

11. Although Universal Credit lowers the taper rates and so the marginal effective tax rates, these both remain quite high, at over 70% for substantial parts of the distribution. So the issue of high marginal tax rates for low earners will not disappear with Universal Credit.