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The disincentive effect of earnings-credit incentives on labour supply

By Tanya Plibersek - posted Friday, 23 May 2003

Today, an increasing number of families have no member in gainful employment, and correspondingly, an increasing number of working-age adults derive most of their income from government benefits.

These are alarming trends. It is not an unreasonable expectation that working-age adults, as long as they are able-bodied, provide for themselves. Their undue dependency on income support points to two problems in the labour market. One is that there are not enough jobs for the jobless, the majority of whom are low-skilled. The other is that low-paid jobs have become, for whatever reasons, an unattractive option compared to government benefits.

To combat these problems, the "Five Economists", in an open letter to Prime Minister Howard that appeared in The Australian on 26 October 1998, proposed a temporary minimum wage freeze and the introduction of "in-work benefits".


A minimum wage freeze would lower the cost of, and thereby increase the demand for, low-skilled labour. Employment opportunities for the jobless would be boosted accordingly.

The consequent minimum wage, however, might be insufficient for some workers to make ends meet and so might give rise to a large working-poor population. In-work benefits, a tax break for low-income families of which one or more members are in paid work, would prevent that.

The proposed in-work benefits would take the form of an "earnings credit". This was is intended to provide an income supplement of up to $30 per week, or $1,560 per annum, for families with earnings below a certain threshold. The credit, because it increases returns from work, was said to strengthen incentives to work and thus boost employment.

International evidence, however, casts doubt on such a claim. In-work benefit programmes that have been in operation in the United States and Britain certainly had some success in improving work incentives for some people. But they also appear to have created work disincentives for others.

It is not viable to offer in-work benefits at all levels of earnings. In-work benefits need to be phased out as earnings rise, and this provides a disincentive to increase one's earnings. US and British experience indicates that the recipients of in-work benefits tend to reduce the hours of work or even drop out of the labour market altogether as the values of their credits diminish.

In-work benefits are assessed on a family, as opposed to individual, basis. This means that the responses of individuals to in-work benefits depend on their positions in their families. In both the United States and Britain, labour supply from lone parents has significantly increased as a result of in-work benefits. Married men, however, have hardly altered their labour-market behaviour, and married women whose spouses are employed have considerably reduced their labour supply. This is primarily because married women are usually second earners and are eligible for in-work benefits as long as their spouses are in paid work. The tendency for them to reduce hours of work or leave the labour market becomes even stronger as in-work benefits are phased out.


The earnings credit proposed for Australia therefore may create just as much work disincentive as work incentive.

One might ask whether there is anything wrong with this - because the reduction of employment among married women, after all, does not affect the incidence of jobless households as long as their spouses are employed.

The work disincentives inherent in in-work benefits, however, represent a formidable problem.

In a free society, additional work effort should be rewarded with a rise in income and a corresponding rise in living standards. The earnings credit, because it is eventually phased out, is in conflict with this ideal. Working harder or longer could in fact be penalised by a withdrawal of credits. This is what gives rise to the anomaly that individuals avoid work in order to maintain their living standards. If they wish to further improve their wellbeing, they would have to wait for the government to raise credit rates. In other words, in-work benefits erode personal initiative.

There is a better way to help the working poor: raise the personal tax-free threshold. The tax-free threshold is currently set at $6,000 per annum. Raising this would represent a significant boost to work. It safeguards personal initiative as well-because people would end up with more of their own money, not with other taxpayers' money.

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Article edited by John Carrigan.
If you'd like to be a volunteer editor too, click here.

This article is based on an Issues Analysis released by the Centre for Independent Studies on 13 may 2003. Click here for the full paper.

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About the Author

Tanya Plibersek MP is Labor's Federal Member for Sydney.

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