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The end of cheap talk about poverty reduction: The cost of closing the poverty gap while considering incentives

Abstract (max 300) Eradicating poverty has been an important goal in the EU policy discourse. Accordingly, researchers

have calculated the cost of closing the gaps between the incomes of poor families and poverty

thresholds. Calculations showed the large effort needed and the unemployment traps in which many

work-poor households would be if low wages were not raised in tandem with closing the gaps. In this

way, the cost of eradicating poverty trying to preserve incentives to work could be considerably

higher. At the same time, the relationship between poverty and incentives was particularly relevant

during the years before the crisis as EU countries faced tough trade-offs between poverty reduction,

activation and expenditure. Arguably, most countries opted for activation over poverty as a way out

of the trilemma, favouring work-rich households over work-poor ones. However, this was not

enough to prevent certain vulnerable working households from sinking further below poverty

thresholds as decreasing low gross wages have put pressure on the capacity of welfare states to deal

with incentives and poverty reduction. Thus, in this paper we calculate the cost of closing the poverty

gap with the minimum necessary leakage above the threshold for working households to not

decrease average participation incentives for those at the bottom of the income distribution. We do

this in Belgium, Finland and the UK. Results reflect the large cost of such an enterprise, highlighting

that a balance between activation and protection would not be cheap and that some leakage would

be necessary. At the same time, important differences across countries in current participation

incentives and, to a lesser extent, in poverty gaps for jobless households are reflected in very

different cost estimates.

Keywords: poverty gap, tax-benefit system, minimum income, in-work benefit, work incentives,

redistribution

1. Introduction Poverty reduction is an important aim of public policy. At the European policy level, increasing

minimum incomes to the level of the poverty thresholds has already been suggested in policy

declarations. Accordingly, researchers have calculated the large cost of such an exercise. However,

usual calculations do not take into account the problem of work incentives at the bottom of the

income distribution, understating the real cost of lifting all incomes to the level of the poverty

threshold if we did not want to reduce work incentives for low income earners. Hence, in this article,

for the first time, we calculate the cost of eradicating poverty without worsening average

participation incentives at the bottom of the income distribution. We find that across countries this

cost would be between two and four times the cost of just lifting all incomes to the level of the

poverty threshold, signalling that a balance between activation and protection would not be cheap


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and that some leakage would be necessary. At the same time, important differences across countries

in current participation incentives and, to a lesser extent, in poverty gaps for jobless households are

reflected in very different cost estimates.

The paper is structured as follows. Section 2 details the policy context in which increasing minimum

incomes has been suggested. In section 3 we take stock of previous research that has calculated the

cost of eradicating poverty and the implication of this on incentives. Section 4 details the data and

method used, section 5 presents the results and section 6 concludes.

2. Policy context The main headline indicator of income poverty in the EU is the at-risk-of-poverty indicator which

defines the poverty line as 60 per cent of household equivalised median income. At the EU policy

level, there has been some support to increase minimum income protection to this level. The Council

Recommendation of 24 June 1992 called on Member states to set a guaranteed minimum income to

cover social exclusion situations; recognize the right to enough resources and social assistance to

‘live in a manner compatible with human dignity’; and adapt protection systems accordingly. Later,

the objective of eradicating poverty by 2010 was included in the Lisbon Agenda and the Commission

recommendation of 3 October 2008 indicated that a combination of quality services, inclusive labour

markets and adequate income support should be available for people excluded from the labour

market. More recently, the European Parliament in its Resolution of 6 October 2010 stated that

‘adequate minimum income schemes must set minimum income at a level equivalent to at least 60

per cent of median income in the Member States concerned’. However, this resolution did not

become a European Directive and only recommended to the Commission to study the instauration of

adequate minimum incomes at the EU level. Lastly, building on the recommendations of the Council

and the Commission, the European Anti-Poverty Network (EAPN) (2010) proposed to set minimum

incomes at the poverty threshold as an intermediary goal while the minimum adequacy of these

instruments is determined through consensual standard budget methodologies, which should not be

below current poverty thresholds.

In parallel, over the last decade EU countries seem to have faced tough trade-offs between poverty

reduction, activation and budgetary restraint. It has been argued that as a way out from this social

trilemma there was an attempt to increase employment by reducing and tightening social protection

(Atkinson, 2010). This would have been a case of ‘negative’ economic incentives, namely ‘making

work pay’ by retrenching benefits, in contrast to ‘positive’ ones in which net incomes of workers are

increased (Vandenbroucke & Vleminckx, 2011). This notion has some empirical back-up as generally

poverty reduction for work-poor households decreased (although less than the general increase of

employment1), whereas their numbers were reduced and policies targeted to work-rich households

became relatively more generous (Cantillon, Van Mechelen, Pintelon, & Van den Heede, 2014). It

could be though that this implied an improvement of the position of working households on low

incomes; however, there are indications that as welfare states ran harder to support them, these

efforts were not enough to sustain the falling incomes of hypothetical vulnerable working

1 The Lisbon Agenda relied on an increase in employment to augment social inclusion, which indeed took place.

Nonetheless, there is indication that due to a skewed distribution of the new jobs which went mainly to second earners, the increase in employment was not fully translated into poverty reduction (Corluy & Vandenbroucke, 2014).


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households in relation to poverty thresholds (Cantillon, Collado, & Van Mechelen, 2015). This would

be the result of decreasing low gross wages which have put pressure on the capacity of welfare

states to deal with poverty reduction and incentives for these vulnerable households (single parents

and couple families with one earner). At the same time, while these trends were not the same

everywhere, not a single EU15 country achieved simultaneously an expansion in employment with a

reduction in poverty and a decrease of spending on cash transfers (Cantillon & Vandenbroucke,

2014). Contrary to the presented trade-offs, at the beginning of last decade the Lisbon Agenda

implicitly assumed that employment and social inclusion could be complementary goals. However, at

that time, the levels of available incomes for different types of jobless households and of single-

earner low income families were already inadequate in relation to poverty lines (Marx, Marchal, &

Nolan, 2013). Thus, if certain vulnerable households had to live from out-of-work or low in-work

incomes, the goal of eradicating poverty established by the Lisbon Agenda was from the beginning

difficult to achieve if these incomes were not raised at least to the level of poverty thresholds.

In relation to activation or ‘make-work-pay’ employment policies, they were only a part of the new

paradigm of social investment in which EU social policy became increasingly framed. This paradigm

puts the focus on investing in people rather than in their economic maintenance, and on equal

opportunities rather than on equality of outcomes (see among others Esping-Andersen, 2002;

Gilbert, 2002; Morel, Palier, & Palme, 2009). This also meant that in a longer term perspective, the

role of human capital in a virtuous cycle of adaptability, flexibility, security and employability started

to gain relevance (European Commission, 2004). To achieve these aims, most member states have

moved their focus from passive social protection to activation and investment in education, more

and better jobs and family-oriented services. In particular regarding ‘make-work-pay’ policies, they

may well be designed as ‘positive’ economic incentives increasing the net incomes of workers

(Immervoll & Pearson, 2009). In turn, social investment offers a potential way out to the trilemma by

increasing employability, reducing poverty and in consequence releasing expenditure that could be

used in other increasing necessities related to aging and health. It is still too soon to make a

judgment about the effectiveness of this paradigm as some of its investments take time in accruing

their profits. However, we believe that situations of financial stress do not support the proper

accumulation of human capital (Mullainathan & Shafir, 2013) and current inequalities might be

translated into future ones (Corak, 2013). In this sense, although our view is static and social

investment might bring reduction in social expenditure in the future, we offer a minimum starting

cost which could represent a balance between a protection and an activation strategy

(Vandenbroucke & Vleminckx, 2011).

3. The cost of reducing poverty and its impact on work incentives Previous research has already calculated the cost of mechanically closing the gaps between the

incomes of poor families and poverty thresholds. Estimations have shown the large effort needed

and the unemployment traps in which many work-poor households would be if net low wages were

not raised in tandem with closing the gaps (Cantillon et al., 2014; Vandenbroucke, Cantillon, Van

Mechelen, Goedemé, & Van lancker, 2013). Estimating the poverty gap is equivalent to calculating

the cost of a transfer on top of current tax-benefit systems that is equal to the poverty line from

which any source of income is withdrawn at a 100 per cent rate. This is bound to decrease incentives

at the bottom of the income distribution: for a working household with an income below the poverty

threshold, keep working the same, more or not at all would result in the same disposable income,


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while for working households just above the threshold the income wedge between working or not

would narrow down. In other words, the usual calculations of the cost of closing the poverty gap

understate the true cost, as it is likely that if such transfer was introduced, some households with low

earnings potential would work less or not at all, given that lower earned incomes would be

compensated by an increased hypothetical transfer. In this paper, we want to improve on previous

estimations by taking work incentives better into account when estimating the cost of ‘mechanically’

eliminating poverty. More in particular, we will estimate the cost of closing the poverty gap with the

minimum necessary leakage for working households above the threshold to not decrease

participation incentives for those at the bottom of the income distribution. The double function of

reducing poverty and not decreasing incentives will be achieved by withdrawing earned income from

the hypothetical transfer at a rate lower than 100 per cent when joining the labour force - as it is the

case when calculating the poverty gap - which contributes to maintain the difference between in-

and out-of-work incomes. The withdrawal rate of the transfer will be the one that does not change

‘much’ incentives to work at the bottom of the income distribution. The specific definition of ‘much’

is detailed in the methodological section.

There are two elements that we can foresee in relation to the impact of calculating the cost of

eradicating poverty in this way. First, work incentives are usually measured in two ways: using

marginal effective tax rates (MTR) to estimate the incentive to work more hours which reflects the

intensity of work on the job (intensive margin), and using participation tax rates (PTR) to measure the

incentive to work at all (extensive margin). In this paper we are primarily concerned with

participation incentives as they particularly affect jobless households which are the most vulnerable

ones, these incentives can produce important changes in welfare for and revenue from these

households, and behavioural responses at the extensive margin tend to be much larger than at the

intensive one (Bargain, Orsini, & Peichl, 2014). More specifically about MTR, they represent the

proportion that is taxed away after a marginal increase of earned income. As we will withdraw

earned income from the necessary hypothetical transfers for working households, this is bound to

increase their current MTR. In this way, a trade-off between not altering much incentives to work at

all and increasing the ones to work more hours might appear. Second, in relation to the cost of

closing the poverty gap with the minimum leakage above the threshold, besides depending on

current tax-benefit systems (both in term of levels and work incentives), it will also depend upon how

populated is the lower part of the income distribution (Bassanini, Rasmussen, & Scarpetta, 1999;

Immervoll & Pearson, 2009; Marx, Vanhille, & Verbist, 2012).

Lastly, in terms of labour supply responses, we only estimate the supposedly small changes in hours

worked in a very simple way following the stylised assumptions and formula for the intensive

elasticity of Immervoll, Kleven, Kreiner, and Saez (2007). At the same time, the responses at the

extensive margin could be small as we do not change much average participation incentives at the

bottom of the income distribution and income effects have been found to be close to zero (Bargain

et al., 2014). In turn, relevant general equilibrium effects such as a changes in wages and

employment levels could also be not too large.


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4. Data and Methods

4.1. Tax-benefit microsimulations and data To calculate incentive measures and costs we use the data produced by the tax-benefit

microsimulation model EUROMOD2 for Belgium, Finland and the UK. This model operates on micro

data and follows the country-specific tax-benefit rules. We use the EUROMOD policy system of 2013

and as input data the uprated EU-Statistics on Income and Living Conditions3 (SILC) 2010 for Belgium

and Finland and the Family Resource Survey (FRS) 2009/10 for the UK. Negative earned incomes are

bottom coded to zero in EUROMOD datasets. In addition, we merge the EUROMOD input data with

more variables coming from the surveys as explained below.

We use slightly different data to calculate incentive measures and costs. To estimate incentives we

assume full take-up of benefits. We do this to estimate the hypothetical budget constraints imposed

by tax-benefit systems, regardless whether or not people decide to face those constraints. In

addition, as incentives are obtained after a change in earnings, we need to simulate as much as

possible changes in taxes and benefits. In this regard, although unemployment benefits are not

completely accurately simulated in Belgium, we will use them to calculate incentives. The data

assuming full take-up of benefits and simulating as much benefits as possible we call it fully simulated

data. From this data we obtain the withdrawal rates that do not change ‘much’ incentives.

To calculate the cost of closing the poverty gap using those withdrawal rates, we use data applying

the EUROMOD non-take up corrections of mean-tested benefits. This means that the effort needed

to close the poverty gap will include the necessary resources to compensate for households with

current incomplete take up. In addition, we use observed unemployment benefits in Belgium due to

the aforementioned reason. We call the datasets used in the cost estimates best simulated data. The

treatment of the benefits in the simulations can be found in the respective EUROMOD country

reports4.

4.2. Measuring work incentives In the literature, mainly two measures are used for estimating work incentives: marginal effective tax

rates (MTR) and participation tax rates (PTR). MTR estimate the effect of tax-benefit systems on

incentives to work extra hours (intensive margin), while PTR on incentives to work at all (extensive

margin). As our main concern is at the extensive margin and the bottom of the income distribution -

including jobless households - and PTR are more complex to calculate than MTR, we will mainly focus

on explaining PTR and briefly refer to MTR. The general formula of PTR is expressed in equation 1.

2 The results presented here are based on EUROMOD version G2.0+. EUROMOD is maintained, developed and

managed by the Institute for Social and Economic Research (ISER) at the University of Essex, in collaboration with national teams from the EU member states. We are indebted to the many people who have contributed to the development of EUROMOD and to the European Commission for providing financial support for it. The results and their interpretation are the authors’ responsibility. 3 The results and conclusions are ours and not those of Eurostat, the European Commission or any of the

national statistical authorities whose data have been used. 4 In BE and FI unemployment benefits are not fully simulated to estimate the hypothetical entitlements of

people currently working if they stopped. Therefore, we did some adjustments in order to run this scenario.


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𝑃𝑇𝑅 = 1 −(ℎ𝑜𝑢𝑠𝑒ℎ𝑜𝑙𝑑 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑖𝑛 𝑤𝑜𝑟𝑘) − (ℎ𝑜𝑢𝑠𝑒ℎ𝑜𝑙𝑑 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑜𝑢𝑡 𝑜𝑓 𝑤𝑜𝑟𝑘)

𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑔𝑟𝑜𝑠𝑠 𝑤𝑎𝑔𝑒 𝑖𝑛 𝑤𝑜𝑟𝑘

=(ℎ𝑜𝑢𝑠𝑒ℎ𝑜𝑙𝑑 𝑡𝑎𝑥𝑒𝑠 𝑖𝑛 𝑤𝑜𝑟𝑘) − (ℎ𝑜𝑢𝑠𝑒ℎ𝑜𝑙𝑑 𝑡𝑎𝑥𝑒𝑠 𝑜𝑢𝑡 𝑜𝑓 𝑤𝑜𝑟𝑘)

𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑔𝑟𝑜𝑠𝑠 𝑤𝑎𝑔𝑒 𝑖𝑛 𝑤𝑜𝑟𝑘

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In this equation benefits are understood as negative taxes. The two versions of the equation allow

for two equivalent interpretations. PTR can be understood as one minus how much people can keep

if they enter/stay in the labour market (i.e. the spread between in- and out-of-work incomes) in

relation to individual gross wages. Or complementary, as how much is taxed away when a person

enters/stays in the labour market. MTR follow the same logic but instead of a change in wages from

not working to working, we use a marginal change in hours equal to 5 per cent. Re-estimating

household incomes after a change in wages - either when joining the labour market or a marginal

one - warrants the use of micro-simulated data. Coming back to PTR, obviously people in work do not

have observed incomes out of work, whereas people out of work do not have observed gross wages.

While incomes out of work can be obtained using EUROMOD setting wages to zero, we must predict

how much gross wages of people out of work would be if they worked. Details on these predictions

and the calculation of PTR can be found in Appendix A – Participation tax rates. What we roughly do

is, first, predicting hourly wages for people available for the labour market who are currently out of

work (and few other groups with non-reliable data) with a Heckman selection model based on the

employed people in work and, second, calculating with EUROMOD PTR for people available for work

living in households composed by couples or single adults with or without children. The reason for

this sub-sample is that PTR assume that decisions to work are based on pooled household incomes,

which is difficult to assume in other type of households. On the contrary, later the costs will be

assessed in the full population. PTR take into account households incomes but they represent an

individual measure of incentives; therefore, for couples we calculate them separately: one time

modifying gross wages of one partner and keeping constant the one of the other, and vice versa. In

addition, as a simplification, we transform gross wages to full-time (FT) equivalent units (38 hours)

and assume that everybody works the full year to make the predicted hourly wages comparable to

the observed ones. In the simulation of unemployment benefits in BE and FI the same is assumed in

relation to wages before the unemployment spell (in the UK this benefit is not earnings related). This

means that we calculate PTR in the case that everybody worked this number of hours and months,

which probably implies a slight underestimation of them5.

4.3. The cost of closing the poverty gap with leakage Estimating the poverty gap is equivalent to calculating the cost of an hypothetical transfer on top of

current tax-benefit systems which is equal to the poverty line of each household minus total net

household income (so withdrawn at a 100 per cent rate). Similarly, we will calculate the cost of an

hypothetical transfer that closes the poverty gap, but with the difference that by allowing some

leakage above the poverty line for working households, our transfer has the potential of not

worsening average participation incentives at the bottom of the income distribution. More 5 PTR of workers not working full-time the full-year (NFTFY) are in general somewhat higher than the ones of

full-time full-year (FTFY) workers (OECD, 2009). This is probably because out-of-work incomes of NFTFY workers are not fully proportional to their fewer hours worked but somewhat higher. At the same time, through progressive tax rates and exemption limits, in-work incomes of part-time workers in full-time equivalent units are relatively higher in comparison to in-work incomes of full-time workers (OECD, 2014). This probably compensates the relatively higher out-of-work full-time equivalent incomes of NFTFY workers but not completely, resulting in their higher PTR.


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specifically, the difference with calculating the ‘traditional’ poverty gap is that we will withdraw net

earned income at a lower rate than 100 per cent – while net non-earned income still at that rate

(equation 2)6. Applying a withdrawal rate below 100 per cent to net earned income is what would

permit households with low earnings potential to keep part of the hypothetical transfer if they

enter/stay in the labour market, allowing to maintain the difference between current in- and out-of-

work incomes when closing the poverty gap. The rate used to withdraw net earned income will be

the one that does not change ‘much’ participation incentives at the bottom of the income

distribution. The specific definition of ‘much’ is explained in the next sub-section. In relation to

measuring poverty, we use the EU at-risk-of-poverty indicator that defines the threshold as 60 per

cent of equivalised median household income using the modified OECD scale. Given that the poverty

line is defined as a percentage of the median disposable household income, the hypothetical transfer

might push up the poverty line, resulting in a requirement for further increasing the transfer.

However, in the current exercise we keep the poverty line fixed.

𝑀𝑎𝑥 (0, 𝑝𝑜𝑣𝑒𝑟𝑡𝑦 𝑙𝑖𝑛𝑒 − 𝑦𝑛𝑒𝑡 𝑛𝑜𝑛−𝑒𝑎𝑟𝑛𝑒𝑑 − 𝑦𝑛𝑒𝑡 𝑒𝑎𝑟𝑛𝑒𝑑 ∗ 𝑤𝑖𝑡ℎ𝑑𝑟𝑎𝑤𝑎𝑙 𝑟𝑎𝑡𝑒) 2

That earned and non-earned incomes are considered net means that the taxes and social

contributions (including credits) arising from each source are subtracted from the respective gross

components. The components of earned and non-earned net incomes are detailed in Table 2 of

Appendix B – Income components. In theory, we could use non-simulated data to estimate the cost

of closing the poverty gap with leakage in this way. However, income components are aggregated at

higher levels in SILC than in the simulated data, which implies that in some cases earned and non-

earned components can be included in the same variable. For this reason we use simulated data,

which allows us to classify as much as possible income components into our two categories.

Nonetheless, allocating taxes and social contributions to net earned and non-earned incomes is not

always possible. When it is not, as an approximation we allocate them proportionally to gross earned

and non-earned incomes7.

4.4. The minimum leakage to not change ‘much’ participation incentives at

the bottom The purpose of this paper is to estimate the cost of closing the poverty gap while allowing the

minimum leakage above the poverty line for working households so as to not worsen participation

incentives at the bottom of the income distribution. Not changing participation incentives with the

6 The different treatments to earned and non-earned income will have some interactions with the hypothetical

transfer. First, in the UK we consider the Child Tax Credit (CTC) as non-earned income since below a threshold entitled parents receive a flat amount regardless their labour market status. As after the threshold the CTC is withdrawn, according to our definition this imply that a marginal increase in earned income beyond that point would result in a simultaneous decrease in non-earned income - although the latter decrease would be smaller due to the tapering of the CTC. In turn, the corresponding reduction in the hypothetical transfer would worsen MTR less for parents in the phase out region of the CTC - compared to e.g. parents in the plateau region or non-entitled ones. Second, we also treat pensions as non-earned incomes; therefore, in a longitudinal perspective, higher contributions might be discouraged as future pensions would be fully withdrawn from the hypothetical transfer. 7 The caveat of this approximation is that it does not include different treatments to both types of incomes

which might provoke some misallocations in the hypothetical transfer. This can be caused e.g. by different tax schedules for each source of income or the fact that some benefits are fully or partially exempted from taxation.


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simple design of our hypothetical transfer is virtually impossible8; hence, we opt for not changing an

aggregate indicator of incentives. That being said, we define the withdrawal rate that does not

change ‘much’ incentives as the one that leaves average PTR of the first three household equivalised

income deciles as in the base line situation. As we would be keeping constant average PTR, it might

occur that high PTR decrease while low ones increase.

Using one-person households, Figure 1 exemplifies graphically what closing the poverty gap allowing

some leakage would mean in terms of disposable incomes. The red horizontal line is the poverty

threshold for a single person which allows us to see that after (or post) closing the poverty gap there

would be no poverty. The continuous blue line to the left of the intersection point with the 45° line

represents the post total income of households that would receive the hypothetical transfer. The

dots scattered above this line are households with positive non-earned incomes which combined

with the withdrawn earned incomes are above the poverty line so they would not receive the

transfer. The dots to the right of the intersection point would not receive the hypothetical transfer

either.

Figure 1. The impact on disposable incomes of closing the poverty gap allowing leakage

Source: EUROMOD simulated data 2013 (based on SILC 2010)

Note: figures correspond to one-person households with positive net incomes

As shown in the two charts of Figure 1, the withdrawal rate defines how steep is the blue line before

the intersection point and where this point is located, after which no household would receive the

hypothetical transfer. In turn, the steepness and intersection point determine the two elements that

we care about: incentives and cost. First, steeper lines imply larger transfers before the intersection

8 In order to be possible, the transfer would need to be defined in such a way that the PTR within households

remain the same. However, since PTR are individual indicators that reflect the diverse incentives faced by different household members, a transfer that does not change the PTR of one household member would almost certainly change the PTR of another.


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point and that this point is located at higher levels of earned income which means that more people

would be reached, both issues increasing the cost. Second, in relation to incentives, closing the

poverty gap allowing some leakage has an effect on both out-of-work and in-work household

incomes. With respect to the former, regardless the withdrawal rate used, the hypothetical transfer

for single-headed households and working partners in one-earner couples would raise the floor up to

the poverty line whenever (observed or derived) out-of-work incomes are below this threshold. For

dual-earner households and non-working partners in one-earner couples there would be an

additional leakage only for the wage of the partner that it is being kept constant for the calculation of

the PTR. Regarding to household in-work incomes, steeper lines imply that the benefit is withdrawn

less which increases the returns to join/remain in the labour force. In this way, the steepness and the

intersection point defined by different withdrawal rates represent the trade-off between

participation incentives and costs. For instance, a withdrawal rate of zero per cent means that

earned income is not withdrawn at all, which for households without non-earned income

geometrically would represent a parallel line to the 45° one and resembles a household basic income

with its positive effects on incentives but high cost. On the contrary, a withdrawal rate of 100 per

cent is equivalent to a horizontal line and calculating the poverty gap with its aforementioned

negative effects on incentives but lower cost.

In relation to what is the specific impact on PTR of allowing leakage with different withdrawal rates,

we would be basically modifying the household incomes in and out of work of equation 1, i.e. in the

hypothetical situations when people work full-time (FT) and not at all. As for single-headed

households and working partners in one-earner couples out-of-work incomes would be raised up to

the poverty line regardless the withdrawal rate used, the impact of different rates on the income

wedge of PTR acts only through modifying in-work incomes. For dual-earner households and non-

working partners in one-earner couples, there is also some leakage in the situation when one partner

works zero hours and the wage of the other is kept constant; however, that wage is also kept

constant when we switch to the FT situation. Therefore, the wages that are kept constant are

partially cancelled out and they are not fully offset just due to the non-linearity of tax-benefit

systems. Thus, withdrawal rates that allow a more generous in-work transfers for a household than

the necessary one to bring the out-of-work incomes of that same household up to the poverty line

(or somewhat higher) would improve their incentives. Therefore, the minimum cost of not worsening

average PTR in the first three equivalised household income deciles would imply a withdrawal rate

that makes the sum of the hypothetical in-work transfers (in relation to gross wages) equal to the

sum of the necessary transfers to bring their out-of-work incomes up to the poverty threshold (or

somewhat higher). As an illustration, Figure 2 shows this for a range of withdrawal rates. It can be

seen how the previous example of using a withdrawal rate of zero per cent would improve

incentives and the one of using a withdrawal rate of 100 per cent would reduce them, while a

withdrawal rate of around 60 per cent maintains average incentives at the bottom of the income

distribution.

Figure 2. The impact on PTR per decile of closing the poverty gap allowing leakage


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Note: bl correspond to the baseline and wX to closing the poverty gap allowing leakage with the

respective withdrawal rate

In order to study the effect in the intensive margin, labour supply responses in terms of hours of

work will be estimated following the stylised assumptions and formula for the intensive elasticity of

Immervoll et al. (2007). This requires assuming a simple income-leisure utility function that takes into

account household income but that, among other limitations, it is individual and does not include

income effects - which as aforementioned tend to be small anyway. In turn, the intensive elasticity

can be expressed just as a function of the change in MTR, hours and the original values of these two

elements. Assuming an elasticity of 0.1 for everybody thus allows us to obtain the expected change in

hours.

5. Results In the best simulated data, poverty in Belgium and Finland is 12 per cent and in the UK 15 per cent9.

In the first row of Table 1 we see that the low poverty in Belgium is achieved imposing a high average

PTR in the first three (equivalised household income) deciles, Finland is able to impose PTR slightly

9 These figures are very similar to the ones for the year 2009 which are obtained using simulated data based on

the non-uprated SILC 2010, while according to EUROSTAT for that year the corresponding poverty rates were 14.6, 13.8 and 17.3 per cent respectevely. Sources of difference can be found in the respective EUROMOD country reports. Costs will be presented as a proportion of total simulated incomes which can partially attenuate over-simulations of them (asymmetrical over-simulations of incomes across the income distribution would not be attenuated).


11

lower in this area, while in the UK poverty is higher but PTR considerably lower. As PTR are a

combination of in- and out-of-work household incomes, it is interesting to decompose the

contribution of each element to study possible differences across countries in the incomes available

in each situation. We do this by estimating separately the average in the first three deciles of the

components of equation 1, i.e. average household incomes in relation to gross wages in the

hypothetical situations when everybody works zero hours and FT. On the one hand, regarding

average household out-of-work incomes in relation to gross wages, this corresponds to 75 per cent in

Belgium and 80 per cent in Finland, while in the UK just to 68 per cent. On the other hand, average

household in-work incomes in relation to individual gross wages are 103 and 112 per cent in Belgium

and Finland respectively, whereas 117 per cent in the UK. Moreover, in the UK this high incomes are

achieved with the lowest effective taxation on low incomes (i.e. the balance between taxes and

benefits) which only reduces household incomes before taxes and transfers in relation to individual

gross wages in 6 per cent, while this corresponds to 17 and 19 per cent in Belgium and Finland

respectively. In sum, the UK offers the lowest out-of-work household incomes in relation to gross

wages, but at the same time effectively tax work the least. Is this combination what allows the UK to

have so low PTR.

Table 1. The cost of closing the poverty gap and PTR

BE FI UK

Scenario Cost PTR at

the bottom

Cost PTR at

the bottom

Cost PTR at

the bottom

Baseline 71% 67% 51%

Closing pgap (or w100) +1.7pp 75% +1.2pp 74% +2.3pp 65%

Closing pgap with the minimum leakage BE=w59/FI=w59/UK=w33

+3.3pp 71% +2.9pp 67% +9.9pp 51%

Closing pgap with leakage to emulate UK BE=w23/FI=w33/UK=w33

+15.2 pp 51% +9.6pp 51% +9.9pp 51%


Note: at the bottom means average in the first three equivalised household income deciles; costs are

estimated as a proportion of current total (non-equivalised) incomes; the cost of closing the poverty

gap with the minimum leakage already includes the cost of closing it with no leakage

Together with PTR, the second and third row of Table 1 show the cost of closing the poverty gap. In

the second row the ‘mechanical’ cost, which is equivalent to apply a withdrawal rate of 100 per cent

in equation 1. In the third row the cost including the minimum leakage to maintain average PTR at

the bottom of the income distribution, where the necessary withdrawal rates applied to earned

incomes are detailed in the leftmost column. All costs in this table are expressed as a proportion of

total net (non-equivalised) incomes to give an idea of the effort needed in relation to the remaining

tax base (in the Annex X we also present the effort in relation to current revenues). That being said,

with respect to the current size of the poverty gap, in the second row we observe that aligned with


12

its higher poverty, the UK also presents a higher poverty gap (2.3 per cent of total incomes)10. At the

same time, despite having similar poverty rates, the poverty gap in Belgium (1.7 per cent) is

considerable higher than in Finland (1.2 per cent), which indicates a deeper poverty. It is interesting

to highlight that in Belgium and Finland the poverty gap is roughly equally divided between jobless

and working households, while in the UK around two thirds correspond to jobless households. This is

consistent with aforementioned low out-of-work incomes in relation to gross incomes offered in the

UK. With regards to participation incentives if we ‘mechanically’ close the poverty gap, we see that as

expected PTR would worsen. This is expected since household incomes when everybody worked

both zero hours and FT would be raised just up to the poverty line, thus narrowing the income wedge

between the incomes available in both situations which increases PTR. As some households with low

earnings potential could work less or not at all after these changes, these costs understate the true

cost of closing the poverty gap.

In consequence, if we wanted to close the poverty gaps and maintain average participation

incentives at the bottom of the income distribution, this would need an important leakage above the

poverty line for working household. Due to the current poverty gaps and participation incentives

imposed by tax-benefit systems, the cost and leakage varies considerably across countries. First, the

smallest effort to close the poverty gap for jobless households needs to be overcome in Finland (6

per cent), followed by Belgium (1.2 per cent) and lastly the UK (1.7 per cent). Second, since the UK

currently presents a very high wedge between in- and out-of-work incomes, the necessary leakage

for working families to maintain PTR after closing the poverty gap for jobless households is also very

high. This is reflected in the low withdrawal rate needed and the extra total cost to simultaneously

maintain PTR and close the poverty gap in the UK (9.9 per cent of total incomes), compared to lower

ones in Belgium and Finland (3.3 and 2.9).

In this way, the latter costs represent the effort required to maintain participation incentives and

accordingly they depend on the current situations which are different across countries. Then, what if

instead of wishing to maintain different situations we would want to arrive to a common one. This

would allow us to at least control the arrival point to then compare costs across countries. For

example, if we wanted to reach the PTR of the UK, this would need in Belgium a huge effort in terms

of making work more attractive by withdrawing less from the hypothetical transfers. As shown in the

fourth row of Table 1, using a withdrawal rate of 23 per cent would allow Belgium to have the same

PTR as the UK. In this case, closing the poverty gap with that leakage would have a cost of 15.2 per

cent of total incomes as the transfer for working households would be much more generous and

would reach many more households. In Finland, the withdrawal rate needed and the cost would be

similar to the ones in the UK. With respect to the reasons of these differences, first, in terms of

tapering the hypothetical transfer, Finland can use a higher withdrawal rate than in Belgium because

average household net earned incomes in relation to gross wages are higher. This is probably due to

more dual-earner households since household incomes before taxes and transfers in relation to

individual gross wages are the highest in Finland, so at a similar withdrawal rate more leakage is

achieved. The same occurs in the UK but in this case is probably due to the aforementioned low

effective taxation on low incomes. In other words, Belgium would be compensating for the higher

10

To be precise, it does not present a higher poverty gap but a higher effort to mechanically close it since results are expressed in terms of total incomes. For this reason, all figures regarding current poverty gaps were contrasted with the normalised poverty gap where the ordering of the countries remained unchanged.


13

effective taxation on low incomes and their perhaps lower number of dual-earner households.

Second, in relation to why the costs would be similar in Finland and the UK, it is because in the UK

the largest poverty gap for jobless households would be overcome and less leakage is necessary,

while in Finland somewhat more resources are needed for leakage and the smallest poverty gap for

jobless households needs to be covered. However, when changing in such a way the budget

constraints, probably there would be increases in labour supply. If there was enough labour demand

to absorb this, the costs might be lower due to the concurrent increase in revenue collection. At the

same time, what are good incentives in general and/or for a specific country is not known. In sum,

more research is needed in these issues.

Lastly, as anticipated, a trade-off appears in relation to incentives to work more hours. The trade-off

is also heterogeneous across countries due to important differences in current MTR. In the baseline,

MTR at the bottom of the income distribution are 43 per cent in Belgium, 39 in Finland and 58 in the

UK. As the hypothetical transfers to close the poverty gap with the minimum leakage to maintain PTR

would withdraw incomes strongly in Belgium and Finland, the initially lower MTR would increase

importantly. In these two countries this would be equivalent to an average of two hours less of work

among workers at the bottom of the income distribution, while in the UK just one. As a general final

remark, the results in the intensive and extensive margins reflect the nature of current systems and

the interaction with the hypothetical transfer. The UK systems already follows the general logic of

the transfer, i.e. imposing relatively lower PTR and higher MTR at the bottom of the income

distribution, while if the other countries wanted to increase PTR in this way, they would worsen MTR.

6. Conclusions We found that the cost of eradicating poverty without worsening average participation incentives at

the bottom of the income distribution across countries would be between two and four times the

cost of just lifting all incomes to the level of the poverty threshold. This signals that a balance

between activation and protection would not be cheap and that some leakage would be necessary.

Current tax-benefits systems across countries deals differently with poverty reduction and work

incentives, which also explains the different results across them. While in Belgium and Finland higher

out-of-work incomes allow for lower poverty gaps for jobless households, higher effective taxation

on low in-work incomes results in relatively low participation incentives. On the contrary, the UK

offers lower out-of-work incomes which is consistent with a higher poverty gap for jobless

households, but effectively taxes low earnings the least, achieving poverty gaps for working

households comparable to the other countries and much higher participation incentives. In

consequence, to maintain currently high PTR, in Belgium and Finland much less leakage is necessary

to increase in-work incomes when out-of-work ones are raised to the poverty line. When instead of

maintaining current PTR we calculate the cost (not including behavioural reactions) of achieving the

PTR of the UK, costs and the distribution of them changes. In this case, in Belgium much more

leakage is needed due to their currently higher effective taxation on low earnings compared to the

UK and less dual-earner households compared to Finland. At the same time, although the effort in

Finland to achieve the PTR of the UK would be similar to the one that this country needs to close its

poverty gap maintaining current PTR, in the UK a larger part of the cost would go to close their

currently larger poverty gap for jobless households, whereas in Finland more to increase in-work

incomes.


14

Appendix

Appendix A – Participation tax rates Several steps are necessary in order to calculate PTR, both in the base line situation and in the

hypothetical scenario when we close the poverty gap allowing for some leakage. As expressed in

equation 1, we need for each person three elements: gross wages and net incomes in and out of

work. Getting out-of-work incomes for everybody and wages with their derived in-work incomes for

people in work is rather simple using the data and EUROMOD; however, people available for the

labour market who are out of work do not have observed gross wages (therefore, neither incomes in

work). Hence, for the latter group we predict what would be their hourly wages if they worked. To do

so, we construct a Heckman selection model based on the observed hourly wages and characteristics

of employed people in work. To build this model we need variables that are not included in the

EUROMOD input file; therefore, we merge this file with SILC and FRS. The resulting file using SILC

presents some inconsistencies to calculate hourly wages. First, the declared number of months

working (either full or part time) and gross wage from employment are not always coherent. Second,

some people respond to be working both part- and full-time and the weekly amount of hours worked

corresponds only to the main job. Third, some respondents declare to work too many or too few

hours, so it is defined that working between 30 and 70 hours for full-time workers and less than 36

for part-time workers are realistic amounts of hours. To deal with all these situations, in the model

we only use the hourly wages from people with consistent information and we impute the wages of

people without consistent data. In the UK we get from FRS the gross wage of employed people in

their first job to use in the model. The variables that we use for the wage equation in the Heckman

model are education and experience (including squared terms) and migration status (in FRS there is

no distinction between EU and non-EU). The extra variables necessary for the selection equation are

region and for women also the presence of children younger than three, between four and six and

between seven and 12 years old. With this information we predict log hourly wages separately for

men and women. For the Heckman model and PTR we only consider people available for work living

in households composed by couples or single adults (with or without children) which correspond to

around 80-90 per cent of the total population available for work. The reason for selecting this sub-

sample is that we utilise household income for the calculations of the PTR under the assumption that

decisions to work are based on pooled incomes, assumption that is difficult to make in other type of

households (e.g. in multiple adult households). We define as available for work people between 20

and 64 years old who are not farmers, pensioners, students, disabled or sick, or family workers not

available for work. In addition, we do not calculate PTR of households receiving housing allowance

and individuals receiving non-simulated benefits because they cannot be adapted to changes in

wages. In contrast, we do calculate PTR of workers with partner’s receiving non-simulated individual

benefits as we believe that these benefits would not change much when partner’s wages are

modified. Once we have predicted gross wages we impute the hypothetical wages of people out of

work and of self-employed in FT equivalent units (38 hours per week) and we also transform the

observed wages to this units in order to make them comparable. In the next step, we run EUROMOD

to get hypothetical net incomes when everybody works 38 hours and zero hours per week during the

whole year. We do this twice: first modifying wages of single-headed households and of the first

partner of couples while keeping constant the wage of the second partner, and subsequently doing

the same for the second partners, which later allows us obtaining the PTR.


15

Appendix B – Income components Table 2. Income components of net non-earned income and net earned income

BE FI UK

Non-earned Earned Non-earned Earned Non-earned Earned

Net Net Net

+ Gross + Gross + Gross + Gross + Gross + Gross

- proportional income & municipal tax and maintenance payments

- proportional income tax, municipal tax and maintenance payments

- proportional taxes and maintenance payments

- proportional taxes and maintenance payments

- proportional income tax and maintenance payments

- proportional income tax and maintenance payments

- Investment & property tax, pension & disability contributions

- Employee, special & self-employed contributions

- Capital & property tax

- Employee & self-employed contributions

- Council Tax - Employee & self-employed contributions

+ Work bonus + Working tax credit

Gross Gross Gross

+ investment income

+ income from employment and self-employment

+ investment income


+ investment income


+ income of children under 16



+ property income

+ property income

+ property income

+ private pension

+ private pension

+ personal pension

+ received transfers



+ benefits + benefits + benefits

+ income from odd jobs


16

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