Article by Monica Costas Dias and Jonathan Shaw, PEPA node of NCRM. This article also appears in the Winter 2012 issue of MethodsNews newsletter (opens a .pdf file).
Most evaluation studies of tax reforms focus on directly affected outcomes. For instance, in-work benefits aiming to improve the incentives to work of families with children have been assessed on their ability to increase employment rates among mothers in low-income families. These are likely to be the key effects in the short-term.
However, some of the most important lifetime decisions, such as those on education and employment, are closely intertwined. Education happens early in life and affects employment and earnings later on; it has also been shown to respond in advance to changes in its expected value for working. Employment status is related over time and can lead to higher future earnings through the accumulation of working experience; conversely, future returns to current employment may affect employment choice. These connections are crucial to understand the overall long-term impact of policies like in-work benefits and how they may differ from their short-term counterparts.
We develop a rich framework that can support the study of interconnected decisions over the course of life and how they interact with the design of taxes and benefits, particularly in the form of work-contingent transfers to low-income families with children.
The focus is on the labour supply, experience accumulation and education choices of women within their families. In the model, women choose education at the beginning of life and subsequently enter the labour market where they can decide to work full-time, part-time or not at all. Their earnings depend on how many hours they work, their education and working experience. They may be entitled to benefits depending on their working status and family circumstances as determined by their spousal income (if they have one) and the presence of children.
The focus on women is justified by their behaviour and exposure to hardship. Women are more responsive than men to work incentives, particularly as mothers. They often live through periods of lone motherhood, are especially vulnerable to poverty and at risk of long career breaks that can have long-lasting effects on future employment and earnings prospects. The recent reforms to in-work benefits in the UK have been driven by these concerns and specifically targeted women. Part of the motivation to incentivise mothers into work has been that continuous work promotes attachment to the labour market and preserves valuable skills.
Within this framework we study a specific reform to the tax and benefits system in the UK. It amounts to the succession of policy changes implemented after the introduction of Working Families Tax Credits in 1999 up until April 2002. Overall, it involved an expansion in the generosity of welfare and tax-credits to families with children.
We find that women can respond strongly to work incentives depending on their circumstances. Less educated single mothers face an especially high risk of unemployment but are very responsive to incentives to work and earn more. Thus, targeting work incentive schemes on them maximises impact.
However, the effect is long-lasting only if working experience matters for future working and earnings. We find that experience is important only if women work full-time, particularly for those with some education above the GCSE level. Part-time work, which is strongly incentivised by the UK tax-credit system, carries a penalty for female wages that can be explained by experience effects: women in part-time work experience no increase in wages.
These results explain why static models of labour supply provide an accurate prediction of the short-run effects of tax-credit reforms on employment of women with basic education. While they are very responsive to work incentives, working experience plays almost no role in determining their wages and thus has little impact both on future employment prospects and on working decisions in anticipation of becoming eligible to generous subsidies.
Finally, we also find that there is a small but important impact of the tax-credit reform on education choices. More generous tax credits provide a strong insurance against low wages that affect women with basic education disproportionately. Thus, the value of education as a means of avoiding low wages is reduced and some women may be induced to invest less in education. This strongly affects the working decisions and earnings of these women.