Tax, benefits and the incentive to seek work

There are two reasons for concern about the effect fo the tax and benefit system on incentives for low paid workers. Because of tax and loss of entitlement to benefits, it is possible that a large increase in gross earnings has little effect on a worker's net income. This problem has been widely recognised as the poverty trap Paragraph 3 - This paper examines the unemployment trap. To do this, we need to evaluate the financial loss from unemployment. A conventional method of doing this is to calculate replacement ratios; that is, the ratio of income received when out of work to income when in employment. The replacement ratio varies from individual to individual, depending on his household circumstances-which influence the level of benefit he can anticipate-and on the level of wages he can expect to obtain if he has a job. The replacement ratio also depends on the length of time for which an individual is unemployed. In general, it is higher for short periods of unemployment than for long periods. We show that because of the interaction of tax and benefit systems, this difference between short and long run ratios is often very large.