Should we keep means-testing to a minimum?

Despite reports to the contrary, it is fairly obvious that Kemi Badenoch, the leader of the Conservative Party, does not want to means-test the state pension. She does, however, want to apply the idea of means-testing more broadly so that other benefits are more narrowly targeted at the least well-off.

Perhaps oddly, that approach does not extend to backing the government’s plan to restrict winter fuel payments to those receiving pension credit (a means-tested income top-up). I suppose you can have too much of a good thing.

The idea of means-testing is one that divides free market economists. On the one hand, yes, the goal of keeping public spending (and income transfers) to a minimum does imply focusing scarce resources where they are most needed. Rather than an all-encompassing welfare state, we ought to have one that provides a safety net.

There’s a downside, though. Means-testing creates a minefield of perverse incentives. A means-tested state pension – to use a topical example – might discourage people from saving privately for retirement and so lead to more old-age poverty.

As for working age benefits, means-testing requires you to withdraw support as people’s earnings rise – and this creates eye-wateringly high effective marginal tax rates. Where income tax, National Insurance, and the Universal Credit taper overlap, for example, people keep less than a third of every pound they earn. (And this is a vast improvement on the old system.)

There’s also a political economy problem. When you combine means-testing with a progressive tax system, you risk creating a ‘makers and takers’ dynamic that skews democratic incentives. The intention might be to take from the richest and give to the very poorest, but there is always a danger that you end up with the kind of state that Bastiat warned of: ‘the great fiction by which everyone tries to live at the expense of everyone else.’ Some might argue that we are there already.

Ultimately, there are some areas of the modern welfare state where means-testing is unavoidable, at least in the short term, because the required support is so costly. But I would be wary of making it a broader policy objective. Better to simplify, consolidate, and take a long-term view of how the tax system and welfare state interact. There is a lot to unpack there, but in a nutshell: incentives matter, so the focus ought to be on reforms that encourage and extend self-reliance as far as possible.

Tom Clougherty
Executive Director & Ralph Harris Fellow

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Executive Director Tom Clougherty, Editorial Director Kristian Niemietz, and Communications Manager Reem Ibrahim discuss the Renters’ Rights Bill, ask whether Britain really wants economic growth, and consider Ed Davey’s suggestion that Britain rejoin the EU Customs Union on the IEA Podcast

Beyond Freeports

In a new report for the Institute of Economic Affairs, Economist Vera Kichanova argues that the UK could and should create new self-governing cities like Hong Kong within its borders, to drive growth and prosperity.

Kichanova, a Senior Economist at the Free Cities Foundation, examines examples from across the world where new private and self-governing cities, special economic zones (SEZs) and special administrative regions (SARs) have had huge success in delivering prosperity to their people and the areas in which they are situated.

She criticises the freeports policy of recent years in the UK for being used as a political tool and merely adding another layer of bureaucracy in order to rebalance economies towards certain areas and industries, rather than removing excessive regulation and administration to allow the market to flourish.

As of 2020, Hong Kong’s GDP per capita was above $45,000 – more than that of the UK, Canada or Japan, and more than four times as much as that of mainland China. Britain played a vital role in this economic success, and so should be able to repeat the feat on its own soil. Its strong institutions of democracy, rule of law and property rights make it fertile ground.

In addition to the direct economic benefits, a self-governing city in the UK could create a liveable community and would unlock opportunities for more regulatory innovation on a local scale, allowing experimentation with policies in contentious areas such as planning. Successes could then be replicated nationwide with a strong evidence base.

Full Publication

• The Radical Plan to make British Cities Thrive and Become as Rich as Hong Kong, The Express

• British Ideas Built Hong Kong, Lets Bring Them Home, CapX

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