The distributional implications of universality (again)

Paul Johnson, the director of the IFS, has an article in the Times (also available on the IFS website without a paywall) about how different ideas about fairness are behind some of our political disagreements. There’s plenty to agree with in the piece. But when he touches on a couple of themes that regular readers of the Policy Sketchbook will be somewhere between familiar with and bored of – social care reform and redistribution – Paul says some things that I think are a bit misleading.

Here are the offending paragraphs:

“The Conservatives got into dreadful trouble over their manifesto proposals on social care funding. We have spent decades making no progress on how to reform the funding system, partly because of the way we think about fairness. Some think it unfair that anyone should have to use their own assets, including their house, to pay for care. Yet one of the reasons why proposals to cap the amount that anyone has to pay have not been implemented is because, compared with the system we have today, the winners would be the relatively well-off.

In fact, this is a fundamental disagreement about the role of the state as much as it is about fairness. If you think the state is there to provide a degree of social insurance, stepping in where private insurance markets don’t work to pay for those who are unlucky enough to need care, then you are likely to favour it paying all the costs above a certain level. That’s how we tend to think of the NHS. But if you think the state is there just to redistribute money from rich to poor then you might think it unfair.”

This is a familiar take: moving to universal benefits means less redistribution and benefits the well-off. But is it true? Well, that depends. The most important thing to remember when thinking about the distributional impact of changes in government spending is that the money doesn’t just appear out of thin air. The effect of a policy on the level of redistribution that government does depends on how it is paid for. By choosing different funding sources you can get pretty much any distributional effect you want, but some scenarios are more relevant and plausible than others.

Three different ways of paying for a universal benefit

So let’s take a look at the distributional consequences of moving from a means-tested benefit to a universal one, paid for in different ways. We’ll use a stylised example for clarity, but the conclusions generalise pretty well. Imagine we have a benefit worth £1000 per person, but means-tested so that only the bottom 30% of the income distribution get it. An independent commission recommends making this universal, so that everyone gets the benefit regardless of their income. There are broadly three ways we can pay for this and each has different distributional consequences.

Reducing means-tested benefits to pay for universal benefits is regressive

One way to pay for the new universal benefit would be to reprioritise some money that is currently spent on means-tested benefits. It’s trivial to see that this is going to be regressive, but let’s run the numbers anyway. Let’s say we take the money that is currently spent on our stylised means-tested benefit and use it to fund a universal version. Instead of the bottom 30% of the income distribution getting a benefit worth £1000, everyone now gets one worth £300. The bottom 30% lose £700 each and everyone else gains £300. This is nailed-on regressive and it would be a similar story if the money were reprioritised from some other area of means-tested spending.

Means-testing one universal benefit to pay for another is distributionally neutral

Another way of paying for the new universal benefit is to reduce universality in another area. This is the sort of thing that was discussed in the wake of the Dilnot Report: universal coverage for social care could be funded by means-testing some of the universal benefits that older people currently get, like winter fuel allowance or free bus passes. The distributional consequences of the switch would depend on the details, but it would be roughly neutral – we are taking money away from the same people who will get more from the new benefit.

Paying for a universal benefit through higher taxes hits the rich

The third way that we could pay for the new universal benefit is through higher taxes. We can design taxes with various distributional profiles, but we can get an idea of who would be hit by a “typical” tax rise if we look at the distribution of current UK taxes as a whole.

The chart below (based on ONS data) shows the distributional impact of extending our £1000 benefit to the whole population and funding it through an increase in “general taxation” – by which we mean a tax rise with the same distributional profile as the current UK tax system. The (positive) green bars show the additional benefits people in each income decile get and the (negative) red bars show the additional taxes they pay. The red and green bars sum to zero because, at risk of labouring the point, the money has not appeared out of thin air.

The winners from this shift to universal benefits are not the poorest, who already got the benefit, but it would be misleading to say they are the “relatively well-off”. The winners are the people in the middle, especially those just above the current means-test threshold. The biggest losers by far (in cash terms) are the richest 10%. This is a key point: the main distributional effect of a tax-funded change from means-tested to universal benefits is to move money from the people at the top of the income distribution to the people in the middle.

But you may have noticed something else in the chart. The bottom 30% of the income distribution also lose out, because they pay more tax and don’t get any additional benefit. They don’t pay much in absolute terms, but relative to their income it’s quite a lot. The chart below shows the same figures as a proportion of income: the richest still pay the most on this measure, but now the poorest are not far behind.

Now, unless you think that the bottom 30% do rather too well out of government as things stand, this doesn’t seem particularly fair. Luckily, it’s cheap to fix, since the bottom 30% only pays 7% of the cost of this policy if the money is raised through general taxation. If we were to exempt them from these tax rises, we’d still have enough to fund a universal benefit worth £970 for the rest of the population. But the point is worth noting: if universal benefits are to be funded through tax rises, the additional taxes shouldn’t hit the poorest.

The size of the state

So we’ve seen three different ways of paying for a new universal benefit with three different distributional effects: regressive, neutral and progressive. It should be obvious by now that unless you are clear which one of these you think will happen, you shouldn’t be saying anything about the distributional consequences.

How we assume the additional spending will be balanced rather depends on our assumptions about the size of the state. If we believe that tax rises are impossible or highly undesirable, then we are going to want a new universal benefit to be paid for by reprioritising spending. Up to a point we can reprioritise from other universal benefits and get something distributionally neutral – but so much of the British state is already means-tested that (unless you are willing to go for pensions or the NHS) there is limited capacity for such reprioritisation. With a fixed public spending envelope and tax profile there is only so much universality you can afford if you also want to do a certain amount of redistribution and under these assumptions, Paul’s claim that “the winners would be the relatively well-off” is just about defensible – although for a small spending item like the Dilnot reforms it would be quite easy to reprioritise spending in a neutral or progressive way.

But if we assume that more universal benefits will mean higher taxes then the picture looks very different. As shown above, the biggest losers from this would be the richest and the winners would be the people in the middle. And there are a couple of reasons to believe that this is ultimately the more reasonable assumption.

The first is that the people who are in favour of universal benefits tend to be the people who are in favour of higher taxes. Elect a government that does one, they are likely to do the other. We can see this in the recent Labour manifesto, where universal free university tuition was proposed, funded by an increase in income tax. Although the Dilnot Commission didn’t say much about how its proposals should be funded, the previous abortive attempt at social care reform (Labour’s National Care Service) was to be funded by an increase in inheritance tax.

The second is that countries with more universal benefits tend to have higher tax rates. There’s more going on in these figures than just universality versus means-testing, but in general the countries with the most universal benefits, such as the Nordics, France and Belgium, raise the most in taxes. Internationally, means-testing goes with low taxes and universality goes with high taxes.

Some conclusions

To be fair to Paul, he is far from the only person to go around saying that universal benefits are regressive. It’s even true under certain assumptions – specifically that the UK must remain a low tax country. The problem is that no one who writes opinion pieces saying that universal benefits are regressive ever seems to find space to clarify that this is their assumption. If they did, readers would probably notice that this isn’t what the proponents of universality are usually proposing, and it isn’t what countries with more universal benefits do. Moving towards a European model with more universal benefits and higher taxes would most likely amount to a transfer from the rich to the people in the middle of the income distribution. I doubt that fans of redistribution would, as Paul suggests, think this is unfair.

Toby Young and the power of education

Toby Young is in the news again. The Tories’ favourite born again educationalist has been given a seat on the board of Jo Johnson’s new universities “regulator”, the Office for Students. This gives me an excuse to publish something I failed to put out last time he was in the news, for claiming that schools can’t do much to reduce inequalities in attainment.

Toby Young has been at the centre of some controversy about the ability of schools to help disadvantaged children. He wrote an article for Teach First arguing that schools can’t really achieve much, which the charity subsequently took down because they disagreed with it. The article is now published on Toby’s blog, and he has been anointed by some as a free speech martyr (although he very modestly says that “martyr is putting it a bit strongly”).

But what about that article? Is it right?

There are a few different threads to it, including Toby’s usual futurology about IQ-enhancing drugs, but the central claim about the efficacy of schools is based on research that attributes variation in GCSE results to different causes. According to Toby, this research finds that IQ accounts for 60-70% of the observed variation in results, differences between schools (such as funding, class size and quality of teachers) account for 10% and the other 20-30% is accounted for by other environmental factors.

I don’t know this research so I’ll leave it for others to debate whether it’s any good and whether Toby is describing it correctly. The results are presumably from a multiple regression of observational data, so the usual caveats about causation versus correlation and unobserved variables will apply. But let’s set that to one side and take the results at face value: what do they mean for schools policy?

The conclusion Toby draws is a tempting one: that schools can’t do much to ameliorate the effects of inequalities. I think that’s the wrong conclusion to draw from these numbers for three reasons, which I’ll address in order of increasing complexity.

The first is trivial: reducing inequalities in attainment by 10% sounds like a major achievement to me. We should do this! (In fact it may be slightly unfair to suggest Toby is arguing otherwise.)

The second is more subtle and requires us to think about what those numbers actually mean. 10% of the observed variation in GCSE results is accounted for by the observed variation in school characteristics. So if we were to equalise all schools on these characteristics (things like funding, class size and quality of teachers) then variation in results would reduce by 10%. If the only intervention we could possibly make in schooling was to equalise these things across schools, then we could only eliminate 10% of current variation in attainment. But this isn’t the only thing we can do. What if we made schools in deprived areas better than those in more affluent areas? What if we gave additional help to the children who face the greatest disadvantages at home? The 10% figure tells us nothing about the efficacy of these things.

The third also relates to the way that 10% figure is constructed. It’s the variation attributed to differences between schools divided by total observed variation, so it’s a function of three things: how big the differences are between schools, how strong an effect school differences have on attainment, and how much variation there is from other sources (like home environment and IQ). So we can’t just look at the 10% figure and say that’s a small number so schools can’t have a strong effect on children’s attainment. If our schools were much more unequal in funding and class size then this number would go up, while if they were identical on these measures it would go down to zero – but these changes would tell us nothing about the power of education to drive attainment. If we were able to reduce variation due to other environmental factors (say, by reducing income inequality between the families of schoolchildren) then the 10% schools figure would increase. This would not mean that schools had become more effective at driving attainment.

So taking all of this into account, what can these figures tell us about schools policy? What would we do differently if this figure were 50% instead of 10%? It seems to me that the answer to both these questions is “very little”. Either way we should make sure that already-disadvantaged children don’t end up in schools that have fewer resources, larger class sizes and worse teaching, since these factors do compound their disadvantage. Either way we should consider helping disadvantaged children with targeted policies, about which these numbers tell us nothing. Where interventions cost money, we will want to know if the effect size is large enough to justify that expenditure, but these numbers tell us nothing about the absolute effect size of school interventions.

In fact, it’s hard to conclude that these numbers are much use at all for policy. The nature versus nurture debate has become an ideological battleground, but its relevance to education policy seems very limited. We can’t control nature, but we can decide how to nurture our children. We can do that by designing, testing and implementing good education policies. Whether in the end these policies explain more or less of the population-level variation in attainment than genetics is rather beside the point, if they are effective and cost-effective at improving attainment and reducing inequalities. It’s easy to see this if you consider an example from another policy area: if you have a demonstrably cost-effective behavioural intervention that reduces the chances of high-risk people developing cancer, but I tell you that only 10% of the observed variation in cancer risk is related to behaviours, does that have any bearing on whether you implement your policy?

The distributional impact of scrapping tuition fees

Since Labour decided to make the abolition of tuition fees a central piece of their election manifesto, we have been treated to a healthy stream of articles arguing for and against the proposal. There are lots of different arguments to be made here, but this post is just going to focus on one: whether abolishing tuition fees would be regressive.

This seems to be a popular line of criticism among centre-left commentators and Tory politicians alike, and they appear to have some heavyweight backing in the form of the IFS. However, since “regressive” is a poorly defined term and routinely abused in public policy debates, it’s generally a good idea to be suspicious this sort of claim. So let’s take a closer look at how tuition fees (and the idea of scrapping them) hold up against different definitions of “progressive” and “regressive”.

Tuition fee repayments raise more money from richer people

The IFS has done some modelling of tuition fees to work out how much graduates with different levels of lifetime earnings will repay. They find that higher fees mean that most people will never repay all of the money they borrow, so graduates who go on to earn more end up paying more for their tuition. Here’s a chart they published a couple of months ago comparing lifetime repayments under the current system with Labour’s proposal to scrap tuition fees and reintroduce maintenance grants:

It’s fairly clear from this chart that tuition fees are, under a certain definition of the term, progressive. People who go on to be richer pay more into the system while those who go on to earn the least pay no more than they would under Labour’s proposals. So if we define the term progressive to mean that richer people pay more then this is clearly a progressive way to raise money to fund our universities.

As a proportion of income, the richest 10% of graduates pay less than the next 40%

It’s no great surprise that rich people pay more, since repayments are proportional to earnings. In fact, the IFS notes that “for [the] majority of individuals, student loans are almost indistinguishable from an additional 9% graduate tax on their earnings” (or more precisely, their earnings above £21,000). But if we are going to think about student loan repayments as a kind of income tax then this suggests another definition of progressivity. Taxes are often called progressive if richer people pay more as a proportion of their income, not just in absolute terms. This definition sets the bar a bit higher – so do tuition fee repayments clear it?

The IFS doesn’t show these figures as a proportion of lifetime income, but I was able to cobble together a rough version based on the charts in their latest briefing note on the subject. The charts below show the difference in repayments between the current system and Labour’s proposal (i.e. the distance between the top and bottom lines in the IFS chart above) in absolute terms and as a proportion of lifetime income.

Now the picture looks a bit more complicated. Student loan repayments remain progressive at lower end of the income distribution. This is because repayments aren’t taken from the first £21,000 of your income and many graduates with the lowest lifetime incomes never earn much above this threshold. However, repayments now begin to look faily regressive at the top end of the income distribution. The richest 10% of gradutes contribute a smaller share of their income than the next richest 40%. This is because if repayments are a graduate tax, they are a tax with capped lifetime repayments. Once the full loan has been paid off, you stop paying tax. A significant proportion of the top 10% of earners pay off the full loan well before the 30-year limit (when it is written off), so they pay this tax for a shorter amount of time than everyone else.

So student loan repayments are progressive at the bottom of the income distribution, but under certain definitions they are regressive at the top end. But of course, that’s not really the question we are trying to answer here. We want to know whether abolishing tuition fees would be regressive. The IFS seem to think they have answered this question with the chart above, saying that “as high-earning graduates repay the largest share of their student loans, they benefit the most from the removal of tuition fees”. This, however, is nonsense. Unless they believe that we are going to replace the funding that universities lose with money that we have conjured out of thin air, they simply haven’t done the analysis that is required to prove or disprove this claim.

There are other progressive ways to fund university tuition, such as taxes

To work out the impact of abolishing student loans we need to have an idea of what will replace them as a funding stream for universities. The answer is of course that universities will get more direct funding from government, which will in turn be funded by higher taxes now or in the future, or by reductions in other areas of government spending. If the net effect of abolishing tuition and raising whatever taxes (or cutting whatever services) will pay for it leads to rich people doing better and poor people doing worse, then it seems reasonable to call the change regressive.

There are countless different ways to increase taxes, but since we are equating loan repayments to a sort of income tax, let’s focus on that. The chart below shows how the distributional effects of tuition fees compare with income tax.

(Since the IFS charts are based on the graduate income distribution – and graduates are richer than the rest of the population – they understate the progressivity of tuition fees in the population as a whole. I have roughly mapped the figures onto the population-wide income distribution so that we can make a better comparison with income tax figures. The mapping is very approximate, so please take the numbers with a pinch of salt.)

Compared to income tax, tuition fee repayments take less money from the people right at the bottom of the income distribution. This makes intuitive sense: income tax kicks in at £11,500 but tuition fees don’t kick in until £21,000 – plus there are more non-graduates at this end of the distribution who don’t make any repayments at all. At the other end of the distribution, tuition fees also take less money from the richest. The top decile pays around 40% of all income tax, but only around 30% of tuition fee repayments. Again it’s not hard to see why: marginal tax rates increase with income under income tax but not under tuition fees; and many of the richest graduates pay off their loans early and then stop paying their 9% “tax”. The people who do worse under tuition fees are those in the top 40% of the income distribution but outside the top 10%.

So what would  be the distributional impact of abolishing tuition fees and raising the same amount of money through income tax (in a distributionally identical way to current income tax take)? Well you would take some money from the richest 10% and some more from the poorest 60% and give it to those in between. Is that progressive or regressive? Well it’s kind of both: regressive with respect to poor people and progressive with respect to the rich. Either way, it’s quite different to the IFS claim that high-earning graduates would benefit the most from the abolition of fees. If the money was raised by increasing income tax equally for everyone then the richest 10% would be the biggest losers.

Of course, there are lots of other ways to pay for scrapping tuition fees and some clearly are regressive. The tax system as a whole is less progressive than income tax and if the policy was funded by a hike in VAT, for example, poor people would end up paying much more than under the current system and rich people much less. If other areas of government spending were cut you could generate just about any distributional profile you wanted, but since a large part of government spending in the UK is targeted to low-income groups, many options would be less progressive than tuition fees. The point though is that you can’t say whether scrapping one funding stream is progressive or regressive unless you consider its replacement.

Labour’s tax proposals are more progressive than tuition fee repayments

As it happens, the Labour manifesto – in which scrapping tuition fees was the biggest spending item – set out a number of tax rises to pay for their spending commitments, including an increase in income tax. However, the Labour policy wasn’t to increase income tax equally for everyone, but to increase it for the top 5% of earners only. We don’t need to draw any more charts to see that this is a much more progressive way to raise money than tuition fee repayments: 100% of the revenue is raised from the top decile. This would only cover a bit more than half of the cost of scrapping tuition fees, but the manifesto also included promises to reverse recent cuts in inheritance tax and capital gains tax, and charge VAT on private school fees. Scrapping tuition fees and paying for it by making these sorts of changes to the tax system would mean poor people paying less and rich people paying more. It would be progressive.

In conclusion

So what have we learned from all this? Well, tuition fee repayments are a progressive source of funding for higher education, insofar as rich people pay more for the same product. The system is great for the poorest, who may not end up paying anything back at all. However, if you look at how much people pay as a proportion of their income – which is how we usually assess the progressivity of a tax – the system starts to look quite regressive at the top end of the income distribution and the richest 10% seem to do rather well.

But just because tuition fees are fairly progressive, this doesn’t mean that scrapping them is regressive. This would be true if loans were scrapped and people had to pay current tuition fees out of their own pockets, but that is not what is being proposed. If taxes are increased to pay for the change then there are plenty of ways that the net effect could be progressive – and plenty of other ways that it could be regressive. But with the sort of tax increases that Labour set out in their manifesto, it seems clear that the net effect would be to increase the overall progressivity of government activity.

Now I don’t mean to suggest that we should scrap tuition fees just because we can find a more progressive way to fund university education. Distributional effects are not the only criteria by which we need to assess policies. Moreover, unless we think that the state currently does too little redistribution, it’s not clear that we would want every policy change to be progressive – and if we do think that, shouldn’t we be rectifying it by reforming the tax and benefit system? The aim of the university system is to educate, not redistribute, and any effects on access for people from poorer backgrounds seem much more important to reducing inequalities than the direct distributional consequences of choosing between tax-based and loan-based funding. So let’s talk about whether higher levels of debt will put some groups off applying to university, or whether a move back towards tax-based funding would lead to caps on student numbers and exclude poorer applicants. Let’s ask whether scrapping fees would lead to lower per capita funding for our universities, and whether this is a good or bad thing. There are many valid arguments to be made for and against tuition fees, but the claim that scrapping them would be regressive is not one of them.

Disclaimer

The analysis in this post is very rough. I don’t have access to the IFS model so I’ve read numbers off charts in their reports, mapped graduates very approximately onto the population-wide income distribution and conflated lifetime and in-year repayments. It wouldn’t be hard for someone at the IFS to do this analysis properly – and I would argue they should have already done it if they are making claims about who benefits from scrapping tuition fees. I’m pretty sure that the results would be similar to mine, but I would be delighted to be proved wrong. The point of this post isn’t to defend scrapping tuition fees. It is to insist that before we use words like “regressive” to describe a policy, we need to do the distributional analysis properly.

The Conservative manifesto, social care and taxing inheritance

UPDATE: Some of this post is a little bit out of date, since in the time between writing and publishing, the PM appears to have done a U-turn and re-committed to the coalition policy of a cap on care costs. I’m not going to update the whole post to reflect this, since I think it’s still worth understanding the impact of the manifesto policy, but I’ve added a section at the end discussing the implications of the U-turn.

The dementia tax as an inheritance tax

The Conservatives’ new social care proposals have caused a stir. Their manifesto promises changes to the way in which state support is means-tested. People with assets less than £100,000 will now be entitled to state support – up from £23,250 – but the definition of assets has changed, so that your house is now included even if you are still living in it. Previously the house was only included if you went into a care home (and you didn’t have any family still in the house). To get around the fact that it’s difficult to sell something you are living in, people won’t have to pay up-front but the money will be claimed from their estate when they die.

The backlash has been fairly predictable, although one must wonder if the Tories underestimated it when they put this in their manifesto. The changes have been labelled a “dementia tax”, referring to the fact that people who get dementia and need support in their own home now incur much higher costs while those with other illnesses continue to get free treatment on the NHS. There are echoes of the Tory cries of “death tax” that sounded the death knell of the last-but-one attempt to reform social care: Labour’s National Care Service.

But there has been support for the policy and some of it has come from a surprising angle, given that this is a Conservative reform relating to the inheritance of wealth. Some commentators have praised the reforms as progressive because they take away some wealth that would otherwise be passed on to children, while additional protection is only provided to those with lower levels of assets. This is set in contrast to Andrew Dilnot’s proposals to cap lifetime social care costs, which offered risk-pooling to everyone, including the wealthy.

Broadly speaking these arguments are correct. The Tory proposals are progressive, in that they make small inheritances (passed on by people who need social care) a bit bigger and medium to large inheritances (passed on by people who need social care) a bit smaller. But if we want to see the dementia tax as a sort of inheritance tax then we don’t need to discuss it in the abstract. We can do some analysis to see exactly what sort of inheritance tax it would be.

Estimating the total rate of “taxation” on inheritance

If we are going to think about social care costs as a tax on inheritance then we need to consider them alongside the other major tax on inheritance: inheritance tax. As well as the changes to social care, the Tories are also cutting inheritance tax by raising the threshold at which it kicks in from £325k to £500k per person. This allowance can be passed on to a spouse, meaning that mum and dad’s estate won’t incur any tax unless it’s worth more than £1m. So what is the combined effect of these two “taxes”?

It’s easy to calculate the effective tax rate on an estate in any given scenario. For example, under Tory policy, someone starting with a £200k estate who needs expensive social care would have £100k of their estate protected and have to spend the other £100k on social care. The “dementia tax” on this person would be levied at a rate of 50%, but they wouldn’t pay any inheritance tax. Meanwhile, someone with an estate of £1.5m who never needs any social care would pay 40% inheritance tax on all assets over £1m, working out as an effective tax rate of 13%, but they wouldn’t be hit by the dementia tax.

The chart below shows how the combined tax rate relates to the value of someone’s house (assuming they also have £50k in savings) under the current system and the Tories’ proposals for social care and inheritance tax. The “dementia tax” rate also depends on how much social care someone needs, so two scenarios are shown: people who don’t need any social care; and those who have very high costs of £250k over their lifetime, which they can’t afford from their income.

There’s quite a lot going on in this chart, so I’ve marked on four changes that will see different groups passing on more or less to their children.

People who will pass on more to their children as a result of these changes

1. Non-homeowners who need social care

There is one group of people that absolutely benefits from the manifesto policy, and that is people who don’t own their own home. The increase in the means-test rules mean they won’t have to use their assets for social care unless they have more than £100k in the bank. People with very low value houses will also benefit: if someone has a house worth £50k and another £50k in the bank, they won’t have to use their assets either. In the current system they do.

2. Most homeowners who go into a care home

People who go into a care home already have to use their housing wealth to pay for care – that is, they already pay a “dementia tax”. If their costs are high enough, they will only be left with £14,250. The Tory proposals raise this to £100k, so many homeowners will be better off. Of course, this only affects people who are going to reach this limit. With £250k of lifetime care costs, you would benefit from the new limit if your total estate is less than £350k. Given that the median house price in England is £220k, this is most homeowners. Fewer people benefit in London, where the median house price in London is £435k.

But while most homeowners who go into a care home are better off under Tory proposals, it’s still not great for their chances of passing on money to their children. Someone with a median-value house who has expensive residential care is still going to see about 60% of their estate going into social care costs.

3. Rich people, unless they need social care at home

Only rich people pay inheritance tax. Assuming that the person in question has a partner who dies before them, the first £650k of their estate will not be taxed. In 2016-17, only 8% of the population paid any inheritance tax – and that was a record high. By raising the threshold to £500k for individuals and £1m for couples, the Tories are giving a tax cut of up to £140k to the heirs of wealthy people.

However, the proposed social care changes take this money back – but only for some rich people. Those who are lucky enough to not need social care are fine – they can still pass on the additional £140k. Those that go into care homes are also unaffected by the rule changes. But those who need care at home are going to find themselves paying more towards it. If they need a lot of home care, they may find that this completely cancels out the inheritance tax cut.

(In reality, people with £1m plus estates are likely to have high incomes, so may be paying most or all of the cost of home care under the current system. In this case they would be unaffected by the social care proposals and their inheritance tax cuts would be safe.)

People who will pass on less to their children as a result of these changes

4. Most homeowners who need care at home

Most people who own a home have most of their wealth tied up in it. Under the current system, this wealth is not considered as part of the means test as long as they are still living in the house. The Tories propose to change that, meaning that anyone who owns a house worth more than about £75k (assuming they also have £50k of savings) will have to pay more out of their assets for home care. This is the vast majority of homeowners.

For people with homes worth around £75-300k, there is a trade-off between coverage for different risks: they pay more for home care, but if they go into residential care they are better protected. However, for those with homes worth £300-600k it is all downside. Even with £250k of care costs they won’t hit the proposed £100k floor, so won’t benefit from that change, but if they need home care they will pay more – sometimes a lot more. Meanwhile they aren’t rich enough to pay inheritance tax in the first place, so won’t benefit from the tax cuts.

Many London homeowners fall into this category. The median house price in London is £435k. Someone with a house worth that much won’t benefit from the £100k floor even if they have £250k of care costs. If they go into a care home they will pay the same as under the current system. But if they have care at home, they will pay much more: more than 50% of their estate will go towards social care costs, compared to around 7% in the current system. Their children will need to sell their house to pay the debt.

Another group that will lose out is people who go into residential care and leave a spouse at home. The value of the house isn’t considered as part of the current means test in this scenario, but under Tory proposals it would be included, leaving people paying a lot more in care home fees.

Summarising the effect on people with different levels of assets

The chart below shows another way of looking at this. It segments the population by house value (again assuming they also have £50k of savings) and identifies which groups win from the changes (shaded green), which lose (red) and which get a mixed bag (orange).

The effect of the changes can be summarised as follows.

• Non-homeowners (or those with very low-value homes) do better thanks to the rise in the means-test floor.
• People who own low-middle value homes (£75-300k) get a mixed bag and see an equalisation of their risks between home and institutional care. Home care will be much more expensive for them, but their residential care costs will be limited. This group includes the median homeowner in England.
• People who own middle-high value homes (£300-600k) lose out. They already faced a risk of losing more than half of their estate paying for residential care. Now they face the same fate if they need home care. Meanwhile, even if they spend the majority of their assets on social care, they are very unlikely to benefit from the increased means test. This group includes the median London homeowner.
• People who own high value homes (£600k-£1.2m) get a mixed bag. If they need a lot of social care in their own home, they are going to have to use up more of their assets paying for it. If they are lucky enough not to need social care (or if they have to go into a care home) then they benefit from the inheritance tax cut.
• Very rich people get to pass on more of their money thanks to inheritance tax cuts. Although people who are asset rich and income poor might see this gain cancelled out if they need home care, they are unlikely to be worse off than in the current system.

In short, the changes to the treatment of assets and inheritance in the Conservative manifesto help the poor and the very rich while hurting the people in the middle.

Comparing Tory policy with the Dilnot proposals

In setting out a new approach to social care funding, the Conservative manifesto also rejects the approach recommended by Andrew Dilnot and adopted by the Coalition: a cap on lifetime care costs. Dilnot recommended that the cap should be set between £35k and £50k, but the Coalition thought this was too expensive and set it at £75k.

It’s not quite fair to compare a cap on care costs with the Tory proposals since the cost isn’t going to be the same. The new proposals help some people and hurt others. It’s not clear what the net effect on government spending would be, but it is plausible that the proposals are cost-neutral. The Coalition’s version of Dilnot’s proposals costs around £1bn a year, so if we are to make a fair comparison we need to consider where this money would come from. As it happens, this is about what the inheritance tax cuts were reported to cost, so capping social care costs and cancelling these tax cuts could be roughly cost-neutral.

The chart below compares these two options: the Tory proposal versus a cap on care costs funded by cancelling the planned inheritance tax cuts.

Some people do better from the Tory proposals.

• Non-homeowners (and those with very low value homes) pay little or nothing towards social care under the Tory proposals. Under the Dilnot proposals these people do much better than in the current system, but they still might use up to half of their assets on social care costs.
• Rich people who don’t get sick are the big winners under Tory policy. There is a tax cut for all estates over £650k which is worth as much as £140k for estates worth more than £1m – although people who need a lot of home care might see it cancelled out.

Other people do better if we cap social care costs instead of cutting inheritance tax.

• Almost all homeowners who need social care (with the exception of those with houses worth in excess of £1m) would be better off with a cap on care costs. People with houses worth the median house price or just above benefit most. Under Tory proposals, someone with a median-value house and £50k of savings would lose over 60% of their estate to social care costs, compared with less than 30% under Coalition policy.

Conclusions

Tory policies in relation to inheritances seem designed to benefit those with the least and those with the most. Those with low levels of assets (mostly non-homeowners) are better protected from social care costs and very rich people get a big tax cut – provided they don’t need social care. But the proposals leave the vast majority of homeowners either worse off full stop or just facing a different distribution of risk between home and residential care.

Reverting to the Coalition policy of a £75k cap and cancelling inheritance tax cuts could be roughly cost-neutral – meaning that the total amount of money coming out of the assets of older people would be the same – but the impact would be different. Non-homeowners would pay less than in the current system, but more than under Tory proposals, while the very rich would pay more inheritance tax. The beneficiaries would be the vast majority of homeowners. Under Tory proposals, the median homeowner could have up to 60% of their estate claimed after their death to pay for their social care, while the Coalition policy would limit this to less than 30%.

Update

Just before hitting publish, word has reached me that the Prime Minister may be in the process of a U-turn on this policy. Despite the Conservative manifesto explicitly rejecting the Dilnot recommendations, the PM appears to now be insisting that we must all be mistaken and that the policy was always going to include a cap on care costs. This puts Tory policy squarely in line with the Dilnot Report, which suggested that the means-test changes for home care could be a good idea if coupled with a cap.

So what would it look like if the manifesto changes to the means were combined with the Coalition’s £75k cap? In short, it looks much better for homeowners.

But if everyone is now going to pay less from their estates, where will the money come from? If the PM is indeed performing a U-turn here, she has just made a spending commitment in the billions. There is one blindingly obvious way to finance at least some of the cost – cancel the inheritance tax cuts. The chart above shows that even with the U-turn, the effective tax rate on estates from social care and inheritance tax combined is regressive: people with assets of £175k (in the chart, a home worth £125k plus £50k of savings) pay the highest rate. Funding the U-turn by cancelling inheritance tax cuts would be both progressive and intergenerationally fair. But it may be too much to ask from a Conservative Prime Minister.

In defence of universality

Writing for the Independent, Ben Chu is not happy about proposals to extend public support for social care to the asset-rich. Universality, it seems, is terribly unfair. Ben’s main complaint is that it will help a generation of asset-rich pensioners to pass on even more, exacerbating the increased importance of inheritance recently highlighted by the IFS. I get Ben’s concerns, but his argument is muddled and he ends up attacking ideas I think he should support.

Before I explain why, let’s separate two issues. Ben is right to point out that demand for social care is projected to rise and that this will cost more money. It’s actually worse than Ben lets on, since the Treasury has been slashing local government funding. Social care budgets are falling at a time when they need to be rising. This does not seem like a sustainable situation.

However, I’m not sure anyone is suggesting that the “solution to the crisis is to scrap means testing and to load more costs on to taxpayers in order to protect the inflated housing inheritances of the already well-off”. Whether more support should be provided to people who currently use their assets to pay for care is a separate question, and this is where Ben’s article misses the point.

Risk pooling

To see this, we need to address a concept that is fundamental to this question, but is entirely missing from Ben’s piece: risk-pooling. This is best illustrated by an example.

Ben tells us that one in ten older people will face costs of over £100,000 in their lifetime. For simplicity let’s imagine that out of every ten older people, one will spend a few years in a care home costing £100,000 while the other nine will die without any significant care costs.

Now take ten people who each retire with £150,000 in housing assets. Under the current system whichever of these people gets sick enough to end up in a care home will have to sell their house and spend two-thirds of the value on care home fees, while the others will not have to pay a penny. Since social care needs are unpredictable, none of them know ahead of time if they will be the unlucky one.

Now imagine another system where each of these people agrees to pay £10,000, either up-front or from their estate after death. This money will be used to pay the social care costs of whichever of them ends up in a care home. Economists usually assume that people prefer this option because they are risk averse. Indeed, this is why we buy insurance in other areas of our lives and why we pool the risk of health care costs through the NHS.

We can buy many types of insurance privately, but others are best provided publicly. Health insurance is the classic example: a set of well-known market failures mean that private health insurance works badly, so all advanced countries (except the USA) provide it primarily via the state. Social care insurance has some similar characteristics. In fact, it’s virtually impossible to buy at the moment because there are very few products on the market in the UK. So if the government can help people to pool their risks, surely this is a good thing.

This is what Andrew Dilnot’s proposals are about. In fact, he proposed a rather modest version whereby risk pooling only applies to people who have already spent tens of thousands on social care. As Ben notes, these proposals have a (fairly modest) cost.

This is all predicted to cost around £6bn to the public purse over five years. And remember: those billions of pounds would otherwise have been extracted from the property assets of pensioners.

There’s a word missing from that last sentence. The billions of pounds will be extracted from the property assets of sick pensioners. Pensioners who don’t end up in care homes won’t have anything extracted from their property assets.

Distributional consequences

Notice that in my example above there is no distributional impact. I’ve taken ten equally rich people and shared a risk between them. The total amount of money passed on as inheritance hasn’t increased, it’s just more evenly distributed. Things are a bit more complicated in reality, but it is important to remember that the Dilnot proposals are about how to structure a risk-pooling scheme, not where to get the money from to pay for it.

So when Ben says:

That’s a £28,000 boost to the inheritance of the children, ultimately courtesy of the taxpayer.

I’m not quite sure who the “taxpayer” is. If we are talking about the people that pay the most income tax, then (insofar as there is a correlation in earning between generations) we are talking about many of the same people who stand to inherit significant wealth from their parents.

But who says we have to fund this from income tax? It may be politically toxic, but if you are worried about the increasing importance of inheritance, you could argue for increasing inheritance tax. This would get you pretty close to my example above – in fact, it would be much more redistributive, as inheritance tax is only paid by the very richest. Alternatively, you might want to suggest changing the tax rules around pension lump sums. These possibilities get only a passing reference in Ben’s article.

Political constraints notwithstanding, we can get pretty much any distributional effect we want by choosing where the money comes from to pay for reform. But we really shouldn’t be trying to solve our distributional problems through the social care system. This system is there to make sure that people get the care they need and to limit the financial disadvantages they face as result of becoming sick. As a way of getting at the assets of old people it is pretty terrible. If we care about distributional effects (and we should) we would better off looking at the tax system.

Taxing wealth is hard. It’s tough to figure out how much people have when they are alive and inheritance tax is unpopular. The IFS tells us that the importance of inheritance is increasing, which is hard to see as a good thing. But – at risk of repeating myself – letting the one in ten old people who become severely dependent spend down their assets while letting the other 90% keep everything is a shoddy way of dealing with it.

An assault on universality

The arguments in Ben’s article aren’t specific to social care. The same arguments can be used to attack universality in all its forms. Ben could have made all of the same arguments against universal coverage for health costs – after all, it is mostly old people who use NHS services and mostly working age people who pay for it. Why not ask them to sell their homes to contribute the cost of their latest operation? Except I don’t think that Ben, or many other people, would make that argument.

Universality does involve governments providing services and support to people who have money. It’s not how most of the public sector works in the UK, but it is not “pro-rich” – in fact, it’s probably the opposite. Its corollary is higher taxes, so the rich pay for it, while the main beneficiaries are the people who fall just outside the criteria of means-tested systems. It is no accident that the countries that we see as the most “progressive” – such as the Nordics – have a wide range of universal benefits and high taxes. It is also arguable that means-testing is divisive, splitting people into those that pay into the state and those that take out.

Priorities – a caveat

In defending universality, I don’t mean to say that it is always better. By all means give me an argument that political limits on taxation make means-testing necessary to achieve certain distributional aims. Please, tell me that wealth taxation is so hard and inheritance such a problem that letting the sickest 10% of old people use up their assets is the lesser of two evils. I am listening.

Nor do I mean to say that universal coverage is the priority for the social care system. Cuts to budgets mean that councils are struggling to fund even the means-tested system that we have now. If we can’t even support the poorest in society then a lack of risk-pooling may not be our most pressing problem.

But if we are going to talk about universality, let’s be clear about what it means. It is not a hand-out to the rich and it is not about protecting people’s inheritances – any more than the NHS is either of those things. Coupled with a fair tax system, it is a progressive goal and one worth defending. I invite Ben to reconsider which side of the argument he is on.

Three golden rules for discussing progressivity

What does it mean for a policy to be progressive? The way this question is addressed by the media (and often by government) can be infuriating. It’s got to the point where I am tempted to say the term should be banned, but instead I am going to make one last attempt to clarify it by proposing three golden rules.

I was reminded of this issue when reading Jo Maugham’s analysis* of the impact of the new “social care precept”. This is essentially a £2bn rise in council tax, a significant proportion of which will be paid by poorer households. Here are the figures that Jo gives:

So is this tax progressive or not? Well, rich people pay more, and for some that’s good enough. Fraser Nelson, for example, likes to point out that “the top 3,000 taxpayers in Britain stump up more income tax than the lowest-paid 9 million”. It is more common to look at how paying tax affects the living standards of different groups by comparing tax paid as a proportion of income. By this measure, council tax is regressive.

This is as far as the discussion usually goes. But both of these comparisons have no basis in reality – unless that reality involves collecting these taxes and throwing the money in the sea. The fact is that this money will show up somewhere else, either as increased spending or lower taxes. Which brings me to my first golden rule: the distributional effect of a policy change can’t be assessed without looking at both sides of the equation.

Since this is called the “social care precept”, we might think that it will lead to increased spending on social care. It’s not easy to find numbers on how social care spending is split between income groups, but modelling done in 2011 for the Dilnot Commission (see figure 11 here) made some estimates. Reading the numbers off the chart, I get something like this.

Social care spending is more heavily weighted towards poor people than council tax collection, so lower income groups make a net gain from this policy. That is, the introduction of this policy increases the total amount of redistribution that the government does, which is the only sensible definition I can think of for the word “progressive”, with reference to a change in policy.

But is higher spending on social care really the effect of this policy? That is, if it weren’t for the social care precept, would we see lower social care spending? You could argue that social care spending is going to rise either way, since we’ve got more old people than ever. If it’s not paid for by council tax rises it will be paid for by higher taxes elsewhere, higher borrowing, or cuts to other services.

So this is my second golden rule: identify a realistic counterfactual. We need to know whether the policy leads to more redistribution than what would otherwise have happened. That “what” can have a huge impact on how we view the distributional consequences.

Let’s say we believe that without the social care precept higher social care spending would have to be funded through an increase in income tax – or perhaps higher borrowing now, funded by future increases in council tax. As Jo points out, income tax is much more targeted on rich people than council tax. Here’s the net effect of raising £2bn through council tax instead of income tax.

This policy change would give money to the richest 20% at the expense of everyone else. I think we can all agree that’s regressive. So depending on the counterfactual, the social care precept is either highly progressive or highly regressive. Take your pick. We need to decide which counterfactual is more realistic. In this case, the first one is probably closer to the truth (raising income tax and borrowing more are not top of this government’s agenda) so I’d argue that the policy is probably progressive.

But there’s another more fundamental question here: how much redistribution do we want? Requiring all policy changes to be “progressive” implies that we think we don’t currently have enough. But at some point, if we were to go on increasing redistribution, we’d have too much. Views will differ wildly as to what the optimal level is, but in principle there must be one. I imagine few people think that there should be no redistribution and few think that redistribution should fully equalise living standards.

And even if we want more redistribution, we might not care if a policy is regressive if its effect on the overall level of redistribution is small and it achieves some other aims. The state does not exist solely for the purpose of moving money from the rich to the poor. My third golden rule is therefore this: the overall level of government redistribution is what matters. We need to know whether we want to increase or decrease it, and how much we care about small changes relative to other policy aims.

These rules really are essential. It is impossible to say anything about whether a policy change is progressive without considering both sides of the equation and being clear about what you think the alternative scenario is. It is impossible to know whether you actually want the policy to be progressive, or whether you care, without considering the overall level of redistribution.

These are not new insights and many organisations (the IFS, the OBR, sometimes even the Treasury) are quite diligent about doing distributional analysis properly. But much of the public discussion of “progressivity” fails to follow a single one of these rules, giving us a rather poor standard of debate on the state’s role in reducing inequalities.

---

* I’m not picking on Jo’s analysis because it is a particularly egregious example. On the contrary, I am picking on it because is one of the better examples of someone tackling this question, so Jo has done most of my work for me.

Means-testing and the progressive state

In Sweden, the amount you get from the state pension is linked to the amount you earned while you were working. That is, the richer you are, the more you get.

I can already hear the howls of “regressive” if this was suggested in the UK. Broadly speaking, our public pension pays out a flat rate (provided you’ve paid national insurance for enough years) which is just about enough for someone to live on. It seems more likely that we would take that away from wealthy people than give them an enhanced rate. Just look at the debate around the winter fuel allowance, which is effectively just a cold-weather top-up to the state pension.

This raises a paradox. Any Guardian reader knows that Sweden is a socialist utopia with high taxes, strong public services and lots of redistribution. How can they be doing something so regressive?

Of course, richer people in the UK also get bigger pensions than poorer people. The difference is that this is done privately, rather than by the government. In the UK, many people pay money into private sector pensions and when they retire they can convert this to an annuity (or at least they could until the government abolished pensions). The Swedish public system mirrors this setup by counting up how much you pay in and converting that to an annuity when you retire. The more you put in, the more you get out.

This is just not how we do things in the UK. State support (the NHS aside) is usually seen as a last resort for the destitute, to prevent poverty and starvation. Means-testing is used to target government resources on the poor and prevent them going to the rich. This is our idea of progressive government.

But our progressive European neighbours like the Nordics actually do a lot less means-testing than we do, while managing to be highly redistributive and have lower inequality than us. How do they manage that? By having higher taxes and a larger public sector. In general, the most progressive countries in the world are characterised not by their efforts to target spending on the poor, but by universal benefits and relatively high, progressive taxes.

Now it is possible to argue that this model is not optimal and that a smaller state would be good for economic growth. In that case means-testing makes sense, since it allows you to achieve more redistribution if you are constrained by the need to keep government small. Alternatively, it could allow you to shrink the size of government if you are constrained by the need to redistribute. Limiting benefits to the poor also supports the small state cause in a more insidious way, by stigmatising claimants and undermining public support for state spending.

I am yet to hear a UK politician make the argument that means-testing is the corollary of small government and low taxes. Instead, Nick Clegg tells us that he “doesn’t see why someone like Alan Sugar should be entitled to a winter fuel payment” since he’s “got a bob or two”. I’m sure that Nick Clegg understands the link between means-testing and the size of the state, but libertarians and state shrinkers clearly think that it is easier to get their policies through by having a pop at the rich than to try to convince voters of the merits of small government. Which is a shame, since there is an interesting debate to be had.