‘Cliff edges’ in tax and benefit system may be disincentivising work, ESRI study indicates

Sharp cliff edges in the PRSI (pay-related social insurance) and USC (universal social charge) tax systems in Ireland may be acting as a disincentive to work, a new study has suggested.

The research by the Economic and Social Research Institute (ESRI) highlighted that individuals with incomes below a certain level (€352 a week for PRSI and €13,000 a year for the USC) were currently exempt from these charges.

“Once income increases above these cut-offs, however, the entirety of a person’s income becomes liable,” it said, noting that this resulted in a drop in disposable income.

An individual whose income rises by €1 from €13,000 to €13,001 incurs a USC liability of €80 annually, while someone whose income rises from €352 per week to €353 incurs a PRSI liability of €119 annually.

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“Both these changes result in very high marginal effective tax rates whereby a small rise in gross income results in a fall in disposable income,” it said.

The study also identified disincentivising cut-offs for part-time workers in receipt of jobseeker’s benefit depending on how bunched together their weekly hours were.

These cliff edges may have behavioural implications, “incentivising individuals to bunch or cluster just below thresholds that, if crossed, would result in a jump in liability,” it said, noting there was evidence of this for the PRSI threshold. However, it acknowledged the PRSI credit introduced in 2016 had softened the cut-off somewhat.

The ESRI said cliff edges tended to occur when benefit entitlements and other supports are withdrawn sharply (or entirely) as income rises or where tax and social insurance liabilities increase steeply as income rises.

“The removal or reduction of such kinks, cliff edges in particular, can therefore avoid possible economic distortions and improve work incentives,” it said.

The institute said the issue of work incentives was of particular importance currently, “with Ireland’s labour market characterised by low unemployment numbers and relatively high vacancy levels”.

Despite criticism of Ireland’s income tax system and the relatively high rate of tax paid by those on low and middle incomes end up paying, the report concluded the income taxation system in Ireland did not have sharp cliff edges compared with the PRSI and USC systems, “in that liability does not jump at a certain point”.

Instead, a person’s income is taxed at three potential rates – 0 per cent, 20 per cent and 40 per cent, it said, noting people receive tax credits so that a proportion of their income is effectively earned tax-free.

However, it said second earners in married couples/civil partnerships faced sharp increases in taxation at certain points.

This is due to the fact that the tax system in Ireland is not fully individualised, it said.

“Instead, married couples can opt for joint taxation, which allows for a sharing of the personal tax credit and partial transferability of an individual’s standard-rate band. This creates a disincentive for second earners in married couples to enter employment,” it said.