Over the last decade, the UK's tax credit regime has delivered over £175.4 billion into the purses and wallets of low-earning households. The credits have helped to ‘make work pay’ for many, and they have supported thousands of people – particularly single mothers – out of poverty and into employment. But the British tax credit regime is not without its critics. There are crucial gaps between policy intent and implementation, which have led to ongoing problems with over- and underpayments. Also, the interactions between the tax credit system and in-work and out-of-work benefits are complex and confusing, leading to some very high marginal tax rates and unusual work incentives, particularly for second earners and larger families.

It is this kind of criticism that is driving the development of the Universal Credit, which will replace the existing system of means-tested benefits and tax credits for working-age adults in the UK beginning in 2013. The Coalition government's ambition to merge in-work support with out-of-work benefits to ‘radically simplify the system to make work pay and combat joblessness and poverty’ is certainly a bold one. The intuitive appeal of a simplified system is undeniable, as is the policy goal to reduce marginal tax rates and improve work incentives.

However, the US experience suggests that there will always be difficult trade-offs to make between targeted, timely support and simplicity on the one hand, and the generosity of support, work incentives and costs to the Exchequer on the other. This chapter draws on major US studies on the impact of the Earned Income Tax Credit (EITC) on work incentives and wages. It concludes with some reflections on the politics of tax-based assistance at a time when this has become a primary mechanism for redistribution in both the US and the UK.

A brief history of tax credits

Although the American EITC has been in existence since 1975, it was greatly expanded by President Clinton, and now the two largest individual income tax credits – the more targeted, refundable EITC and the more universal Child Tax Credit (CTC) – together represent over US$81.2 billion in tax expenditures in 2011. Given the spending and revenue loss involved, income tax credits have enjoyed an unusually smooth political path: neatly side-stepping limited public support for expanding welfare, at the same time as channelling significant government resources to the pockets of working poor families.