Canary Wharf skyscrapers on the Isle of Dogs. Photograph: Getty Images.
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Why "skin in the game" could be the key to reforming markets

Those with the power to make decisions on your behalf should share in the risks, not just enjoy the rewards.

"We are all in this together" has become the political catchphrase of this parliament. The phrase has come back to haunt a government that has introduced tax breaks for millionaires in an era of austerity, but Labour’s critique runs wider than this. Our argument at the next election will be about the way our economy works so that we tackle the causes of the cost-of-living crisis, not just the government’s priorities on tax and spend.

The campaign for a living wage embodies this idea. The question is not just whether tax credits can be protected, but whether companies will pay people a wage they can get by on. The debate on energy prices is another example. The job is not just to fund winter fuel payments but to reform the energy market so that customers are not taken for a ride. Occupational pensions typify the challenge: the difference between a 1 per cent and a 1.5 per cent charge from a provider can be tens of thousands of pounds more in a pension pot at the end of a working lifetime. Sharing in prosperity is about how our economy works, not just what the government spends.

In this context, a new paper by Duncan O'Leary published this week by the think-tank Demos is a welcome contribution to the debate. The paper explores a new idea for reforming markets: "skin in the game". The phrase comes from Warren Buffet, who demands that people investing his money have some of their own money at risk. They must have some skin in the game. The principle is that people who have the power to make decisions on your behalf should share in the risks, not just enjoy the rewards. Only then can they be truly accountable.

In the US, the government is already experimenting with the skin in the game idea. Banks can no longer package up and sell on all the debt from the mortgages they offer. They must retain some skin in the game: 5 per cent of every mortgage must stay on their balance sheets. The idea is that lenders start to consider not just whether they can sell a loan on to others in the market, but whether the loan itself is a good one. The hope is that more skin in the game will encourage more responsible lending.

O'Leary explores what this idea might mean in different policy areas. Is it right, for example, that half of FTSE 100 chief executives are not invested in the pension schemes that more than 90 per cent of their new staff are auto-enrolled into? Would companies pay more attention to pension charges if they were coming out of the CEOs pocket too? Is it sustainable that ratings agencies are paid by the organisations whose financial products they are rating? Should at least some of the fees be held back and paid according to how accurate the ratings prove? Perhaps some skin in the game would lead to greater accuracy.

The idea has the most obvious applications in finance. Is it fair that all financial services companies should pay the same industry levy to fund debt advice, regardless of their lending practices? Shouldn’t the lenders who drive people to debt advice, through hiking up rates when people miss payments, contribute more? Some skin in the game might encourage lenders to adopt a less adversarial approach with their customers.

But O'Leary also examines what it might mean in other areas too. Could companies be given more of a stake in whether the staff they make redundant find work when they leave? Could the skin in the game idea improve back-to-work support for those who find themselves off work through illness or accident? In Holland, for example, companies must pay up to an extra year’s sick pay if they do not take reasonable steps to reintegrate staff who suffer illness or disability. Here we have around 300,000 people flowing from work onto state benefits each year because of health-related issues, adding to the welfare bill.

The value of the skin in the game idea is twofold. First, it avoids the kind of top down micro-management that belongs to the politics of the last century, not this one. The task is to ensure that we really are "all in this together", but through reforming the incentives within markets, not tying business up in complex rules and regulation. The skin in the game idea has a simplicity to it that is attractive. Second, the principle seeks to prevent problems occurring and to align power and accountability where they have become detached from one another. Both are organising principles of Labour’s policy review that I lead, whether in the public or private sectors.

For Britain to become the global standard for an inclusive economy we must create a system that is fair from the start. The policy review will need to look at the skin in the game principle in more detail. But at first sight it looks like a key ingredient in the "recipe for responsible capitalism".

Jon Cruddas is Labour's policy review coordinator and MP for Dagenham

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Q&A: What are tax credits and how do they work?

All you need to know about the government's plan to cut tax credits.

What are tax credits?

Tax credits are payments made regularly by the state into bank accounts to support families with children, or those who are in low-paid jobs. There are two types of tax credit: the working tax credit and the child tax credit.

What are they for?

To redistribute income to those less able to get by, or to provide for their children, on what they earn.

Are they similar to tax relief?

No. They don’t have much to do with tax. They’re more of a welfare thing. You don’t need to be a taxpayer to receive tax credits. It’s just that, unlike other benefits, they are based on the tax year and paid via the tax office.

Who is eligible?

Anyone aged over 16 (for child tax credits) and over 25 (for working tax credits) who normally lives in the UK can apply for them, depending on their income, the hours they work, whether they have a disability, and whether they pay for childcare.

What are their circumstances?

The more you earn, the less you are likely to receive. Single claimants must work at least 16 hours a week. Let’s take a full-time worker: if you work at least 30 hours a week, you are generally eligible for working tax credits if you earn less than £13,253 a year (if you’re single and don’t have children), or less than £18,023 (jointly as part of a couple without children but working at least 30 hours a week).

And for families?

A family with children and an income below about £32,200 can claim child tax credit. It used to be that the more children you have, the more you are eligible to receive – but George Osborne in his most recent Budget has limited child tax credit to two children.

How much money do you receive?

Again, this depends on your circumstances. The basic payment for a single claimant, or a joint claim by a couple, of working tax credits is £1,940 for the tax year. You can then receive extra, depending on your circumstances. For example, single parents can receive up to an additional £2,010, on top of the basic £1,940 payment; people who work more than 30 hours a week can receive up to an extra £810; and disabled workers up to £2,970. The average award of tax credit is £6,340 per year. Child tax credit claimants get £545 per year as a flat payment, plus £2,780 per child.

How many people claim tax credits?

About 4.5m people – the vast majority of these people (around 4m) have children.

How much does it cost the taxpayer?

The estimation is that they will cost the government £30bn in April 2015/16. That’s around 14 per cent of the £220bn welfare budget, which the Tories have pledged to cut by £12bn.

Who introduced this system?

New Labour. Gordon Brown, when he was Chancellor, developed tax credits in his first term. The system as we know it was established in April 2003.

Why did they do this?

To lift working people out of poverty, and to remove the disincentives to work believed to have been inculcated by welfare. The tax credit system made it more attractive for people depending on benefits to work, and gave those in low-paid jobs a helping hand.

Did it work?

Yes. Tax credits’ biggest achievement was lifting a record number of children out of poverty since the war. The proportion of children living below the poverty line fell from 35 per cent in 1998/9 to 19 per cent in 2012/13.

So what’s the problem?

Well, it’s a bit of a weird system in that it lets companies pay wages that are too low to live on without the state supplementing them. Many also criticise tax credits for allowing the minimum wage – also brought in by New Labour – to stagnate (ie. not keep up with the rate of inflation). David Cameron has called the system of taxing low earners and then handing them some money back via tax credits a “ridiculous merry-go-round”.

Then it’s a good thing to scrap them?

It would be fine if all those low earners and families struggling to get by would be given support in place of tax credits – a living wage, for example.

And that’s why the Tories are introducing a living wage...

That’s what they call it. But it’s not. The Chancellor announced in his most recent Budget a new minimum wage of £7.20 an hour for over-25s, rising to £9 by 2020. He called this the “national living wage” – it’s not, because the current living wage (which is calculated by the Living Wage Foundation, and currently non-compulsory) is already £9.15 in London and £7.85 in the rest of the country.

Will people be better off?

No. Quite the reverse. The IFS has said this slightly higher national minimum wage will not compensate working families who will be subjected to tax credit cuts; it is arithmetically impossible. The IFS director, Paul Johnson, commented: “Unequivocally, tax credit recipients in work will be made worse off by the measures in the Budget on average.” It has been calculated that 3.2m low-paid workers will have their pay packets cut by an average of £1,350 a year.

Could the government change its policy to avoid this?

The Prime Minister and his frontbenchers have been pretty stubborn about pushing on with the plan. In spite of criticism from all angles – the IFS, campaigners, Labour, The Sun – Cameron has ruled out a review of the policy in the Autumn Statement, which is on 25 November. But there is an alternative. The chair of parliament’s Work & Pensions Select Committee and Labour MP Frank Field has proposed what he calls a “cost neutral” tweak to the tax credit cuts.

How would this alternative work?

Currently, if your income is less than £6,420, you will receive the maximum amount of tax credits. That threshold is called the gross income threshold. Field wants to introduce a second gross income threshold of £13,100 (what you earn if you work 35 hours a week on minimum wage). Those earning a salary between those two thresholds would have their tax credits reduced at a slower rate on whatever they earn above £6,420 up to £13,100. The percentage of what you earn above the basic threshold that is deducted from your tax credits is called the taper rate, and it is currently at 41 per cent. In contrast to this plan, the Tories want to halve the income threshold to £3,850 a year and increase the taper rate to 48 per cent once you hit that threshold, which basically means you lose more tax credits, faster, the more you earn.

When will the tax credit cuts come in?

They will be imposed from April next year, barring a u-turn.

Anoosh Chakelian is deputy web editor at the New Statesman.