IFS: Childcare reforms create a new branch of the welfare state - but also huge risks to the market

Expanding the ‘free entitlement’ to a funded childcare place to children aged 2 and under in working families will save the average family with a toddler using formal childcare over £80 a week. Those using full-time formal childcare, or with multiple young children, or living in London and the Southeast, are set to benefit considerably more. This sounds like great news for parents - but there are serious risks. 

Based on existing patterns of childcare use, this reform will leave Whitehall in charge of the price of 80% of all pre-school childcare in England (up from just under 50% now). That raises the stakes for getting the funding rate right: too low, and providers could opt out of delivering the new entitlement or even exit the market entirely. That could leave today’s promises a theoretical entitlement only, and risks making it even harder for parents to find a childcare place. 

More financial pressure on providers also risks the quality of care on offer. A large expansion of free entitlements alongside under-funding of providers would certainly be to prioritise the parental employment purpose of childcare over the child development purpose.

Extra funding for existing entitlements, worth £288 million in 2024-25, is about a 7.5% uplift on the current budget - broadly in line with the expected increase in providers’ costs over the next two years. But since 2017-18 (when real-terms core funding per hour peaked), the sector has already absorbed a 13% real cut when adjusted for the cost inflation faced by childcare providers. 

Thus far, one of the key ways in which providers have plugged the funding shortfall is through cross-subsidy via the price charged to younger children. That option is now being closed off. 

Christine Farquharson, Senior Research Economist at IFS said: “For such a huge reform to the early years system in England, today’s Budget gave us remarkably little detail about the one thing that will really matter: the funding rate that providers will receive. Even under current patterns of childcare use, expanding the 30-hour offer to almost all pre-schoolers in working families will put Whitehall in charge of the price of 80% of childcare hours delivered in England. That raises the stakes for getting the funding rate right, with the potential for huge damage to the quality and availability of childcare if the government gets it wrong.” 

Public spending on childcare

• Based on existing childcare use, today’s expansion of the free entitlement will directly benefit just over half of parents with a child aged 9 months to 2 years old. That includes just a fifth of families earning less than £20,000 a year, but 80% of those with household incomes above £45,000 (based on 2019 data).  

• Today’s announcements will radically change the way that childcare subsidies are targeted. At the moment, just under half of total spending on childcare subsidies goes on universal programmes (i.e. the free 15 hours for all 3- and 4-year-olds). We estimate that the share is set to fall to about a quarter by 2027. Meanwhile, the share of childcare subsidy spending targeted at working families will more than double.

Impacts on parents’ working patterns

• The Chancellor is expecting his reforms to bring another 60,000 parents into employment, working an average of 16 hours per week, with a similar impact from increasing the hours of parents who would have been in work anyway. 

• It represents a potentially very large giveaway for beneficiaries. The typical gain for a parent using 30 hours of childcare for a 2 year-old would be larger, for most full-time working women, than abolishing all their income tax and NICs.

• Delivering a package so explicitly focused on helping parents to work through the free entitlement system looks odd. The ‘30-hour’ offer is based on term-time take-up (38 weeks a year). If parents spread their hours out over the year, the offer is closer to 22 funded hours a week. 

Impacts on childcare workforce

• Relaxing the staff-to-child ratios for 2-year-olds (from four to five children per adult) could in a best-case scenario free up about 7,300 full-time equivalent childcare workers (10% of the existing 0- to 2-year-old workforce) if providers were able to fully implement the change. That would be enough to deliver about 50,000 new 30-hour places for 2-year-olds (fewer for younger children, where ratios are tighter). If the OBR’s (necessarily highly uncertain) prediction for the impact on parental labour supply is right, we calculate that England’s childcare market could need about 65,000 new 30-hour places by 2027.   

• The childcare sector has seen a long-term decline in the number of childminders, driven in most recent years by fewer entering the profession. The introduction of a £600 sign-up bonus for childminders (£1,200 for those joining childminding agencies) may help to recruit new childminders, offering families greater choice over their childcare. But this is unlikely to radically reshape the market: while childminders make up 55% of providers, they supply just 17% of places. 

Massive distortions to incentives for high-earning parents

Free childcare entitlements, as well as access to the “tax free childcare” subsidy scheme, remain limited to families where no parent earns £100,000 or more. Above that level, the entire value of that support is removed - creating a “cliff-edge” effect whereby families can easily be worse off overall even after a substantial pay rise.

By extending free entitlements to 1 and 2 year-olds, the government will significantly expand the scope of those cliff-edges, and their size - since many more families will now find free entitlements at stake for two or more pre-school children at the same time.

The distortions that this can create are among the most severe you will ever see within a tax and benefit system.  A parent with a 1 year-old and a 3-year old whose childcare provider charges England’s average hourly rate for 40 hours per week would, after these reforms, find that their disposable income (i.e. earnings net of tax and childcare outgoings) falls by £14,500 if their pre-tax pay crosses £100,000. Disposable income would not recover its previous level until pre-tax pay reached £134,500, meaning a parent earning £130,000 would be worse off than one earning £99,000.

For those with higher childcare costs the distortions are even more absurd. A similar parent paying average London rates for childcare, using 50 hours per week, would see a £20,000 fall in disposable income when their pre-tax earnings cross £100,000. Disposable income would not recover its previous level until pre-tax pay reached £144,500.

This provides a massive incentive to keep taxable income below £100,000 while children are young. For many, the obvious way to do this is via pension contributions. The example London parent above could, if earning £139,000, put £40,000 into their pension pot and still have higher disposable income today than if they contributed nothing. It is notable that, in the same budget, the government has raised the annual limit on pension contributions qualifying for tax relief to £60,000. Even parents with young children earning £160,000 would have large incentives to use all of that new annual allowance. Many of them would effectively be able to buy a £60,000 pension pot while only reducing their current disposable income by a small fraction of that. Responses of this kind are inevitable.

Robert Joyce, Deputy Director of IFS said: “A presumably-unintended effect of today’s childcare announcements is to exacerbate one of the most severe distortions you are ever likely to see within a tax and benefit system. The 30 hour offer is, together with tax-free childcare, removed in its entirety when earnings reach £100,000. This means that high earning parents can be worse off overall even after a pay rise of tens of thousands of pounds, especially in high-cost areas and where they have 2 or more pre-school children. This is somewhat ironic in a budget that was so focused on work incentives, though the easiest response to this distortion will typically be to make large pension contributions for short periods when children are young.”

Read our full response to the Budget here.