Whatever Iain Duncan Smith's intentions, all his benefits system can do is sweep up after economic policy that fuels poverty

Iain Duncan Smith may be sincere when he spoke this week of his "determination to build a fairer society" with a "welfare system that is simple, more efficient and helps to restore the social mobility that should be at the heart of British society". David Cameron says much the same. But the hard questions come next.

Like every other work and pensions secretary before him, the new man opens the books and throws his hands in the air with horror. What is this? A bill for £87bn to pay for the benefits of 5 million people who are sick or out of work, many for a decade. For too many, he says, "work simply does not pay". Some people lose 95p in benefits for every pound they earn in work (though this is in rare cases). Next horror, the system is a cat's cradle of complexity, as claimants must apply for benefits from the Department for Work and Pensions, tax credits from HM Revenue & Customs, and housing and council tax benefits from their council. It must be simplified! Duncan Smith said the system was so complex "even I can't understand it", so the danger is he will reach for a pair of shears.

Almost every DWP secretary reacts with hyperbolic promises. David Blunkett, James Purnell and John Hutton made much the same noises. Shudder at the likes of Liam Byrne now saying Labour lost because they weren't tough enough on benefit claimants. What wasn't tough enough about a dole of £65.45 a week, lower in real value than under the last Tory government?

Whoever is in power, the issues stay the same, since the Elizabethan poor laws, the workhouse or Speenhamland's first tax credits. How do you stop the poor starving while avoiding the moral hazard of taking away their work incentives? Beveridge's social insurance never paid out enough to avoid means testing, with its perverse incentives. Rents vary so much that housing benefit has to be paid by locality, or there are heavy losers in the southeast. The Con-Libs will cut tax credits from families on £50,000. Sounds sensible – except that makes the taper even steeper as benefit is withdrawn, many more losing 70p for every extra pound they earn.

The real moral hazard is not for the unemployed but for the rest of society. Most poor people are in work. Say that again: they work, yet still fall below the poverty line. That is why increasing work incentives would be really expensive, paying extra dead weight to millions who already work for little more than the dole. The wonder is not that some people think work doesn't pay – but that so many millions do work hard in low-status jobs for not much extra. The work ethic is phenomenally strong, defying narrow economic explanations of human motivation. As unemployment will rise greatly under this "shrink the state" government, why waste money obsessing about the few who won't work? Killing off the expensive but excellent Future Jobs Fund, which aimed to employ 117,000 young people, suggests no new funds.

Benefits are complex for a reason – fairness. Mike Brewer of the Institute for Fiscal Studies has voluminous studies on benefits' sharp corners: he concludes the only way work incentives can increase without spending billions is to cut benefits for the unemployed and increase tax credits to make low-paid work more attractive. How would you pay for that? Scrapping child benefit and increasing income tax, he says, but overall "it makes more people worse off". Not a price Cameron may think worth paying.

There is just one simple reason why the DWP conundrum is insoluble: the pinch in a profoundly unequal society. This is the result of low pay, that "non-inflationary growth" Gordon Brown boasted of when even in the boom years pay at the bottom and middle stayed almost static. His GDP growth only swelled income and wealth at the top. But some of that was redistributed through taxes to the state, which employed significant numbers of people, especially in the most deprived areas, doing valuable work – classroom and health assistants, builders and wardens. Those jobs are now about to be cut, more joining the 2.5 million people already chasing 500,0000 vacancies. Cameron yesterday talked of cutting the deficit to get more people back to work: that is the opposite of what will happen.

Who wins the war within the Conservative party over raising capital gains tax (CGT) to the same level as income tax will reveal this government's view of "fairness". Cameron says he is "listening". Absurd press claims that it's an "attack on the middle classes" fail to mention that only 130,000 of the very richest pay CGT at all, and only 250,000 people have second homes. But notice the embarrassed silence from Labour, struck dumb by its own shocking past on this. Nigel Lawson rightly fixed CGT at the same level as income tax, to stop rich cheats redefining their income as capital and avoiding slabs of tax. It was Gordon Brown who cut it right down to 10% to please private equity donors. How can Conservatives, yes Conservatives, be arguing over a more radical policy than Labour dared consider?

That question crystallises Labour's problem. Do they have the imagination for deep rethinking on fundamental economics – or are they trapped by their recent past? A living wage is a vital part of the solution. It takes 70 hours work at the minimum wage for a family to earn enough to cross the poverty line. Why should taxpayers subsidise such low-paying employers with tax credits? The state could start at once with its own employees: the IFS notes that every 10p rise in the minimum wage saves up to £300m on tax credits. Ed Miliband launched a campaign yesterday for all Labour councils to adopt a living wage, and the other leadership candidates will surely follow.

But all the likely candidates voted for a Labour policy of deficit reduction, job losses and cuts so similar to the Conservatives that effective opposition is stifled. This week the US treasury secretary and Barack Obama's senior economics adviser both raised the alarm that Europe's growing frenzy of spending cuts is tipping the world economy towards deeper recession. "Spurring growth comes first," warned Obama's adviser Larry Summers. Instead, an army more of the unemployed are heading Duncan Smith's way, costing a fortune. Whatever his intentions, all the DWP can do is sweep up after an economic policy designed to create more poor people, paying them too little to live on, in or out of work.

Figures suggest 600,000 people were lifted out of poverty under the Labour government as take-home pay grew for seventh consecutive year

Campaigners warned tonight that the new government must not jeopardise falling rates of child and pensioner poverty with spending cuts after figures showed Britons' average incomes actually rose during the first full year of the recession.

Pensioners and children saw their overall situation improve during the financial year 2008-09 as hundreds of thousands were lifted out of poverty, offsetting a rise in the number of working-age people living below the breadline, the Department for Work and Pensions (DWP) said.

The numbers run counter to rising unemployment and squeezed household budgets during the deepest recession in decades, prompting experts to caution against reading too much into one year's data. There was less good news on the gap between rich and poor, however, as income inequality stuck at its highest level in half a century.

Still, the headline figures were largely positive for the recently defeated Labour government, suggesting that 600,000 people had been lifted out of poverty since it came to power.

According to the DWP's annual Households Below Average Income report, mean take-home incomes grew for the seventh consecutive year, by 1% in 2008–09. At the same time, the number people in poverty fell by 100,000 from a year earlier to 10.9 million, before taking housing costs into account. After taking housing costs into account, the level was almost unchanged, at 13.4 million.

That left the number of people in poverty after housing costs down 600,000 since Labour's first full financial year in power.

Possibly reflecting tax credits and rises in benefits during the year, child poverty fell 100,000 in 2008-09 and was down 600,000 over the past decade. The Trades Union Congress welcomed the fall as evidence of "tremendous commitment and prioritisation by the last government".

"It will be a tough challenge for the new coalition to match up to these reductions in child poverty," said TUC general secretary Brendan Barber, urging similar action to stamp out increasing poverty among adults.

The Child Poverty Action Group raised its concern that the improving trend could be snuffed out by the new government's attempts to tackle Britain's parlous public finances."Child benefits are currently under attack from commentators and politicians seeking to reduce the deficit," said its chief executive, Shan Nicholas.

"Policies that impose cuts on hard-pressed family budgets will drive child poverty up – blighting children's lives and driving damaging and divisive health and educational inequalities. Today's poor children will be tomorrow's poor parents."

"Spending in the weeks and months ahead must be based on what is right for children and society not what is easy to cut from spreadsheets."

Experts noted that there remains much work to be done if the previous government's bid to halve child poverty are to be met. It would still need to fall by 1.1 million between 2008-09 and 2010-11, said the Institute for Fiscal Studies.

The IFS analysis also put poverty among working-age individuals without children at the highest since at least 1961. It noted a similar record for income inequality.

"People might be surprised to see poverty falling in the midst of the recent recession, but something similar happened during the recessions of the early 1980s and early 1990s," said David Phillips, a senior IFS research economist.

"Pensioners are largely insulated from the increase in unemployment affecting other groups, and falling rates of poverty for them, and for children, will doubtlessly be welcome news for both the outgoing and incoming governments. But a further increase in poverty among working-age adults without children continues what may be seen as a worrying trend that started even before the recent recession."

The numbers of those in poverty are based on people living in households with incomes below 60% of the median income of £407 per week before housing costs and £343 per week after housing costs. For pensioners, there was a fall of 200,000 people in poverty on a year earlier.

Michelle Mitchell, charity director at Age UK, welcomed the drop but said there was a long way to go to help those still below the poverty line.

"The new government's commitment to relink the state pension to earnings from April 2011 with a 'triple guarantee' is a good start. However, in the short term the coalition must move quickly towards paying benefits automatically so that the poorest and most vulnerable older people receive all the financial help they're entitled to," she said."Clearly there are huge challenges ahead for the new government, but now is the time to renew the fight against pensioner poverty and commit to eradicating it once and for all."