Saturday Blognado: Taxes and Welfare
This post is something of a coda to my Tuesday post on taxes, this time taken from the other direction.
The most common objection to welfare system is that it discourages work, leading to protracted welfare dependency. This can indeed happen, and through a similar mechanism to one of the reasons that the laffer curve eventually bends downward. Pretty much every benefit in the Western world is abated as your income increases, by which I mean it is partially (or in some cases totally) withdrawn as your income rises. A benefit structured in this way lowers a person’s average tax rate (to negative numbers in some case), but increases their marginal tax rate (for every extra dollar they earn, they lose a few cents in taxes but more cents in lost welfare. In extreme cases a household receiving many different benefits can end up with an effective marginal tax rate of greater than 100%. It should come as no surprise if people in such circumstances don’t try very hard to improve their circumstances since very extra dollar they earn is making it harder to make ends meet. Even before you hit the 100% mark things become problematic – how hard would you work to improve your income when you’re only getting 10-20 cents on the dollar? Some of the highest marginal tax rates accrue to people on low incomes thanks to the way welfare is structured, poverty is persistent not because of laziness but in large part because people are rationally reacting to their circumstances.
So how to fix this? There are two major solutions, with varied ideological appeal. One option is to make beenfits less generous, which makes the effect they have on incentives less powerful. The othe ris to make beenfits abate more slowly, which means you end up helping more people who don’t actually need help, increasing the cost of the programme.
This phenomenon is also what led Milton Friedman to propose the Negative Income Tax, which in it’s most common form is a combined tax and welfare system that combines a flat income tax with a universal deduction so everyone would pay (for example) 33% of their income in taxes, less $10,000. If you earned $100,000 you would pay $100,000 * 0.33 – 10,000 = $23,000 for an average tax rate of 33%. If you earned $30,000 you would pay no tax at all, and if earned nothing at all the government would pay you $10,000. A system like this could replace unemployment, social security and most other benefits, it spreads the disincentives of taxation evenly across the income spectrum and it would eliminate the need for welfare offices entirely. The downside is large though – it is expensive to run (carrying on my example from above multiply $10,000 by the number of adult sin the United States, and you’ll see what I mean). Still I, and a lot of economists, think it would be a worthwhile approach to look into. Ultimately the improved incentives could improve the lives of the poor immensely, why promoting independence, a combination that should appeal to left and right.