Negative income tax

Last updated January 25, 2024

In economics, a negative income tax (NIT) is a system which reverses the direction in which tax is paid for incomes below a certain level; in other words, earners above that level pay money to the state while earners below it receive money, as shown by the blue arrows in the diagram. NIT was proposed by Juliet Rhys-Williams while working on the Beveridge Report in the early 1940s and popularized by Milton Friedman in the 1960s as a system in which the state makes payments to the poor when their income falls below a threshold, while taxing them on income above that threshold. Together with Friedman, supporters of NIT also included James Tobin, Joseph A. Pechman, and Peter M. Mieszkowski, Jim Gray ^[1] and even then-President Richard Nixon, who suggested implementation of modified NIT in his Family Assistance Plan. After the increase in popularity of NIT, an experiment sponsored by the US government was conducted between 1968 and 1982 on effects of NIT on labour supply, income, and substitution effects.^[2]

Generic negative income tax

The view that the state should supplement the income of the poor has a long history (see Universal basic income § History). Such payments are seen as benefits if they are limited to those who lack other income, or are conditional on specific needs (such as number of children), but are seen as negative taxes if they continue to be received as a supplement by workers who have income from other sources. The withdrawal of benefits when the recipient ceases to satisfy a firm eligibility criterion is often seen as giving rise to the welfare trap.

The level of support provided to the poor by a negative tax is thought of as parametrically adjustable according to the opposing claims of economic efficiency and distributional justice. Friedman's NIT lacks this adjustability owing to the constraint that other benefits would be largely discontinued; hence a wage subsidy is more representative of generic negative income tax than is Friedman's specific Negative Income Tax.

In 1975 the United States implemented a negative income tax for the working poor through the earned income tax credit. A 1995 survey found that 78% of American economists supported (with or without provisos) the incorporation of a negative income tax into the welfare system.^[3]

Theoretical development

Income redistribution expressed equivalently as a negative income tax or as a basic income Cjcbi.svg — Income redistribution expressed equivalently as a negative income tax or as a basic income

Theoretical discussion of negative taxation began with Vilfredo Pareto, who first made a formal distinction between allocative efficiency (i.e. the market's ability to give people what they want subject to their incomes) and distributive justice (i.e. the question of whether these incomes are fair in the first place). He sought to show that market economies allocated resources optimally within the income distributions they give rise to, but accepted that there was nothing optimal about these distributions themselves. He concluded that if society wished to maximise wellbeing, it should let market forces govern production and exchange and then correct the result by 'a second distribution... performed in conformity with the workings of free competition'.^[4] His argument was that a direct transfer obtained a given redistributive effect with the least possible reduction of economic efficiency, and was preferable to government interference in the market (as happens in modern economies through the minimum wage) which damages efficiency by introducing distortions.

Abram Bergson and Paul Samuelson (drawing on earlier work by Oscar Lange ^[5]) gave a more formal statement to Pareto's claims.^[6] They showed that the optimum of efficiency associated with market competition fell short of maximum wellbeing as reflected by a social welfare function only through distributional effects, and that a true optimum could be obtained if the state were to transfer income through 'lump sum taxes or bounties', where 'bounties' are negative taxes and 'lump sum' is Samuelson's term for a hypothetical redistribution with no distortionary consequences.

Optimal taxation theory

It follows from the Bergson/Samuelson analysis that any proposed measure (including the proposal to leave things as they are) can be assessed according to the balance it achieves between three factors: (i) the improvement in overall wellbeing from a more equitable distribution; (ii) the loss in economic efficiency due to the distortions introduced; and (iii) the administrative costs. The first of these cannot easily be equated to a sum of money; the last is unlikely to be a dominant factor. Hence redistribution should be pursued up to the point at which any further (non-monetary) benefits from a more equal distribution would be offset by the resulting monetary loss of economic efficiency.

The Bergson/Samuelson theory was developed in a broadly utilitarian framework. A fourth factor could be added in the form of a moral claim derived from present ownership or legitimate earning. Considerable weight was placed on this during the Enlightenment but Hume and the Utilitarians rejected it.^[7] It is seldom mentioned nowadays but cannot be dismissed a priori as a relevant consideration.

The theoretical study of the trade-off between equity and efficiency was initiated by James Mirrlees in 1971.^[8] Eytan Sheshinski summarised:

In various examples calculated by Mirrlees, the optimal income-tax schedule appears to be approximately linear with a negative tax at low incomes.^[9]

Friedman's NIT

Rose and Milton Friedman Friedmanluckypeople.jpg — Rose and Milton Friedman

"Negative Income Tax" became prominent in the United States as a result of advocacy by Milton and Rose Friedman, who first put forward a concrete proposal in 1962 in a brief section of their book Capitalism and Freedom .^[10] Their system is equivalent in its operation to most forms of universal basic income (UBI) (qv., particularly the section § Fundamental principles for the equivalence).

In the aforementioned work, Friedman provides five benefits of the negative income tax. Firstly, Friedman argues that it provides cash which the individual sees as the best possible way of support. Secondly, it targets poverty directly through income rather than through general old-age benefits or farm programs. Thirdly, negative income tax could in his opinion replace all supporting programs present at that time and provide one universal program. Fourthly, in theory the cost of negative income tax can be lower than the cost of existing programs mainly due to lower administrative costs. Lastly, the program should not distort the market in the way minimum wage laws or tariffs do.^[10]

Friedman envisioned the NIT followingly in an interview in 1968: Considering family A of four with income $4000 and Family B of four with income $2000. If the break-even income would be $3000, after filing the tax report, family A would pay the tax on $1000 while family B would be entitled to receive, assuming the 50% NIT rate, $500. Meaning half of the difference between what they earn and the break-even income. Therefore, a family with $0 income would be entitled to receive $1500 in subsidy. Friedman argued NIT would not destroy the incentive to work, as compared to guaranteed income programmes (GIP) with 100% effective marginal tax rate, i.e. with the GIP workers lose $1 of subsidy for each $1 increase in wage.^[11]

In his 1966 "View from the Right" paper Milton Friedman remarked that his proposal...

has been greeted with considerable (though far from unanimous) enthusiasm on the left and with considerable (though again far from unanimous) hostility on the right. Yet, in my opinion, the negative income tax is more compatible with the philosophy and aims of the proponents of limited government and maximum individual freedom than with the philosophy and aims of the proponents of the welfare state and greater government control of the economy.^[12]

Friedman also elaborated and provided two reasons for the hostility from the right. Firstly, he mentions that the right is frightened due to the introduction of a guaranteed minimum income the poor would have a disincentive to improve their well-being. Secondly, the right is not certain about the political outcomes of the NIT, as there exist threats that there will be an upward pressure on the break-even incomes among politicians.^[12]

The Friedmans together promoted the idea to a wider audience in 1980 in their book and television series Free to Choose . It has often been discussed (and endorsed^[3]) by economists but never fully implemented. Advantages claimed for it include:

Alleviating poverty
Eliminating the "welfare trap"
Streamlining the benefits system.

The alleviation of poverty was mentioned in Capitalism and Freedom, where Friedman argued that in 1961 the US government spent around 33 billion on welfare payments e.g. old age assistance, social security benefit payments, public housing, etc. excluding mainly veterans' benefits and other allowances. Friedman recalculated the spending between 57 million consumers in 1961 and came to the conclusion that it would have financed 6000 dollars per consumer to the poorest 10% or 3000 dollars to the poorest 20%. Friedman also found out that a program raising incomes of the poorest 20% to the lowest income of the rest would cost the US government less than half of the amount spent in 1961.^[10]

The Friedmans' writings were influential for a period with the American political right, and in 1969 President Richard Nixon proposed a Family Assistance Program which had points in common with UBI. Milton Friedman originally supported Nixon's proposal but eventually testified against it on account of its perverse labor incentive effects.^[13]^[14] Friedman was mainly opposed to the idea that Nixon's program would be combined with existing programs at that time, rather than replacing the existing programs as Friedman originally proposed.^[2]

Meanwhile, support for negative income tax was increasing among the political left. Paul Samuelson argued in Newsweek that it was an idea whose time had come, and more than 1,200 academic economists signed a petition in support of it. Friedman withheld his signature, possibly on the grounds that the petition didn't explicitly describe the new measure as a replacement rather than a supplement to existing programs.^[14]

As civic disorder diminished in the US, support for negative income tax waned among the American right. Instead the doctrine came to be particularly associated with the political left, generally under the name "basic income" or derivatives. It received further impetus in Europe with the founding of the Basic Income Earth Network (BIEN) in 1986. Asked in 2000 how he viewed a basic income "compared to the alternative of a negative income tax", Friedman replied that the measures were not alternatives and that basic income was "simply another way to introduce a negative income tax", giving a numerical example of their equivalence.^[13]

Experiments on the effect of NIT on the labour supply

The experiments on NIT have been conducted in the US between years 1968 and 1982 and the expenditures were 225 million recalculated for the 1984 value. The first results have been that the husbands reduced labour supply by about the equivalent of two weeks of full-time employment. On the other hand, wives and single female heads reduced it by three weeks and the youth reduced the labour supply by four weeks.^[15]

The experiments were conducted in the following states:

New Jersey (1968–1972) observing 1,357 families for a period of 3 years and testing the guarantee levels from 0.5 to 1.25 of the poverty line and tax rates from 0.3 to 0.7.
Rural Iowa and Carolina (1969–1973) involving 809 families for a period of 3 years and testing guarantee levels from 0.5 to 1.00 and tax rates from 0.3 to 0.7.
Gary^{[ clarification needed ]} (1971–1974) observing 1,780 families for a period of 3 years and testing guarantee levels from 0.75 to 1.00 and tax rates from 0.4 to 0.6.
Seattle–Denver (1971–1982) the biggest of the four experiments, containing three lengths of treatments (3, 5 and 10 years) and testing guarantee levels from 0.95 to 1.40 and a non-constant tax rate.

It has been concluded that the most relevant sample size is from the Seattle-Denver experiment, and the experiment should yield the most precise estimates. Importantly, the results may vary not only due to sample sizes but also due to different design, methods of analysis or operations.^[15]

Results of the individual experiments

The individual results were districted into four categories: husbands, wives, single female heads, the youth. Firstly, it was noted that there is an unambiguous decrease in labour supply as a result of NIT and that there exists a pattern among each of the groups. The results show that husbands are the least responsive to NIT in terms of withdrawal from labour force while the youth is the most responsive. Moreover, the percentage responses are from 5-25% equalling 1–5 weeks of full-time work. The employment rate ranges from 1 to 10% .^[15] It is however important to note that while on one hand the youth was the most responsive to NIT, on the other hand the decrease in labour supply was equalled by increase in school attendance. Moreover, the chances of completing school education also rose notably in New Jersey by 5% and in Seattle-Denver by 11%.^[16]

Considering results from the Seattle-Denver experiment, it can be shown that the two-parent families that received $2,700 decreased their earnings by almost $1,800. Therefore, spending $2,700 on transfers to two-parent families in Seattle-Denver increased their income by only $900. This raised the question whether taxpayers would be willing to pay $3 in order to increase the income of aforementioned families by $1.^[17]

Implications to the real world

An attempt was made to synthesise the results and provide a nation-wide estimate of the effects of NIT in the US using two plans, one with 75% and the other with 100% guarantee and 50% and 70% tax rates. The corresponding programmes would cost between 6.7 and 16.3 billion dollars, (-5.3) to 4.5 billion dollars, 55.5 to 61.1 billion dollars and 15.4 to 25.7 billion dollars (value expressed in 1985 dollars) respectively. These are net costs, meaning how much more the NIT would cost relative to the welfare programmes in effect at the time. For the latter two options, i.e. 100% guarantee with either 50% or 70% tax rate, it would represent an increase in spending equal to 1.5 percent of the gross national product (GNP) and 0.4-0.6 percent of GNP. The net increase could be financed by increase in federal taxes from 2 to 4 percent. While the cost of eliminating poverty seemed attainable, the issue of decreased earnings and self-support among families remained prevalent.^[17] Hence, the issues likely caused the decrease in interest in implementation of NIT, as the work of donor is a bit higher than the work of the recipient and can potentially lead to free riding which would destroy the entire framework.^[18]

Comparison to universal basic income

A negative income tax is structurally similar to a universal basic income, as both are capable of achieving the exact same net transfer of income. However, the two mechanisms may differ in the cost to the government, the timing of payments, and the psychological perceptions from taxpayers.^[19]^[20]

Related Research Articles

A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer by a governmental organization in order to collectively fund government spending, public expenditures, or as a way to regulate and reduce negative externalities. Tax compliance refers to policy actions and individual behaviour aimed at ensuring that taxpayers are paying the right amount of tax at the right time and securing the correct tax allowances and tax relief. The first known taxation took place in Ancient Egypt around 3000–2800 BC. Taxes consist of direct or indirect taxes and may be paid in money or as its labor equivalent.

A Pigouvian tax is a tax on any market activity that generates negative externalities. The tax is normally set by the government to correct an undesirable or inefficient market outcome and does so by being set equal to the external marginal cost of the negative externalities. In the presence of negative externalities, social cost includes private cost and external cost caused by negative externalities. This means the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product. Often-cited examples of negative externalities are environmental pollution and increased public healthcare costs associated with tobacco and sugary drink consumption.

Welfare economics is a field of economics that applies microeconomic techniques to evaluate the overall well-being (welfare) of a society. This evaluation is typically done at the economy-wide level, and attempts to assess the distribution of resources and opportunities among members of society.

Guaranteed minimum income (GMI), also called minimum income, is a social-welfare system that guarantees all citizens or families an income sufficient to live on, provided that certain eligibility conditions are met, typically: citizenship and that the person in question does not already receive a minimum level of income to live on.

Social insurance is a form of social welfare that provides insurance against economic risks. The insurance may be provided publicly or through the subsidizing of private insurance. In contrast to other forms of social assistance, individuals' claims are partly dependent on their contributions, which can be considered insurance premiums to create a common fund out of which the individuals are then paid benefits in the future.

The Friedman rule is a monetary policy rule proposed by Milton Friedman. Friedman advocated monetary policy that would result in the nominal interest rate being at or very near zero. His rationale was that the opportunity cost of holding money faced by private agents should equal the social cost of creating additional fiat money. Assuming that the marginal cost of creating additional money is zero, nominal rates of interest should also be zero. In practice, this means that a central bank should seek a rate of inflation or deflation equal to the real interest rate on government bonds and other safe assets, to make the nominal interest rate zero.

Mincome, the "Manitoba Basic Annual Income Experiment", was a Canadian guaranteed annual income (GAI) social experiment conducted in Manitoba in the 1970s. The project was funded jointly by the Manitoba provincial government and the Canadian federal government under Prime Minister Pierre Trudeau. It was launched with a news release on February 22, 1974, under the New Democratic Party of Manitoba government of Edward Schreyer, and was closed down in 1979 under the Progressive Conservative of Manitoba government of Sterling Lyon and the federal Progressive Conservative Party of Joe Clark. The purpose of the experiment was to assess the social impact of a guaranteed, unconditional annual income, UBI, including whether a program of this nature would create disincentives to work for the recipients and, if so, to what extent.

Arnold Carl Harberger is an American economist. His approach to the teaching and practice of economics is to emphasize the use of analytical tools that are directly applicable to real-world issues. His influence on academic economics is reflected in part by the widespread use of the term "Harberger triangle" to refer to the standard graphical depiction of the efficiency cost of distortions of competitive equilibrium. His influence on the practice of economic policy is manifested by the high positions attained by his followers in national agencies such as central banks and ministries of finance, and in international agencies such as the World Bank.

<i>Capitalism and Freedom</i> 1962 book by Milton Friedman

Capitalism and Freedom is a book by Milton Friedman originally published in 1962 by the University of Chicago Press which discusses the role of economic capitalism in liberal society. It has sold more than half a million copies since 1962 and has been translated into eighteen languages.

In economics, the excess burden of taxation is one of the economic losses that society suffers as the result of taxes or subsidies. Economic theory posits that distortions change the amount and type of economic behavior from that which would occur in a free market without the tax. Excess burdens can be measured using the average cost of funds or the marginal cost of funds (MCF). Excess burdens were first discussed by Adam Smith.

Optimal tax theory or the theory of optimal taxation is the study of designing and implementing a tax that maximises a social welfare function subject to economic constraints. The social welfare function used is typically a function of individuals' utilities, most commonly some form of utilitarian function, so the tax system is chosen to maximise the aggregate of individual utilities. Tax revenue is required to fund the provision of public goods and other government services, as well as for redistribution from rich to poor individuals. However, most taxes distort individual behavior, because the activity that is taxed becomes relatively less desirable; for instance, taxes on labour income reduce the incentive to work. The optimization problem involves minimizing the distortions caused by taxation, while achieving desired levels of redistribution and revenue. Some taxes are thought to be less distorting, such as lump-sum taxes and Pigouvian taxes, where the market consumption of a good is inefficient, and a tax brings consumption closer to the efficient level.

Public economics(or economics of the public sector) is the study of government policy through the lens of economic efficiency and equity. Public economics builds on the theory of welfare economics and is ultimately used as a tool to improve social welfare. Welfare can be defined in terms of well-being, prosperity, and overall state of being.

Universal basic income (UBI) is a social welfare proposal in which all citizens of a given population regularly receive a minimum income in the form of an unconditional transfer payment, i.e., without a means test or need to work. In contrast a guaranteed minimum income is paid only to those who do not already receive an income that is enough to live on. A UBI would be received independently of any other income. If the level is sufficient to meet a person's basic needs, it is sometimes called a full basic income; if it is less than that amount, it may be called a partial basic income. No country has yet introduced either, although there have been numerous pilot projects and the idea is discussed in many countries. Some have labelled UBI as utopian due to its historical origin.

Universal basic income in Canada refers to the debate and trials with basic income, negative income and related welfare systems in Canada. The debate goes back to the 1930s when the social credit movement had ideas around those lines. Two major basic income experiments have been conducted in Canada. Firstly the Mincome experiment in Manitoba 1974–1979, and secondly the Ontario Basic Income Pilot Project in 2017. The latter was intended to last for three years but only lasted a few months due to its subsequent cancellation by the then newly-elected Conservative government.

Universal basic income (UBI) is discussed in many countries. This article summarizes the national and regional debates, where it takes place, and is a complement to the main article on the subject: universal basic income.

Universal basic income pilots are smaller-scale preliminary experiments which are carried out on selected members of the relevant population to assess the feasibility, costs and effects of the full-scale implementation of universal basic income, or the related concept of negative income tax, including partial universal basic income and similar programs. The following list provides an overview of the most famous universal basic income pilots, including projects which have not been launched yet but have been already approved by the respective political bodies or for the negotiations are in process.

Universal basic income and negative income tax, which is a related system, has been debated in the United States since the 1960s, and to a smaller extent also before that. During the 1960s and 1970s a number of experiments with negative income tax were conducted in United States and Canada. In the 1970s another and somewhat related welfare system was introduced instead, the Earned Income Tax Credit. The next big development in the history of basic income in the United States came in 1982, when the Alaska Permanent Fund was established. It has delivered some kind of basic income, financed from the state's oil and gas revenues, ever since.

Optimal labour income tax is a sub-area of optimal tax theory which refers to the study of designing a tax on individual labour income such that a given economic criterion like social welfare is optimized.

A wage subsidy is a payment to workers by the state, made either directly or through their employers. Its purposes are to redistribute income and to obviate the welfare trap attributed to other forms of relief, thereby reducing unemployment. It is most naturally implemented as a modification to the income tax system.

The Family Assistance Plan (FAP) was a welfare program introduced by President Richard Nixon in August 1969, which aimed to implement a negative income tax for households with working parents. The FAP was influenced by President Lyndon B. Johnson's War on Poverty program that aimed to expand welfare across all American citizens, especially for working-class Americans. Nixon intended for the FAP to replace existing welfare programs such as the Aid to Assist Families with Dependent Children (AFDC) program as a way to attract conservative voters that were beginning to become wary of welfare while maintaining middle-class constituencies. The FAP specifically provided aid assistance to working-class Americans, dividing benefits based on age, the number of children, family income, and eligibility. Initially, the Nixon administration thought the FAP legislation would easily pass through the House of Representatives and the more liberal Senate, as both chambers were controlled by the Democratic Party. In June 1971, the FAP under the bill H.R. 1 during the 92nd Congress, passed in the House of Representatives. However, from December 1971 to June 1972 H.R.1 bill that included the FAP underwent scrutiny in the Senate chamber, particularly by the Senate Finance Committee controlled by the conservative Democrats, while the Republicans were also reluctant on passing the program. Eventually, on October 5 of 1972, a revised version of H.R.1 passed the Senate with a vote of 68-5 that only authorized funding for FAP testing before its implementation. During House-Senate reconciliation, before Nixon signed the bill on October 15, 1972, the entire provision on FAP was dropped. The FAP enjoyed broad support from Americans across different regions. Reception towards the program varied across racial, regional, income, and gender differences. The FAP is best remembered for beginning the rhetoric against the expansion of welfare that was popular during the New Deal. It initiated the support for anti-welfare conservative movements that became mainstream in American political discourse during the Reagan era.

References

↑ Gray, James P. (26 February 2004). "#262: Turn A Crutch Into A Ladder". Judge Jim Gray. Retrieved 24 January 2024. Republished in Gray, James P. (October 2023) [2019]. 2 Paragraphs 4 Liberty: Solutions That Are Practical, Effective, Responsible, Libertarian. PageTurner: Press & Media. ISBN 979-8-89174-097-6. ISBN 978-170817785-0
1 2 Moffitt, Robert A (2003-08-01). "The Negative Income Tax and the Evolution of U.S. Welfare Policy". Journal of Economic Perspectives. 17 (3): 119–140. doi: 10.1257/089533003769204380 . ISSN 0895-3309.
1 2 Alston, Richard M.; Kearl, J.R.; Vaughan, Michael B. (May 1992). "Is There a Consensus Among Economists in the 1990s?" (PDF). The American Economic Review . American Economic Association. 82 (2): 203–09. Retrieved 17 October 2015.
↑ Manuale di Economia Politica con una Introduzione alla Scienza Sociale (1906) / Manuel d'Économie Politique (1909), §53 and §55 of Chap. VI.
↑ O. Lange, "The Foundations of Welfare Economics" (1942).
↑ P. A. Samuelson, "Foundations of Economic Analysis" (1947), pp. 219–249.
↑ See Edwin G. West, "Property Rights in the History of Economic Thought: From Locke to J.S. Mill" (2001/2003).
↑ Sir J. Mirrlees, "An Exploration in the Theory of Optimum Income Taxation" (1971).
↑ E. Sheshinski, "The Optimal Linear Income Tax" (1972).
1 2 3 M. Friedman assisted by R. Friedman, "Capitalism and Freedom" (1961), pp. 190–195.
↑ Milton Friedman - The Negative Income Tax , retrieved 2021-04-30
1 2 M. Friedman, "The Case for Negative Income Tax: A View from the Right" (1966). Republished several times.
1 2 Suplicy, Eduardo (June 2000). "Eduardo Suplicy's Interview With Milton Friedman". The U.S. Basic Income Guarantee NewsFlash.
1 2 Leland Neuberg, "Emergence and Defeat of Nixon's Family Assistance Plan" (2004) https://usbig.net/papers/066-Neuberg-FAP2.doc.
1 2 3 Robins, Philip K. (1985). "A Comparison of the Labor Supply Findings from the Four Negative Income Tax Experiments". The Journal of Human Resources. 20 (4): 567–582. doi:10.2307/145685. ISSN 0022-166X. JSTOR 145685.
↑ Matthews, Dylan (2014-07-23). "Paying everyone enough to escape poverty is doable". Vox. Retrieved 2021-04-30.
1 2 Burtless, Gary (1986). "The work response to a guaranteed income: a survey of experimental evidence". In Munell, Alicia H. (ed.). Lessons from the income maintenance experiments. Conference Series; [Proceedings]. Vol. 30. Federal Reserve Bank of Boston. pp. 22–59.
↑ Solow, Robert M. (1986). "An economist's view of the income maintenance experiments". In Munell, Alicia H. (ed.). Lessons from the income maintenance experiments. Conference Series; [Proceedings]. Vol. 30. Federal Reserve Bank of Boston. pp. 218–226.
↑ Harvey, Philip (December 2006). "The Relative Cost of a Universal Basic Income and a Negative Income Tax" (PDF). Basic Income Studies. 1 (2). doi:10.2202/1932-0183.1032. S2CID 154259702.
↑ Hammond, Samuel (9 June 2016). ""Universal Basic Income" is Just a Negative Income Tax with a Leaky Bucket". Niskanen Center . Retrieved 28 November 2022.