Negative Income Tax
The Negative Income Tax and the Evolution of U.S. Welfare Policy
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The Negative Income Tax and the Evolution of U.S. Welfare Policy
Over the past decades U.S. welfare policy has shifted in many directions. In 1962, Milton Friedman drafted a proposal that consisted of implementing a negative income tax; a tax system that would give money back to the taxpayer at a decreasing rate as the taxpayer’s income rises. Even though the negative income tax as stated by M. Friedman never passed Congress, a number of policies used it as a basis in order to reform the tax system. Moreover, this tax system is used as a benchmark for the analysis of actual programs. Robert A. Moffitt, in his article “The Negative Income Tax and the Evolution of U.S. Welfare”, in The Journal of Economic Perspectives, reviews this proposal and outlines its advantages as viewed by M. Friedman, states the two most important challenges to the negative income tax (its effects on labor supply and usage of work requirements) and, provides us with an outline of U.S. welfare policy over the past three decades and how it relates to the proposal in question.
The first section of the article labeled “Milton Friedman’s Negative Income Tax”, begins with the comparison between a welfare program with a 100 percent negative income tax rate and a welfare program with a tax rate less than 100 percent. Both tax rates are presented in the same labor-leisure diagram and in the latter case, labor supply increases because an individual that did not work moves to a higher indifference curve in order to maximize his utility given his new budget constraint. Apart from increased work incentives, M. Friedman outlined five additional advantages of this scheme. First of all, poor families are supported on the basis of their income and not some other characteristic. In addition, this system provides cash and, can be substituted for the existing bundle of programs, thus bringing about a reduction in administrative costs. Finally, resources can be allocated easily to the poor and prices are not distorted as with minimum wages for example. In 1980, in the book Free to Choose, Milton Friedman along with Rose Friedman stated that special needs that cannot be supported by this system could be met by private charity and proposed a guaranteed income that would be less than the existing so as not to provide too much income support and induce people not to work at all.
The second section of the article, “Federalism and Family Structure” concerns the large variation in benefit levels across states in 1960 and the incentives of people to adapt their family structure in order to capture the benefits of the negative tax system. First of all, according to the negative income tax, the program should be federalized and a standard benefit level should be set, adjusted however for the cost of living in each state. The result would be however, higher welfare expenditures because this benefit level would be set at a higher level than the existing one in many states and policy has moved away from this plan and towards a local benefit level. Furthermore, this system argues that it should be universal and not restricted to single mothers or even families so that it does not shift the family structure towards specific one, e.g. not married individuals. However, even this system cannot entirely correct this problem if the tax unit is the family (i.e. two eligible individuals may not qualify for this program if they get married).
The third section, “Are the Labor Supply Effects Ambiguous?”, deals with the effects of this system on the labor supply, which is one of the challenges of the negative income tax. With the use of a diagram, it states that the change in average labor supply is ambiguous in sign and it is not because of the change in associated costs or the income and substitution effects pushing the labor supply in different directions. Empirical evidence shows that the effects of a negative income tax on labor supply may differ across places, groups and time and this ambiguity is shared by other reforms as well. This ambiguity arises from the fact that the marginal tax rate increases in some regions of the diagram and decreases in others and is shared by other reforms as well (e.g. welfare programs that have “notches”). Moreover, in the negative income tax system there is no way to manipulate the budget constraint in order to increase labor supply unambiguously. The author’s last argument in this section is that the Mirrlees model and the report of Fortin, Truchon and Beausejour show that a negative income tax might be a socially maximizing system despite the lack of work incentives for near-poor families.
The next section, “Work Requirements and Categorical Transfer Systems” is about the division of the population into employables and nonemployables and how it is at odds with M. Friedman’s proposal. Following this division, employables get no benefits if they do not work or work less than the stated minimum hours, whereas nonemployables are given a guaranteed income. The drawbacks of this system when compared to Friedman’s proposal lie in the fact that government intervention is needed in order to screen people, government agencies may not be able to distinguish between the two groups and thus, large variations in categorization may arise. In addition, people may have incentives to change their characteristics in order to change their “placement”. On the other hand, Akerlof (with his tagging system for the poor), Parsons (with his two-sided error model) and Besley and Coate as well as Nichols and Zeuckhauser (with their systems that deter entry to the more able) have built models where work requirements have been advantageous and superior to Friedman’s proposal.
The final section of the article is labeled “Policy Developments in the U.S. Welfare System” and deals with the three most important trends in U.S. welfare systems (Welfare Tax Rates, Work Requirements and Multiple Welfare Programs). Friedman proposed that the negative income tax rate should be kept low but the policy recorder is not clear on that issue. The rate of the Aid of Families with Dependent Children moved from 100 percent (1935) to 67 percent (1967) and back to 100 percent (1981) and in 1996 was replaced by Temporary Assistance for Needy Families. Under this system, states withdraw benefits at the rate they choose and generally, states have a tax rate of around 50 percent, few have a tax rate of 100 percent and few have a tax rate below 50 percent. After 1996, work levels have increased among those who receive welfare payments but it is not clear if it is solely the result of reduced tax rates; work requirements and an earnings subsidy, Earned Income Tax Credit, have been introduced as well. The Earned Income Tax Credit subsidizes income until a certain level, after which subsidies gradually disappear and is not intended to replace the welfare programs because families with no income are not supported at all. A diagram shows us the effects of both programs (negative income tax and earnings subsidy) when working simultaneously, where the tax rate individuals face is the sum of the tax rates of both programs. When observing the actual policy after 1996, it is apparent that the level of guaranteed income is low and so is the average tax rate. Moreover, one study shows that the overall labor supply of women has increased. In 1980, the Regan administration encouraged states to experiment with mandatory work programs and, following the 1996 reform, a work requirement of 20 hours per week, which was later increased to 30 hours per week, was imposed. This policy has resulted in increased administrative costs because the government is more involved and evidence shows that more resources are allocated to those that need them most because money has freed up and new programs have been created. Instead of substituting all programs with the negative income tax, as proposed by Friedman, U.S. policy has moved to the opposite direction; many different programs are being used for special purposes and different populations. As a result, administrative costs have risen and the participation rates of those eligible decline as the number of programs increases (increased individuals’ mobility costs). As one can clearly see, some aspects of the welfare system have taken the idea that Friedman envisioned even further but others have moved on the opposite direction and critiques of the existing welfare system cannot be avoided.
To sum up, this article provides the reader with a comprehensive overview of the negative income tax; how it works, what are its advantages, what are its disadvantages and, how it manifests itself in U.S. welfare policy. The author of this article accomplishes his purpose because even though he is an economist and analyzes a complex economic issue, the reader can grasp the material without having background knowledge. His arguments are relevant to the topic at hand, they are explained clearly and carefully and, they do not mislead the reader. In addition, his conclusions follow directly from his analysis which consists of theoretical models as well as real world applications and empirical evidence. Moreover, his theoretical analysis can be validated by the economics text book Modern Labor Economics: Theory and Public Policy by Ronald G. Ehrenberg and Robert S. Smith and the evidence that is presented is not only in support of his arguments, meaning that he does not exclude relevant information in order to strengthen his arguments by misinforming his audience. As a result, this article is unbiased and the author manages to keep his personal feelings and inclinations out from his analysis. In all, I believe that Robert A. Moffitt adequately addresses the scope and complexity of the issue at hand and his article can be used as a good reference point when studying this topic.
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