Negative Income Tax – An alternative to the welfare system?

I’m currently on holidays and have decided to spend my time productively, watching Milton Friedman’s hit 1980s series Free to Choose. About two years ago, I stumbled across a copy of the companion book for this series in an OP shop. I quickly grabbed hold of the book and guarded it in case someone else wanted to buy it. Surprisingly, the book looked like it had been on the shelf for a while and it did not create the kind of excitement used copies of Harry Potter can cause. The bewildered shopkeeper seemed surprised at my excitement. On another another occasion a staff member at an op shop seemed amazed when I was clearly excited buying a TI-84 programmable calculator for only $10.

Anyway, Friedman in an episode about the welfare state raised the prospect of a negative income tax. I have provided a link to information on this idea but basically instead of having welfare payments and a massive welfare bureaucracy to administer it, you would instead get paid the equivalent of your tax free threshold and the low income offset in cash if you weren’t working and this would be phased out the more income one earns. The idea is that this would remove many of the perverse barriers to work that the interaction between the welfare system and the tax system currently produce. It would also be dramatically cheaper, Centrelink and the Employment Services industry would be largely abolished leaving only minimal paperwork to confirm how much income one earned.

To assess this idea we need to consider how the current welfare system came about. In the early 20th century the welfare system was created with the idea that when people fall on bad times the state will help support them. This is a good idea in theory, however within one generation of the welfare states creation entire communities became completely depended on the state. Many people who would choose to work decide not to because the money they can earn in an entry level job does not exceed the value of their benefits and the value of what economists call their leisure time. This is the value people put on the time they would otherwise spend at work, for example a mother being at home with their children. Or they fear losing their welfare payments. A negative income tax would eliminate this second barrier to employment.

In a backlash by the community against those who choose not work, the people have demanded that those on unemployment are forced to look for work and in some cases work for the dole. It would be fair to say despite some success these programs have not forced many voluntarily unemployed people into work. Equally, many of those with the genuine desire to work have found themselves having to work with a welfare and employment services bureaucracy that is often demeaning and inefficient. Although these programs are popular and make the government look like they are doing something about unemployment they cannot be said to be effective.

Working in the employment services industry I have a vested interest in the current system. However, I feel that the negative income tax system has never received proper consideration and faces resistance from the welfare bureaucracy and the employment services and training sectors. This combined with the fact some people on welfare especially those are receiving what could be classed as middle class welfare will lose out making the idea politically difficult. Another problem is that welfare payments vary between groups. For example, presently pensioners receive more on the welfare system than the unemployed. Clearly, this is due to political reasons not due to any rational argument that it is cheaper for the unemployed to live than those people on pensions.

The employment and training sector under a negative income tax would be significantly smaller and would be working with clients who have voluntarily chosen to look for work and participate in study. In the show Friedman shows a technical college which is design to equip the unemployed with skills for the labour market. Then like now such schemes had a very low completion rate and had limited success. Any training government provided or subsidised under a negative income tax would only goes to those who choose to do it rather than forced to do it as a way of meeting their activity test as a condition of receiving welfare.

So the question is would a negative income tax, increase the incentive for those to who can to work, reduce the humility imposed on those who can’t by welfare rules and regulation and reduce the financial cost to the taxpayer? From what I’ve read and experienced, probably.

22 thoughts on “Negative Income Tax – An alternative to the welfare system?

  1. First of all, I thoroughly enjoyed Friedman’s Capitalism & Freedom and Free To Choose (both the book and, especially, the series)

    But, actually, the negative income tax idea is not that great, for two main reasons (apart from all the classic arguments against any kind of tax or welfare of course):
    – it presupposes the elimination of all other welfare programs, which in reality of course won’t and didn’t happen, and instead it is added as another layer of welfare on an already strained system
    – it assumes that the program won’t become bigger and bigger until it becomes uncontrollable

    For the first reason, Milton Friedman actually argued against his own proposal when it nearly made it into law under the Nixon administration.
    And the similar tax policies which have been implemented in numerous countries around the world (eg the Earned Income Tax Credit in the US and the Working Tax Credit in the UK) and were supposed to be geared towards giving people incentives to work have in practice been transformed into typical welfare programs.

    For an article discussing this issue, check out
    For a more in-depth response, the incomparable Henry Hazlitt wrote this rather brilliant rebuttal back when Friedman first proposed it:

    But I must agree with the general message of your article. IF the welfare system were entirely replaced by the Negative Income Tax and IF there would be checks in place on government that would prevent the ballooning and transformation of the program, then surely it would be a big step in the right direction from a libertarian, and humanitarian, point of view. But that’s two ifs too many imo..

    Lastly, a TI-84 for $10?! That’s outrageous.

  2. I totally agree, I didn’t write the article thinking it could ever work. Just as an interesting discussion. As we are seeing with Ron Paul, ideas about minimal Government intervention are seen as “wacky” and “crazy” the average person could perceive of a welfare system which is far more automatic and hands off than the current system. The political system would build a bureaucracy around a negative income tax.

    About the TI-84 I still have to work out how to use it. I did upgrade the software on it so now it has Mathprint. Which means you can enter in formulas like they appear in the textbook.

  3. The NIT has a lot to recommend it. It’s currently LDP policy. However, there does seem to be a significant downside – a lot of people not currently in the welfare system, but who are on low incomes for various reasons, would receive a benefit.

    This could be rectified through various qualification criteria, but that tends to take things back to where we are now.

  4. Another problem is that welfare payments vary between groups. For example, presently pensioners receive more on the welfare system than the unemployed. Clearly, this is due to political reasons not due to any rational argument that it is cheaper for the unemployed to live than those people on pensions.

    There is a big difference between these two forms of welfare. We do expect retired people to live on the pension. We don’t expect unemployed people to live on unemployment benefits, we expect them to get a job and in the interim we give them a very modest allowance. It would be mad to cut the pension to the level of unemployment benefits or to increase unemployment benefits to the level of the pension. Although I think we should increase the retirement age over time and phase out the pension as an entitlement as people are conditioned into saving for their twilight years.

    Although they can be mathematically equivalent I prefer a “social wage” and a “flat tax” over a negative income tax based on a threshold. Mainly because I think it’s meaning is more explicit and it’s operation more transparent. However for a party like the LDP to promote a “social wage” and still market itself as libertarian would be extremely awkward. That said I only think the introduction of a social wage makes any sense at all if it is as a replacement for the minimum wage and the tax free threshold. If it is in addition to a minimum wage and tax free threshold then it’s a monsterously counter productive move.

  5. The NIT, if it were a REPLACEMENT for the current welfare system, would be fantastic.

    An earlier reply said that the NIT was introduced in the US, and Friedman argued against it. This is true, but it is because a variant of the NIT (the Earned Income Tax Credit or EITC) was introduced as a SUPPLEMENT to the current tax-welfare system rather than as a replacement.

    Is an NIT, properly implemented (as a replacement) feasible? I think so, even if the political-bureaucratic class are against it. It keeps a very visible and obvious safety net in place, thus making it easier to argue that those against it are simply trying to protect their own jobs.

  6. By chance, I’ve recently had an article on this general area accepted, though it only touches on Negative Income Tax lightly (by mistake, the final draft wasn’t put up, so it still has some typos and outstanding tweaks; that should be fixed soon). Drawing on that and the other items it links to (one of which is on this site), I can make the following observations:-

    – The history of welfare state measures actually goes back further and has different origins.

    – This article doesn’t address the limited results that various Negative Income Tax pilot studies have had. My own view is that those didn’t go on long enough or across the board enough to allow prices and wage levels to adjust properly; basically, the desired effects “leaked”.

    – A Negative Income Tax would be better than what we have now once it settled in, but even then it would need huge and continuing funds flows. This partly shows up in the “taper”, i.e. how incentives to earn more are worse than they otherwise would be over a wide range of incomes because of the marginal rates of Income Tax involved. Once things reached a steady state, there would be a large number of highly taxed people and a large number of people in poorly paid work getting a top up from the tax system, with the government churning funds flows from one group to the other and the incentives hindering people climbing into the paying group. However, the outgoings on the poorly paid would have replaced the outgoings on the unemployed of the present system, so it wouldn’t be necessary to provide a minimum that was enough to live on; a top up for the poorly paid would be enough.

    – Until enough people eventually got back into work, there would be an overhang, during which there would be excess outgoings. This would be because the system would be providing for both groups, the poorly paid as well as for a large number still out of work. The base level of support would have to be higher than for the final steady state, as it would have to be enough to live on, so this transitional stage would cost quite a bit more (this higher level applying to both groups is pretty much the problem that DavidLeyonhjelm spotted). Because of “stickiness”, this stage would probably last years; in particular, it would last longer than the electoral cycle that politicians respond to.

    – If the support level wasn’t eventually lowered, say by fiscal drag, even the final steady state would end up as bad as the transition – and there would be political pressure to keep it that way, say by indexing. (This is basically the bludger-tolerant scenario that some people fear.)

    – Galudwig’s idea that “the Earned Income Tax Credit in the US and the Working Tax Credit in the UK” are “similar tax policies” doesn’t hold up, because (largely for budgetary reasons) they simply don’t apply at a crucial point: where the unemployed seek work. They only cut in afterwards, once someone has found poorly paid work, so the unemployed still face loss of benefits by taking that work – they would need to survive during an initial period of low pay until they got the replacement support.

    I would welcome any feedback.

  7. PML – one idea we don’t hear enough about is the negative payroll tax you were promoting some time ago. I actually think it is a much simpler thing to implement, doesn’t require the political difficulty of axing the minimum wage, or the implementation issues associated with dismantling existing welfare systems but still delivers most of the same benefits. However I intermittently forget about it and it wasn’t until I saw your name here that I remembered.

    However given that most places have a job destroying positive payroll tax (it is 28% in Greece) maybe it is enough to simply push for abolition. Abolition of payroll tax seems to be an issue on which economists from both the left and the right can agree on, at least until the question of what to do about the lost revenue comes up.

  8. TerjeP, abolishing regular Payroll Tax on its own isn’t enough, for the reasons I gave at that link above – basically, that it wouldn’t lower the going rate of wages enough to price everybody at the lower end into work. However, as I also mentioned there, such things are an improvement.

    Curiously enough, in Australia from about the ’40s to the ’60s, conditions were such that there was so much demand for labour that it made things non-optimal in the other direction. Under those circumstances, a regular Payroll Tax at the right levels actually was Pigovian, i.e. tending to restore incentives that made things nearer optimal. But the world changed under us without the politicians realising that that made that tax worse…

  9. PML – I’ve now read your link. Good stuff. I agree that merely abolition existing payroll tax only offers an improvement but I think we should grab those sort of improvements where we can. That said it must surely represent a big improvement in places like Greece where payroll tax is currently 28%.

  10. Bottom of page 43 on the following document has some payroll tax rates in South America. It is obviously several years old but I don’t have anything more up to date.

    Click to access AlmLopez_PayrollTaxesinColombia.pdf

    Argentina 38% – 42%
    Brasil 19.15% – 22.8%
    Colombia 36.5%
    Costa Rica 32%
    Chile 20.05% – 20.55%
    Ecuador 21.5%
    El Salvador 19%
    Guatemala 11.5% – 14.5%
    Honduras 15%
    Mexico 42.29% – 44.92%
    Nicaragua 15.25% – 23.5%
    Panama 21.31% – 26.35%
    Peru 24.53% – 25.55%
    Venezuela 24.17% – 27.17%

    These rates are embarrassingly high. Bits of Europe are no better.

  11. The 28% isn’t the serious thing, by itself. Think of how it falls on different wage levels (imagine a straight line graph – if I could draw a graph and mark things off on it, it would be a lot easier to explain). The damage is actually done at the low end, by the way it pulls already low wages down. That increases the number of people who can’t price themselves into work, by moving some people from “just enough” to “not enough”. But it doesn’t touch two other groups, those who already couldn’t price themselves into work (who wouldn’t even be helped by cutting the rate), and those with high enough value to be worth higher wages (who end up worse off on the higher rate, but whose job prospects stay good).

    So what counts most is the detailed shape of the graph at the low end. The 28% does affect that, but it’s really telling you more about the whole graph without quite giving the relevant details in full. In fact, you could even adjust a Payroll Tax to be the carrying tax for a Negative Payroll Tax instead of a GST, though it would be even more distorting of other things (and a GST isn’t the best possibility either, just the best of those already in place). That would involve increasing the rate from 28% to much more (distorting even more, in other respects), and shifting the line so it no longer moved through the origin but rather fell below it.

    Over and above Payroll Tax issues, there are other issues like the minimum wage, regulations, and various employer obligations, e.g. as discussed in this recent article at Lew Rockwell’s site. All these things working together tend to produce a bifurcation or splitting of the labour pool into the overworked and the under-employed or unemployed, since doing that rather than spreading the work also reduces the overhead (deadweight) cost of employing people as well as externalising the direct costs of the unemployed – even though that is less productive under overall, true and undistorted costs.

  12. The negative income tax is a big distraction from us getting serious about getting rid of government departments, and raising the tax free threshold. Its not that one might not see it as a fine thing some day. But first things first.

  13. As someone new to these ideas, i have a question of practicality rather than theory. How easy is it to embed in the tax system payments of the ‘negative income tax’ that would presumably need to occur more regularly than typical income taxation windows (eg quarterly, half-yearly or annually), without in effect ending up with a similar amount of bureaucracy to what we have today (perhaps in a different govt department). The practicality of paying the poor regularly, then transitioning when they reach an income threshold to no longer paying them but expecting them to pay the tax office annually, appears fraught with potentially unintended consequences. One would be those who defer notifying the tax office (because they don’t want to give up the benefit quickly), but then end up owing a repayment bill at the end of their first tax paying year … potentially creating a new form of disincentive. Interested in thoughts about practical implementation … or is that why things like a ‘flat tax + social wage’ or ‘higher tax-free threshold’ as others have put forward, might be more pragmatic alternatives?

  14. I think a negative income tax in combination with a negative sales tax would be good. Neither by itself is realistically going to replace existing welfare payments without being steeply progressive. The ‘negative’ part of the former is to streamline what the low income tax offset and tax free threshold currently do, the latter essentially allows the basic necessities to be tax free and allows a higher ‘social wage’ than the NIT alone without higher EMTRs. The administrative cost of both against just one shouldn’t be much higher since both involve shoving an advance, fixed payment to the same group of people – everyone – and after that the effective tax rates are flat.

  15. True, but I would tie the sales tax rate more directly to government spending to create downward pressure on such spending. I don’t know if you’re proposing just a consumption tax with no income tax but there seems to only a certain rate to which consumption taxes are politically acceptable, and retaining the income tax components allows the former to be lower than otherwise with minimal extra overhead.
    You could also give states or regions control over the rate and threshold (and revenue) of the consumption tax as areas with lower cost of living won’t need as high a rate, and I think we all agree on the benefits of fiscal federalism.

  16. Mitch, a VAT (GST) is not a consumption tax, it was just over-simplified to be called that to sell it. It is actually a production tax that hits other things as well as consumption, particularly investment, as I describe here.

    I don’t see how you could put a useful “negative” aspect into a true sales tax, i.e. something that would flow through to make the cost of living easier for people. Even linking it to government spending wouldn’t help, as it would be easy to rearrange the books to make things look good around election times or to favour marginal electorates or whatever.

  17. TP, who gives a stuff about practicality? We are all ardent idealists here! As soon as you introduce ‘reality’ and ‘practicality’ into our discussions, we feel sick and nauseous! Please, let’s keep things at an immaterial level.

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