Negative Income Tax

Social security and, consequently, redistribution are one of the most debatable topics, a discussion that goes even beyond the boundaries of economics. Some argue that the level of redistribution differentiates our political spectrum, while others solely focus on the justification of distribution. However, this article will solely focus on economic aspects of a social security scheme. A specific scheme that has been promoted by one of the most influential economists of the last century, namely the negative income tax by Milton Friedman. Even though the negative income tax hasn’t been directly in the center of the debate recently it can still be considered as relevant due to its similarities with popular basic income schemes. But what is a negative income tax? Is it as straightforward as the name suggests? It almost is. A negative income tax is a linear tax where some receive money, a negative tax, and others pay money. Whether you pay or receive a tax depends on your income and a beforehand established limit. To further illustrate this tax, consider the following example: “There is a tax rate of 50% and an income limit of €5.000. In this case, an economic agent with an income of 7.500 euro would pay €1.250, (7.500-5.000)*0.5, in taxes, where an agent with an income of 2.500 euro would receive €1.250, (7.500-5.000)*0.5, in taxes.” At first a rather simple and straightforward system, yet it has some unique attributes. The main attractiveness of this system arises from the fact that it overcomes a big economic problem mostly present in social security schemes, the so-called poverty trap. The poverty trap refers to a situation in which working more or working at all results in a loss of income. This seems to be contradicting at first. However, if one takes into account that most social welfare payments are restricted to a certain income level it is easier to understand. In short, for economic agents who are receiving social security and have the opportunity to work and, consequently, earn higher wages it might not be beneficial to undertake this opportunity as the increase in wages is (more than) completely offset by the loss in social transfers. This situation cannot occur with a negative income tax as it is designed such that working is always beneficial. To illustrate this, consider again the following example: “There is a tax rate of 50% and an income limit of €5.000, and an economic agent with an income of €1.000. Currently, this agent receives €2.000 in taxes resulting in an income of €3.000. If the opportunity arises to work more and gain an extra wage income of €1.000, he would only receive €1.500 in taxes. However, his total income would still rise to €3.500. This will also hold if the extra wages result in crossing the limit of €5.000, as an increase in wages of €5.000 for example will result in a tax payment of €500 and a total income of €5.500.” A negative income tax seems promising, but as all social security schemes it also has some disadvantages. The main disadvantage is the costs. When the relative poverty line or the desired level of minimum income is close to the average income the implementation of a negative income tax will become extremely costly. In sum, the debate about social security schemes will never end. However, as economists we should always strive to overcome the disadvantages of current schemes and try to create a social security system where the debate focuses on political and philosophical issues and not economical.

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