Thoughts on the Negative Income Tax

Introduction

Recently I was in a discussion on poverty, helping the poor, subsidizing education, etc. (socialist and liberal ideas/theories) with a co-worker. I, being a very libertarian capitalist, was confronted with the notion of Universal Basic Income (UBI). Immediately I stopped. I'd had this discussion before. My answer was a firm "NO." My co-worker responded with "Well ... what would you propose?"

In all honesty this was something I was quite defeated by. All I could answer with was "I honestly don't know what I should say. I've never really had to give an alternative to this before. I'll do my homework and get back to you on it." With that the discussion concluded, at least between the co-worker and I, and I was off to find an answer.

The Discovery

As soon as I got home I went on Google and searched up Milton Friedman. I've read a couple of his essays and remembered something about his notions on taxation and the welfare state. I stumbled upon this web article on Friedman's notion of Libertarian Redistributionism.

"In his 1962 book Capitalism and Freedom, Friedman acknowledged that some form of welfare was necessary in capitalist societies and that the state would likely play a role in its provision. The trick was to imagine a very different, radically improved, and more efficient form of welfare—what Friedman’s son, David, also an economist, calls “libertarian redistributionism.” What kind of program could help protect every citizen from destitution without granting excessive power to bureaucrats, creating disincentives to work, and clogging up the free-market economy, as the modern welfare state has done? Friedman’s answer was the negative income tax, or NIT."
- Guy SormanWhy Not a Negative Income Tax?

After looking into NIT I actually discovered that it wasn't his creation.

"The Negative Income Tax (NIT) is a concept that was first concocted by former Liberal MP Juliet Rhys-Williams in the 1940s before being popularised by ... economist Milton Friedman."
- Chris WhitingWhy The Negative Income Tax Is The Future

Regardless of its origin I will be speaking in line with what Friedman had to say about it.

Definition

"The NIT is easy to describe. “The basic idea,” Friedman wrote in a 1968 Newsweek column, “is to use the mechanism by which we now collect tax revenue from people with incomes above some minimum level to provide financial assistance to people with incomes below that level.”
In Friedman’s plan, the poor would similarly receive a fraction of their “negative taxable income” ... [,] the amount by which their earnings fell short of that level. This direct cash grant would replace all other welfare programs for the poor.
But wouldn’t the NIT ... in effect, a government-guaranteed income ... still be a disincentive to work, just as no-questions-asked welfare benefits were before being reformed in the 1990s?
“Any state intervention, any income redistribution, creates disincentives and distortions,” admits Gary Becker, a University of Chicago economist and Friedman disciple. “But if society decides that a certain level of redistribution must take place, the NIT is the best, the most minimally distorting, solution ever devised.”
To limit the disincentive, Friedman argued, the NIT should be progressive. Say the government drew the income line at $10,000 for a family of four and the NIT was 50%, as most economists recommend. If the family had no income at all, it would receive $5,000 ... [,] that is, 50% of the amount by which its income fell short of $10,000.
If the family earned $2,000, it would get $4,000 from the government—again, 50 percent of its income shortfall—for a total post-tax income of $6,000. Bring in $4,000, and it would receive $3,000, for a total of $7,000. So as the family’s earnings rise, its post-tax income rises, too, preserving the work incentive. This is very different from many social welfare programs, in which a household either receives all of a benefit or, if it ceases to qualify, nothing at all. The all-or-nothing model encourages what social scientists call “poverty traps,” tempting the poor not to improve their situations.
Robert Moffitt, an economist at Johns Hopkins University and a leading authority on the NIT, notes another advantage of the program over other forms of state assistance: “No stigma attaches to the NIT.” Everyone fills out the same forms, and no infantilizing government meddles with a household’s food, shelter, and health care, as under the current system. The NIT simply provides the poor with money, which they can use to meet their various needs. Friedman strongly believed that individuals have the capacity to promote their own interests.
Yet another NIT advantage is a freer labor market. No minimum wage would be necessary, since a minimum income would now be guaranteed. This would boost employment: as economists recognize, a legal minimum wage tends to increase joblessness by discouraging employers from recruiting unskilled labor. The NIT would reduce illegal immigration, too. Managed by the IRS, it would apply only to citizens and legal residents, and since it would eliminate welfare programs, aliens would have less incentive to cross the border illegally for government benefits (though local authorities would still have to decide whether to grant them access to schools and hospitals). “From an economist’s perspective, the negative income tax is the perfect design,” Moffitt says. “The only reason an economist would oppose it would be from a strict libertarian perspective—opposition to any kind of government-managed welfare.”
But the biggest advantage of the NIT is that it requires the smallest possible bureaucracy to implement. The IRS already exists; it knows how to assess income statements; and, to run the NIT, it has only to take money or pay it out. No longer would the federal and state governments maintain the sprawling multiple agencies necessary to distribute food stamps, public housing, Medicaid, cash welfare, and a myriad of community development programs. Nor would they need to pay the salaries and enormous future pensions of the public employees who run all these programs. According to a Heritage Foundation study by Robert Rector, Kiki Bradley, and Rachel Sheffield, the federal portion of America’s welfare system cost a staggering $522 billion in 2008, which works out to about $12,000 per poor person aided. Speaking very generally, then, we can estimate that so long as a federal NIT’s average payout amounted to less than $12,000, it would cost less than the current welfare system does. True, replacing Medicaid with a cash benefit would pose great difficulties in America’s current, heavily regulated health-care system, in which private insurance is artificially expensive. One solution would be leaving Medicaid in place and bestowing a less generous NIT; another, which Friedman himself proposed at the end of his life, would be health-care vouchers, which would work along the same lines as school vouchers."
Guy SormanWhy Not a Negative Income Tax?

Clarifying the Formula

Since I know somewhere along the lines of "how can I test this" will be thrown at me here is the simple formula:

I = M - (M-E)(T)

Key:
I - Final Income After NIT Theory
M - Amount of Money You Made
E - The Exemption Level
T - Tax Rate

Example Scenario For Conceptualization

Say you make $10,000 a year, the Exemption Level is set at $15,000, and the tax rate is 50% then:

I = 10,000 - (10,000 - 15,000)(0.5) = 10,000 - (-5,000)(0.5) = 10,000 + 2,500 = 12,500

So in this scenario you are given $2,500 to supplement your income. If what you made was $30,000 in this scenario instead then you actually have to pay taxes, since you are above the Exemption Level. To clarify the amount of taxes paid: $7,500 (25%). At $50,000 - $17,500 (35%).

The Theory's Beauty

The beauty of NIT is that those below the Exemption Level pay no taxes, rather are supplemented. As well, those near the Exemption Level pay very small amounts of tax who are above it. Thus, as the income of the person grows the taxed amount progressively reaches the actual tax rate. You can see this in the Example Scenario as the tax rate goes from 0% ($12,500) to 25% ($22,500) to 35% ($32,500); it will eventually meet 50% (the actual tax rate) as it nears infinity. The point of this theory being to have a sense of equilibrium between a conservative flat tax and a liberal progressive tax that actually works.

Solving an Obvious Question

One thing I've found is that much of the formula applies to annual income, but what about those paid weekly, bi-monthly, every month, or some other division if a year? There is an easy solution that hit me and quite literally I jumped out of my seat and shouted "THAT'S THE STUFF!" Yes ... I really did that 🙂

So here's the answer:

Assume a year to be 365 days or 52 weeks depending on your income.
Divide the Exemption Level by the relevant value.
Adjust the annual formula with the relative values.

Example
Say you're paid every 2 weeks (bi-monthly) and that the Exemption Level is set at $10,000 with a 50% tax rate. Well take 52 divided by 2 (yields 26) and use that to divide the Exemption Level appropriately. In this case $10,000 divided by 26 (yields $384.62 (rounded up)). Thus, say you make $200 in your paycheck that week well we need only apply the formula clarified above with the values found here. In all this would be the result: I = 200 - (200 - 384.62)(0.5) = 292.31. So you'd be given $92.31 for that paycheck and have no taxes ... NOICE! Say that you received $200 every paycheck, well at 52 weeks you'd have $7,600.06 (a supplement of nearly 46.2% overall).

Conclusion

After finding all this I thought I'd summarize it for you (incase you're the kind of person who looks straight for this w/o actually reading my article). Friedman has explicitly stated that the tax rate is capped at 50% (hence why I used it in my example scenarios). Besides that and the formula already given I thought I'd see if I could improve upon it in at least some minute manner. Turns out I could.

The place of which you live in drastically impacts the necessary income you need to live as a specific class (poor, middle, etc.). With that said I believe that the Exemption Level should be directly correlated to the standard for the state you live in. More specifically, it should be defined as the minimum requirement to be middle class.

Just as an example I'll use my state, CA. In CA (2017) the lower bound of an individual middle class citizen was $27,000 (upper bound of $81,000). So say I make $9,000 a year then the NIT using the $27,000 as the Exemption Level and a 50% tax rate supplements my income by $9,000; a literal doubling of my income for that year. Say I made $81,000, then I'd pay $27,000 in taxes (approximately a 34% tax rate), the literal Exemption Level.

Now the question remains is what should the tax rate be? On a personal note, I don't think someone making the upper bound of the middle income bracket should be taxed anything more than 25%. This notion might differ from person to person, but in all it is a crucial element to deciding the bigger question of the overall tax rate. Comment below your thoughts.

Here are some statistics for you. I went through the link in the next paragraph and amassed all the data. If you recall just a moment ago I said I dont think the upper bound of the middle class should pay more than 25%, well I thought I'd show you the necessary overall tax rate used in intervals of 5 starting at 5% up to 50%. Something astonishing to note was that all states differed in the overall tax rate by less than 0.1% so it's safe to use these rates for the nation (USA) in my opinion. In addition you'll also note that the ratio between the hypothetical middle class upper bound tax rate is 1.5 times smaller than the overall tax rate. As you can see the overall tax rate goes above 50% in-between 30 and 35%, but where exactly? The answer: 33.33%. Thus, even by Friedman's maximum allowance the upper bound of the middle class individual shouldn't be taxed more than 33.33%.

5% - 7.5% overall
10% - 15% overall
15% - 22.5% overall
20% - 30% overall
25% - 37.5% overall
30% - 45% overall
35% - 52.5% overall

For some relevant references here's how you can find out what determines middle income according to PEW Research as of 2017 by household size.

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