The Dangers of a Negative Income Tax (NIT)

2009-10-31T15:34:00.000-07:00

(Note: This article was greatly assisted by Prof. Moffitt’s article explaining some of the issues behind Friedman style NIT. I have approached this article with minimal mathematics, knowing that my colleagues will present empirical data in due time. Furthermore, the focus of this article is on the principles behind those models, the concept of values which underlie our arguments.)

The Negative Income Tax (NIT) has long been advocated by the Chicago School of Economics, particularly by Milton Friedman. It was therefore a surprise to me that my fellow colleagues here have expressed such a keen interest on this issue, and that interest seems to also be present in Hong Kong Society (Here). Nevertheless, I must insist that I clarify what exactly the NIT is meant to do, and what policy implications it entails, because these implications may not be as acceptable as my colleagues may believe them to be. A Friedman-type NIT would mean that all other government sponsored programs would have to cease and be replaced solely by NIT, in other words, there will no longer be subsidized healthcare, no subsidized education, no subsidized transportation or utilities. All public benefits even current lump sum payments to the elderly will be stopped if the NIT is to be truly implemented. At least this was Friedman’s vision: the NIT was intended to be a simple and cost-efficient welfare system that would just latch onto the tax system that the US had and replace the complex system of welfare benefits in the US. But that is all it was: it was simply a lesser evil. Just like any governmental policy, the NIT poses dangers both economically and politically.

Welfare systems: once created cannot be removed

A form of the NIT (the Earned Income Tax Credit) was implemented in the US, but the welfare system that it was intended to replace was not removed. This displays one of the major problems with welfare policy: once instituted, it can never be removed. Politicians who are vested in system and who rely on “one person one vote” to gain their seats cannot possibly have the incentive to remove benefits that will give them votes. That is the practical reality of the matter. If Hong Kong institutes the NIT, it will not remove the benefits that it now provides. It will not privatize the extensive education system it has. It will not privatize healthcare. It will not remove price controls on transportation and utilities. It simply will not do that, because the Government and the politicians who have power to control the budget, will not give up the votes that give them their seats so lightly. On these grounds I am against any welfare policy that is particularly tailored to the majority: it must be tailored to ALL individuals, poor and wealthy alike.

NIT will distort the labor market

A second issue is economic distortion, similar to the first point. The NIT is ultimately tailored to individuals below a certain income by its own very design, this will create distorted economic incentives, regardless of how the system is designed. (The distortion arises in the work-leisure decision that individuals make.) Individuals at the margin (that is whose incomes are between where they will be paying taxes and where they will be paid payments) will reside on the side of receiving payments. While the incentive to work may still exist in the design of the NIT (when the NIT tax rate is relatively low), individuals will not move across the margin, because otherwise they would have done so without the tax. Distortion will thus exist no matter what because incentives with regards to income must change in order for the tax to have any effect. (As to why economists are so concerned about distortion, I can briefly summarize that distortion results in a waste of resources and that individuals and firms will pay more than they ought to)

NIT may not be less costly in Hong Kong

I am generally skeptical of the NIT, but as Friedman would put it, it is a lesser evil compared to the array of welfare schemes that a Government can dream of. But for Hong Kong, because we already receive so little welfare, and our welfare system isn’t that extensive, it is uncertain whether the NIT is actually a benefit over the welfare system that we actually have. Therefore, Friedman’s characterization that the NIT is less costly or less complex may not be true for Hong Kong. If the NIT is not less costly nor less complex than the current system there will be no policy argument in favor of the NIT.

Lump sum payments instead of NIT

If we really wanted to institute a non-distortionary welfare system, despite the problems above: we can give lump sum payments to everyone, regardless of who you may be. This means that poor and rich people alike can receive a sum of say $50,000 a year instead of the NIT and instead of the series of benefits that the Government now provides. I do not understand how this system would be more costly that the system that Friedman have suggested, and this final goal of lump sum payments must have been at the back of Friedman’s head. As all economists know, the lump sum payment is the ultimate dream of economists because it is the ONLY scheme that creates no distortion. Think about this, there was already distortion because of a progressive income tax, by taxing income we already discourage work, it could not possibly be rational to increase the distortion by instituting an NIT welfare scheme. We are already taxing wealthy people at a higher rate, the last thing we want is to compensate individuals more if they work less.

There are also problems with the lump sum payment scheme. In economic theory, a lump sum is non-distortionary only if there are no externalities. If an individual is given a lump sum of money and ends up spending it on a good that produces vast external costs (such as cigarettes), that would produce negative effects on society. By giving a lump of money to an individual we fall pray to individual’s choice, which is the ultimate problem with any welfare scheme including lump sum payments. The question is whether disparity is a good or not, should we have a goal or reducing disparity?

Parity is not a goal: NIT relieves the Government of its job

The NIT is targeted at income. The NIT makes the disparity of income a target. Its whole purpose in other words is to try to reduce the Gini coefficient, and does not tackle the actual problem with society that led to disparity in the first place. The Government has the responsibility to identify goods and services which provide external benefit and costs which it ought to target in its policies, such as education and healthcare. Similarly, it has a responsibility to provide goods and services that no private agent would provide. NIT relieves the Government of this responsibility. It tells low income private agents to do it themselves, when the very point of the Government is do things that they cannot do themselves! What is the point of taxing individuals and then just giving it back to the people? To so characterize is (to paraphrase) “ask workers to dig holes and then ask them to cover them up again.” To “cure” income disparity then is to avoid the problem: disparity in education levels, disparity in access to healthcare, disparity in access to housing. It is a cheap way to let the Government finish its “job” without it actually doing the job it was meant for.

I am not suggesting that if people of low income receive a sum of money they will use it unwisely, or that these private agents will squander their money. I am suggesting that parity should not be a goal, because there are no clear disadvantages to disparity. Critics will say that crime and political unrest are disadvantages of disparity as civil discontent, but these will not be solved solely by solving parity. If they are indeed social costs, then we can easily target them, such as building more prisons and getting more police on the ground. Similarly, I would argue that creating parity in education, healthcare and access to housing would better solve the above problems that critics have cited, because they actually target potential benefits for society.

Disparity may be good

Becker and Posner (in Uncommon Sense and Here) suggested that disparity is an indication that human capital is being recognized, and that human productivity in relation to education is rising. In other words education is being rewarded and disparity is a result of this. I’m not sure whether this is true in Hong Kong, but it would be important to see whether real income of more educated individuals has increased relative to less educated individuals. If true, the argument that disparity is bad would cease. Indeed disparity would be an appropriate reward to those who made good decisions of investing in education.

There is some indication that human capital is increasingly more important and valued in Hong Kong. Vast sums are paid for private tuition centers and associate degrees at universities and these are already indications that individuals are willing to make investments ahead of time for greater returns in the future. To curb inequality would then curb the incentives to invest in education.

I make a strong disclaimer here. Rejecting income equality as a goal does not equate to rejecting poverty as an issue to be tackled with. These two are different issues. I believe poverty is a very important issue, and should be remedied, because it indicates that individuals lack resources to sustain a basic livelihood in our economy. While the policies for alleviating poverty may induce income parity, our policies should ultimately target poverty rather than attempt to simply “tweak the numbers” and pat ourselves on the back just for improving the Gini coefficient at the expense of perhaps a lower average income. Indeed, Becker and Posner warned that over-obsession with the Gini coefficient would mean that we should be happy to be all equally dirt poor rather than content with a situation where the poorest person was earning $100,000 per year while the richest earned a million dollars per year (in Uncommon Sense). We should accept the fact that different individuals with different abilities and talents should be rewarded differently in a diverse economy, but at the same time recognize that all individuals are worth some amount at a minimum level.

Conclusion: Values as our guide post to policy

Ultimately, however, whether you agree with what I have written above depends on our values. Whether you think a policy is good or not depends on whether you believe the policy furthers your values. The objective of any policy is necessarily the welfare of the population, but how should this be characterized? Should the reduction in disparity be a goal in of itself, or should a consideration of external benefit and cost be how we approach policy? The answer to these questions are what support parity as an objective itself. If you believe that parity provides external benefits then you would be support an NIT, but what I have suggested above is that there are better policies to achieve the same results as parity, and more importantly, questioned whether parity should be a goal at all. Therefore, in the end, what we contest are questions of value rather than economics. What we can do here on paper is merely to debate the implications of the NIT, which is undoubtedly what my colleagues would do, i.e. whether the NIT will affect employment or wages or standards of living, but not whether these implications or the underlying principles supporting the NIT are valuable in of themselves. These questions cannot be answered on paper, but must be answered through political deliberation.

Week 1: Negative Income Tax

2009-10-28T10:56:00.000-07:00

For our first week, we would like authors and contributors to write about the Negative Income Tax, particularly its viability in Hong Kong and of course the implications it may have. We would like authors to focus especially on how the tax would play out in Hong Kong, though examples from abroad can also be considered.

In order to assist readers (and perhaps writers also), we will follow a commonplace definition of the NIT: A progressive tax system where individuals earning below a certain amount is entitled to a lump sum payment that is a fraction (at the negative tax rate) of the difference between the limit and level that the individual is earning.

The definition above is intentionally framed to be distinct from a guaranteed minimum income system or other welfare systems. For more background information, follow this link to the Wikipedia article.

Hong Kong Students' Think Tank

The Dangers of a Negative Income Tax (NIT)

Week 1: Negative Income Tax