System penalizes those who work

Published 11:00 pm Wednesday, December 12, 2012

The War on Poverty, which was crystallized by Lyndon Johnson’s Great Society programs, has harmed a lot of the people it was designed to help. Though $15 trillion has been spent on fighting poverty in the last 50 years, poverty rates remain comparable to their 1960s levels. The countless programs rolled out since the 1960s have caused an erosion of the family, a surge in out of wedlock births, and strong disincentives to work. Some of the side effects of the War on Poverty are difficult to fix, but some, such as the disincentives to work, are pretty easy and straightforward.

Here’s the problem our current approach to welfare has created: When a poor person finds work, they lose many of their means-tested benefits. For example, food stamps and housing subsidies are based on earned income; as a person’s income increases, the government support gets cut. When taxes are also factored into the equation, work appears to be a losing proposition for many poor people: the lost subsidies from earning income, which economists capture by looking at implicit marginal tax rates, plus the taxes on earned income are often greater than 100 percent.

When implicit marginal tax rates are 100 percent or greater on earned income, work doesn’t make a lot of sense. Economists call the income range over which there’s little incentive to work the “dead zone” because a person’s total compensation—income plus government subsidies—remains flat (and sometimes declines) as earned income rises. The dead zone is present at low income levels, and implicit tax rates often spike above 100 percent for a family up until about $35,00-$40,000 of earned income. For every dollar earned in the dead zone, one less dollar in government support is paid out. In many cases, in fact, the poor face implicit marginal tax rates of 125 percent or more; for each $1 earned, they lose $1.25 or more in government support!

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Milton Friedman, one of the best economists of all-time, had a straightforward solution to the problem: bring down implicit taxes on the poor! Friedman first wanted to do away with the multitude of government programs supporting the poor and make it a single cash transfer. With just one agency paying for welfare, it becomes easier to make sure incentives to work are preserved and exorbitant implicit tax rates are avoided.

Now, here’s a concrete example of how to create better incentives for the poor: Suppose a family of four in Alabama has no earned income. To provide a safety net for them, we might want $20,000 of cash transferred to them from the I.R.S (i.e., $5,000 per person). Let’s also suppose a member of the family finds work. Thanks to our current system, earned income is going to mean a cut in benefits.

What if, instead of taxing the poor person at 100 percent, we fix the system? The cash payment from the government could, for example, be reduced by 50 percent whenever income is earned. A family of four earning $10,000 per year from work, then, would receive a supplement of $15,000 per year instead of $20,000 (i.e., the initial $20,000 minus the $5,000 tax on the family’s earnings). Under the old system, $10,000 in income means $10,000 less in subsidies, so the family is no better off. Under the system we are talking about, the family enjoys household income of $25,000, which is a net gain of $5,000 thanks to a change in implicit taxes.

From here, people can argue about the appropriate implicit rate to be charging, but the bottom line is clear: Any rate below 100 percent gives the family some incentive to work, which is a big improvement over our current approach to poverty.

Escaping poverty often means a person must work hard, make smart choices, get educated, and, perhaps have a bit of good luck too. Often, though, the most hard-working and lucky person still faces an uphill battle thanks to perverse policies created by government programs stacked on top of each other and working towards contradictory ends. Poor people trying to escape poverty deserve better, and it’s on us—academics, policymakers, and people who care about how their money is being spent—to make sure our policies are encouraging work and helping people prosper.

Scott Beaulier is Executive Director of the Manuel H. Johnson Center for Political Economy at Troy University.