It's Time for a Negative Income Tax

A worker views a monitor at the drive-thru window of a McDonald's Corp. restaurant in Little Falls, NJ Photograph by Emile Wamsteker/Bloomberg

The latest data show that the job market continues to improve, slowly. Payrolls have expanded at a moderate average monthly rate of 189,000 over the past 12 months. Assuming no government shutdown or debt ceiling crisis in the fall (please), most economists predict more of the same. The median forecast of economists surveyed by Bloomberg call for an average monthly gain of 185,000 in the fourth quarter of this year and 191,000 a month in the first quarter of 2014. All told, the job market is on the mend.

The same cautious optimism doesn’t hold for wages. Employees took home less income in July, with hourly earnings down an average 0.1 percent for the month. Over the past 12 months, hourly earnings are up 1.9 percent (ending in July), essentially flat after taking the 1.8 percent rise in consumer price inflation into account (ending in June). While these figures reflect a subpar job market, they’ve become normal for low-income and middle-income workers. Hourly wages of workers with less than a high school education are down 20.4 percent from 1979 to 2011 (in 2011 dollars), according to the Economic Policy Institute. The Washington (D.C.) think tank calculates that hourly wages for high school-only workers have fallen 4.68 percent and for those with some college, 1.4 percent. Little wonder low-wage fast-food workers are staging protests calling for higher wages in major cities. (For a powerful illustration of the everyday impact of growing income inequality, check out McDonald’s $8.25 Man and $8.75 Million CEO Shows Pay Gap.)

With rare exceptions, just about everybody agrees that the paltry pay gains for the bottom half of society is bad for individuals, for their families, and for economic vitality. What’s different today is the realization that even with the most optimistic job projections and economic growth assumptions, the long-term prospects for genuine improvement in the real incomes of low-wage and moderate-wage workers are bleak. Economists long assumed the wealth generated by productivity growth—doing more with less, the basic building block of higher living standards—would translate into better wages for all workers, not just the well-educated and lucky. Productivity growth and wages rose together from 1948 to 1973. Since then, productivity is up 80.4 percent, while median hourly compensation has risen a mere 10.7 percent, the EPI calculates.

OK, the bottom half of society needs a pay raise. What kind of bold action might best hike worker paychecks? There is no easy answer, no simple solution, but relying on market forces alone won’t do. Markets are amazing social institutions for transmitting information, creating incentives to innovate, and for allocating scarce resources. But markets have faltered at sharing prosperity in recent decades.

How about dusting off an idea promoted by Milton Friedman, the late Nobel laureate, in his 1962 book, Capitalism and Freedom: Institute a negative income tax. Friedman’s basic idea was to get rid of an alphabet of antipoverty programs, such as food stamps, rent subsidies, unemployment insurance, and other “in-kind” transfers. Instead, put cash into the hands of low-income people through a negative income tax.

In 1978, he gave a simple illustration of the idea. With a negative income tax rate of 50 percent, a family of four with no income would get $3,600 per year ($12,885 in 2013 dollars). When the family’s income reached $7,200 ($25,769), the tax benefit reached zero. Still, the negative income tax wouldn’t discourage work incentives, since, as earnings rise, so does post-tax income. The negative income tax system would be integrated into the existing “positive” tax system, administered by the IRS. “In Friedman’s view, this integration of the positive and the negative income tax would reduce invidious distinctions between the poor and nonpoor or, in modern parlance, reduce stigma” writes Robert Moffitt, economist at Johns Hopkins University in The Negative Income Tax and the Evolution of U.S. Welfare Policy.

Congress adopted a narrower version of the negative income tax—the earned income tax credit, or EITC. The EITC is the most successful antipoverty program in the U.S., and it’s a reward to working Americans. Problem is, the EITC has evolved into a program that’s too complicated while being geared toward families in a society where many single workers struggle from paycheck to paycheck. The negative income tax is simpler to administer and offers a slightly greater reward for work. Friedman’s fundamental insight (shared by most economists) is that cash directed at the poor, the working poor, the near-poor, and the financially brittle is far more cost efficient and cost effective than handing out billions in means-tested programs, such as food stamps. Representative David Camp (R-Mich.) and Senator Max Baucus (D-Mont.) should add discussions of the negative income tax to their traveling road show selling tax simplification to ordinary Americans.

Adopting a negative income tax would be a strong public statement about the importance of inclusion, but in practice it would be only a modest step. The negative income tax should be supported by other actions that will raise both low-income wages and jobs prospects. Subsidies targeted at employers hiring low-wage workers for full-time jobs would boost incomes. Bolstering state support of community colleges, which bear the brunt of educating students from low-income families and retraining older workers, would go far toward improving worker skills.

America has long distributed its wealth through the job market, the great American job machine. Unfortunately, the system has been stuck in low gear for a variety of reasons over the past three decades for low-income and moderate-income Americans. The challenge of our era is to improve America’s work-based system of redistributing wealth.

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