Negative Income Tax

A negative income tax is a way of supporting people on low incomes through the tax system. Households whose income falls below a break-even level receive money from the government, in effect a tax with a minus sign, while those above it pay tax in the normal way. The payment falls gradually as earnings rise, so a person who works more always ends up with more total income, unlike some benefit schemes that withdraw support pound for pound or dollar for dollar.

The idea is most associated with economist Milton Friedman, a leading figure of the Chicago school, who promoted it in his 1962 book Capitalism and Freedom as a simpler replacement for many separate welfare programmes. It is often compared with universal basic income: both guarantee a minimum, but a UBI pays everyone the same amount up front, while a negative income tax targets the payment by income.

Imagine a staff canteen that promises every worker lunch worth a set amount each day. Those who bring nothing from home get the full lunch. Those who bring a sandwich get a smaller top-up, and those who bring a full meal get nothing extra and instead chip in to the canteen fund. Nobody is punished for bringing more food; they just need less help.

A negative income tax works the same way with money. The government sets a floor. If your earnings are low, it tops you up; as you earn more, the top-up shrinks a little at a time until it disappears and you start paying ordinary income tax.

A simple negative income tax has two settings: a guaranteed income for someone with no earnings, and a phase-out rate at which the payment falls as earnings rise. The payment is:

• $P$ is the payment from the government (if the result is negative, no payment is made and normal tax applies).
• $G$ is the guaranteed income for a household with no earnings.
• $t$ is the phase-out rate, which acts as a marginal tax rate on earnings.
• $Y$ is the household's earned income.

The payment reaches zero at the break-even income $Y^{*} = G / t$. Suppose the guarantee is $10,000 a year and the phase-out rate is 50%. A household with no earnings receives $10,000. One that earns $8,000 receives 10,000 − 0.5 × 8,000 = $6,000, for a total of $14,000. The break-even income is 10,000 ÷ 0.5 = $20,000, above which the household pays tax rather than receiving money.

The design involves a trade-off between three goals. A high guarantee reduces poverty; a low phase-out rate keeps work incentives strong; and low overall cost keeps taxes down. Raising the guarantee or lowering the phase-out rate pushes up the break-even point and the cost, because more households qualify.

In the United States, the government ran four negative income tax experiments between 1968 and 1982: in New Jersey and Pennsylvania, in rural Iowa and North Carolina, in Gary, Indiana, and the largest in Seattle and Denver. They generally found modest reductions in hours worked, larger for second earners and young people than for main earners. An early finding from Seattle and Denver that marital break-ups rose was later challenged by re-analysis. In Canada, the "Mincome" project paid a guaranteed income in Dauphin, Manitoba, from 1974 to 1979; a 2011 study by economist Evelyn Forget reported that hospitalizations fell by about 8.5% relative to comparison areas.

President Richard Nixon proposed a related Family Assistance Plan in 1969; it passed the House of Representatives but failed in the Senate. The Earned Income Tax Credit, created in 1975, adopted part of the idea by paying refundable credits through the tax system, though only to people with earnings. Tax credits in other countries, and the UK's Universal Credit, which reduces payments by 55 pence for each extra pound of net earnings above a work allowance, share the feature of gradual withdrawal.

• Simplicity. Supporters across the political spectrum argue that one payment run through the tax system is cheaper to administer than many overlapping transfer payments and avoids intrusive checks.
• Work incentives. Because benefits fall gradually, a negative income tax avoids the very high effective tax rates that can create a poverty trap in programmes that cut benefits sharply as earnings rise.
• Dignity and choice. Cash lets people decide what they need rather than receiving in-kind help.
• Cost and labor supply. Critics note that a generous guarantee with a gentle phase-out reaches far up the income scale and is expensive; a steep phase-out keeps costs down but weakens incentives. Some fear it reduces labor supply, as the experiments found to a modest degree.
• Timing and fit. Annual tax-based payments may not respond quickly to sudden falls in income, and replacing targeted programmes for disability or housing can leave some groups worse off.

A negative income tax and a universal basic income can be designed to produce identical net incomes: a UBI of $10,000 combined with a 50% tax on earnings gives the same result as the example above. The difference lies in administration and in how many people see money flowing in each direction. Policies such as welfare-to-work programmes and the minimum wage pursue similar goals by other routes, and a negative income tax interacts with progressive tax schedules and inequality debates. It also bears on the reservation wage, the lowest wage at which someone will accept a job.

• Internal Revenue Service: Earned Income Tax Credit
• American Economic Association: Robert Moffitt, "The Negative Income Tax and the Evolution of U.S. Welfare Policy" (2003)