Negative income tax, explained

What is negative income tax?
The negative income tax is a way to provide people below a certain income level with money. In contrast to a standard income tax, where people pay money to the government, people with low incomes would receive money back from the government.

Theoretically, this would work by giving people a percentage of the difference between their income and an income cutoff, or the level at which they start paying income tax. For instance, if the income cutoff was set at $40,000, and the negative income tax percentage was 50 percent, someone who made $20,000 would receive $10,000 from the government. If they made $35,000, they would receive $2,500 from the government. (This is different from a universal basic income in which everyone, regardless of income level, receives the same amount of money.)

This structure is designed so that people who work will always make more than people who don’t, which would ideally incentivize people to work. While someone who makes a little money — but not enough to pay income tax — will receive less from a negative income tax than someone who doesn’t make any money, overall, the person earning more will have more. The goal with a negative income tax is that no one is destitute, and earning even a small salary is always preferable to earning nothing.

The U.S. doesn’t currently have a negative income tax in place. It does, however, have the earned income tax credit, which functions similarly and benefits millions of Americans. That program generally has bipartisan support, and there is even legislation proposed to expand it.

The idea.
The idea of a negative income tax began gaining steam with the 1962 publication of economist Milton Friedman’s book “Capitalism and Freedom.” Friedman thought a negative income tax would alleviate poverty — and he believed it would have many additional benefits, as well.

Friedman argued that a negative income tax improved on traditional welfare — he wanted to give poor people cash rather than an array of welfare benefits. People could then use the money as they saw fit. He contended this would simplify the system —  since it would be administered centrally by the IRS, who would cut the checks, instead of many different organizations — and be more valuable to intended beneficiaries, thereby increasing our transfer system’s bang for its buck.

According to MIT economics professor Joshua Angrist, Friedman’s reasoning was sound — most economists agree the welfare system is flawed. “From the point of view of consumer welfare, money is always just as good and probably better than in-kind transfers,” he said.

Welfare versus a negative income tax.
Today, many branches of the welfare system in the U.S. provide people living below a certain income level with in-kind benefits. These are goods or services people need, like food stamps or housing vouchers, where instead of money recipients can use on anything, they get vouchers that must be used for one thing only.

Economists agree there are problems with this system, such as in-kind benefits taking away people’s autonomy to buy what they think they need most and being generally less effective at lifting people out of poverty.

But perhaps one of the biggest flaws in the system is what happens when welfare recipients start to earn more money. “The irony of our welfare system is that poor people pay very high taxes — for each dollar of earnings they lose benefits,” Angrist said.

That is to say, by working, people on welfare may actually find themselves worse off — particularly if they earn enough to lose benefits but not enough to pay for those things themselves.

For example, suppose someone on welfare earns an extra $1,000, but loses $500 of their benefits as a result. This amounts to a 50 percent marginal tax rate. Some people face marginal tax rates of 80 percent — one study even showed marginal tax rates of more than 100 percent [PDF]. “Rich people with salaries don’t pay a marginal tax rate that high,” Angrist said. “Milton Freidman was one of the first to look at this and say, ‘We ought to scrap the whole system.’”

A negative income tax, as Friedman saw it, would therefore solve two main problems: It would give people cash as opposed to in-kind benefits and have a much lower tax rate. While people would still lose benefits the more they made, with a negative income tax, they would always come out ahead with a higher income.

That was Friedman’s view. According to MIT Sloan senior lecturer Robert Pozen, “whether or not a negative income tax would actually be better than welfare is a complicated question.”

Questions regarding negative income tax.
For a negative income tax to be preferable to welfare, Pozen thinks a number of questions would need to be addressed. For instance, are there conditions beyond income that recipients would need to meet? Is income data available for everyone on welfare? What income level does the government want to provide?

Other questions that need to be answered are whether a negative income tax would be a good consolidator of income. “If the government is willing to give cash to anybody below a certain earnings level, then a negative income tax may be an excellent approach. But many politicians and policy makers are not prepared to do that,” Pozen said.

That begs the question: If there are conditions, what should they be? Would the government treat a working pregnant mother the same way as an unemployed single person? Should there be a requirement to work? What about a requirement to acquire retraining when necessary? For standards in childcare? How would local conditions, like minimum wage, play into the equation?

Then there is the issue of administration. Currently, welfare is administered through individual programs. If people aren’t working, does it make sense for the IRS to administer a negative income tax? Furthermore, how much would the program cost?

Negative income tax experiments.
It turns out, the U.S. government did try to answer some of those questions.

Early in his presidency, Richard Nixon proposed the Family Assistance Plan. The plan had a negative income tax at its center — it guaranteed money to families with children, with assistance payments declining as a function of earnings.

Nixon’s vision never came to fruition, but between 1968 and 1982, the U.S. and Canada tested the idea of a negative income tax in a series of five social experiments. Unfortunately, according to Angrist, these experiments were not as useful as they might have been. The designs were complex, with too many treatment arms, a feature that reduced statistical power. The data collection strategy was not well thought out, and when social scientists looked back at the records years later, they found a high rate of misreported income.

As a result, “the findings were ambiguous,” Angrist said.

Some of the results from the experiments showed that there was a modest reduction of work among recipients, especially among primary income earners. However, this generally only amounted to the equivalent of two to four weeks a year, and for some people, it was due to pursuing educational opportunities.

Another often discussed report concluded that receiving a negative income tax increased divorce rates. “I never read a good explanation for this finding. But this was bad for the political economy of the policy, because we don’t want social programs to encourage family dissolution,” Angrist said.

The early negative income tax experiments taught social scientists many important lessons about research design, although they were inconclusive for policy. That doesn’t mean the idea faded away, though. 

Earned income tax credit.
Just a few years after President Nixon’s Family Assistance Plan, President Ford authorized the earned income tax credit. Later expanded under President Reagan, the EITC functions similarly to how a negative income tax would and has become one of the pillars of American transfer policy.

For people to qualify for the EITC, they first have to work. As long as someone earns at least one dollar — and meets other basic criteria — they are eligible for the EITC. The credit is equal to a fixed percentage of someone’s income, based on the number of children they have and if they file their taxes jointly with a partner or not. The amount of money they receive from the EITC continues to rise, or phase in, up until a point. People can continue to receive the maximum tax credit until they earn above a certain amount, at which point the EITC begins to decline, or phase out.

For the 2017 tax year, the EITC provided tax credits for single people without children earning less than $15,010, and couples with three or more children filing jointly earning less than $53,930. The tax credit maxed out at $510 for single filers without children and $6,318 for couples with three or more children. Last year, a total of 27 million people received $65 billion in EITC.

The program has proven beneficial, with one study showing a $1,000 increase in EITC results in more than a 7 percent increase in employment for some families. A new proposed legislation, the Grow American Incomes Now Act, would roughly double the EITC for families with children. The gains would be even larger for people without children.

“The earned income tax credit is the closest thing we have to a negative income tax. But we don’t just give it to anybody. And we don’t just give any amount,” Pozen said.

Since one of the requirements of the EITC is that people are working and filing taxes, the program is administered by the IRS. But for all the people not working, does bringing them into the fold of the IRS for a negative income tax make sense?

Ultimately, “the debate shouldn’t be about negative income tax,” Pozen said. “It should be about the income level and the conditions. Once you decide those, you should find the most efficient ways to deliver the money.”

Ready to go deeper?

Watch Milton Freidman speak about the negative income tax in this 1968 interview.

The experts

Robert Pozen is a senior lecturer at MIT Sloan and a senior fellow at the Brookings Institution. He is also an independent director of Medtronic, Nielsen, and AMC; chairman of the board of the Tax Policy Center; and on the advisory board of Perella Weinberg Partners. Previously, Pozen was the executive chairman of MSF Investment Management. His most recent book is “Extreme Productivity: Boost Your Results, Reduce Your Hours.” Pozen teaches an executive program on maximizing your personal productivity.

Joshua Angrist

is an economics professor at MIT. Angrist studies the economics of education and school reform, social programs and the labor market, the effects of immigration, labor markets, and institutions, and economic methods for program and policy evaluation. 

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