How eligibility cut-offs trap the poor

July 13, 2012

This analysis by Eugene Steuerle of the Tax Policy Center is a couple of weeks old, but the conclusion is astounding enough that it's worth highlighting. Steureule calculates the effective marginal tax rate for low-income Americans, taking into account the effect on income of losing eligibility for programs like the Earned Income Tax Credit, Medicaid, and so forth. It turns out, some families that move from $10,000 to $40,000 in income pay astounding marginal rates:

In plain English: a family going from $10,000 and $40,000 and benefiting from welfare (TANF), housing subsidies, Medicaid, food stamps (SNAP), etc. pays an average of 82 cents per dollar earned in new taxes and lost benefits. And that's just the average. As this chart shows, those making around $25,000 to $30,000 face marginal tax rates of around 100 percent. That is, if they work to gain one more dollar, all of that is given up in new taxes and lost benefits:

You don't have to be Arthur Laffer to think that's a big work disincentive. Indeed, this problem - known as the "welfare trap" - has long troubled economists and prompted some, like Milton Friedman, to embrace an alternative called the negative income tax. Under that approach, welfare programs would be replaced with a lump sum cash transfer to all households. Middle-class and rich families would pay all of that transfer back in taxes, but it would make the tax burden for low-income people negative (hence the name). More importantly, because all people are eligible for it, it does not phase out and in the process jack up the marginal tax rates of low-income people, meaning there's more of an incentive to work than under the existing system.

Such a plan - just giving all Americans a check - may seem impossibly left-wing today, but a version of the negative income tax designed by future Senator Daniel Patrick Moynihan was endorsed by Richard Nixon and almost passed Congress under his tenure.

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Suzy Khimm · July 13, 2012