Negative Income Tax

What is Negative Income Tax?

Negative income tax is a system where cash is given by the government to eligible tax residents who are earning below a certain threshold. We can consider negative income tax as a mirror image of regular income tax, where those individuals earning above the threshold pay tax to the government, and those below receive refundable credits from the government.

Rationale

Negative income tax was initially proposed by Nobel laureate Milton Freidman as a utopian way of addressing inequality in society. The purpose of the scheme is to provide a kind of self-correcting safety net. It helps neutralize to a great extent the income gap that exists between the masses in the society, thereby providing positive externalities.

Advantages of Negative Income Tax

1. Precise targeting

In an ideal world, suppose an individual pays income tax only if the household income crosses $10,000. In our case, our protagonist, Mr. X, makes $8,000 per annum.

• Get the difference between the threshold ($10,000) and the actual money earned ($8,000). The amount, in our case, $2,000, will be taxed negatively, i.e., paid by the government at the rate of say 20%. It works out to a negative income tax of $400.
• So, instead of $8,000, Mr. X now earns $8,400. As can be seen in this example, only people earning income below a certain level are targeted, the rest will not be paid the negative income tax amount.

2. Plug leakages in welfare schemes

Once an individual files a tax return, there is a paper trail available with all the personal information. Hence, people cannot falsify claims.

An automatic self-check mechanism is built into the system. It will automatically eliminate people with bad intent, as it can prove to be too costly to deceive the government with an established paper trail coupled with a concrete trail of one’s economic activity.

Many welfare schemes suffer from leakages, wherein the benefit does not reach the targeted citizens. However, negative income tax is applied to all tax filers.

3. Absence of disincentivization

Suppose an individual earns $10,000. Based on a negative income tax rate of 20%. The maximum that a person can earn is $10,000 * 20%, which is $2,000. The amount is substantially less than the $8,400 earned by Mr. X in our previous example.

This illustrates that below the threshold, all applicants are not treated similarly. There is an incentive to look for a source of income, thereby maximizing the impact of the negative income tax. The purpose of the tax scheme is to help keep the vulnerable sections of the society in good stead, especially during bad times.

4. Simpler tax regime

Currently, there is a long list of deductions, subsidies, social welfare, and many other difficult to administer schemes. With a negative income tax, many schemes can be eliminated. It will save a substantial amount of financial resources on admin-related work, thereby leading to greater compliance and streamlined service delivery.

Challenges

The biggest challenge confronting negative income tax is the fiscal burden on the government of the day. Currently, nearly 24% of the federal US budget is spent on social security, which amounts to around $950 billion.

Across the world, all countries employ some kind of social benefits scheme that target the weaker segments of society. Therefore, the government is already spending funds on the same goals as that of negative income tax.

The biggest challenge is to channel existing governmental resources into the negative income tax regime as there are many overlapping social welfare programs that strain the system. Unless some of the existing welfare is not curtailed, it is very difficult to create fiscal space for the execution of negative income tax.

Negative Income Tax vs. Other Alternatives

With automation and artificial intelligence expected to make several jobs redundant, a new form of robust, sustainable, and scalable welfare/social security net is needed.

There are a few alternatives, such as universal basic income, which are also talked about quite favorably. Nevertheless, universal basic income suffers from the issue of imprecise targeting. As the name suggests, universal basic income would provide a fixed amount of income to all the citizens regardless of their existing income levels.

The imprecise targeting will lead to minuscule benefits, thereby rendering the whole exercise meaningless. It is where negative income tax may be more effective in providing tangible benefits to society.

Conclusion

Negative income tax provides a interesting solution to a complex problem of delivering benefits to the needy segments of the society. The policy is simple to administer and would help plug leakages in the current service delivery by providing precise targeting. The tax is a self-correcting safety net.

Additional Resources

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

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• Flat Tax
• Tax Shield
• Voluntary Compliance
• See all accounting resources