People have many reasons for supporting a universal basic income (UBI). Moralists maintain that an income sufficient to cover the necessities of life is a basic human right that should be guaranteed by society as a whole. Futurists fear that jobs, as we know them, will become obsolete due to automation. Environmentalists see a UBI as a way of breaking a treadmill of overproduction and overconsumption that is destroying the planet.
Economists, for their part, make the more limited claim that a UBI would be a more efficient and effective way of reducing poverty than the patchwork income support system we have now. This commentary explores the simple economics of a UBI and compares it to existing policies.
Criteria for evaluating income support systems
What makes an income support program good or bad? I suggest these four criteria:
1. A good income support program should be effective in leaving no one below an agreed poverty level.
2. It should be targeted in the sense that it should provide support to those who need it rather than to those who already have adequate means.
3. It would, as much is possible, leave work incentives intact.
4. It would be administratively efficient, in the sense of holding down administrative costs per dollar of support received by beneficiaries.
Unfortunately, no income-support mechanism can simultaneously meet all of these criteria. There are inherent trade-offs among them. Let’s take a look at the different ways that various actual and proposed programs handle these trade-offs.
A simple top-up
The simplest income transfer system would be a commitment to top up the income of each household to, but not above, the poverty level. (The official federal poverty level for 2019 is about $12,500 for an individual and $25,000 for a family of four.) The following diagram shows the effects of a simple means-tested guarantee:
The horizontal axis shows the income that the household earns. The vertical axis shows its disposable income after payment of taxes and receipt of transfer payments. The dotted line labeled “Before T&T” shows that without any taxes or transfer payments, disposable income would equal earned income. The solid line labeled “After T&T” shows the effects of taxes and transfer payments. Households with lower earned incomes receive a cash transfer payment sufficient to bring their disposable income up to the poverty level.
In the range where people pay more in tax than they receive in benefits, the “after” line lies below the “before” line. For simplicity, the diagram assumes a 20 percent flat tax on all earned income above the poverty level. If a progressive income tax were used, the slope of the “after” line would decrease at higher incomes.
The simple top-up approach scores well by the first two of our criteria. It is 100 percent effective, in that it leaves no one with a disposable income below the poverty line. Also, it is well targeted. No payments go to households whose earned incomes alone would lift them above the poverty line, and no transfer beneficiary receives more than is needed to reach the poverty level. However, the simple top-up scheme scores poorly in other respects.
Poor work incentives are its most conspicuous drawback. Three terms are helpful in understanding how transfers affect work incentives:
- The benefit reduction rate for a program is the amount by which benefit payments fall for each dollar of added earned income.
- The marginal tax rate is the amount by which tax payments increase for each dollar of added earned income.
- The effective marginal tax rate is sum of the benefit reduction rate and the marginal tax rate. For example, if benefits are reduced by 25 cents for each dollar earned and if the marginal tax rate on earned income is 20 percent, then the effective marginal tax rate is 45 percent. In that case, disposable income after taxes and transfers would rise by just 55 cents for each dollar of additional earned income.
As the diagram shows, the simple top-up plan imposes a benefit reduction rate and effective marginal tax rate of 100 percent on poor households, leaving them little incentive to work at all. Work incentives are also weak for those just above the poverty line. True, at the margin, such households can keep 80 cents of each added dollar of income, but varying income by a dollar at a time is not always feasible. Instead, people will often face the choice between taking a job for a set number of hours per week, or remaining unemployed.
Suppose, for example, that the poverty line for a family is $25,000 and one member gets an offer of a job that pays $30,000. Taking the job would raise disposable income by just $4,000, after taking into account the loss of $20,000 in benefits and a 20 percent tax on income over the poverty line. Work related expenses like childcare and transportation could easily eat up that whole amount.
Finally, despite its structural simplicity, a program that topped up income to the poverty line would not necessarily score well on administrative efficiency. It would require periodic reporting of earned income and adjustment of benefits, a task that would be all the harder because the 100 percent benefit reduction rate would provide a strong incentive to hide earnings.
Adding a taper
One way to strengthen work incentives is to taper transfer payments gradually as income increases, rather than cutting them dollar-for-dollar. A tapered benefit was one of the central features of Milton Friedman’s famous negative income tax. Under that proposal, people with no earned income would receive a refundable tax credit, or “negative tax,” sufficient to live on. As their income rose, the amount of the credit would fall by some set percentage of earned income. Once the credit fell to zero, they would start paying pay income tax on any additional earnings.
The next diagram shows a simple version of such a scheme. The basic credit is set at the assumed poverty level of $25,000. The credit is subject to a 50 percent benefit reduction rate until it falls to zero at an earned income of $50,000. Further earnings above that level are subject to a 20 percent income tax.
This scheme, like the flat means-tested grant discussed earlier, is fully effective in lifting everyone at least to the poverty threshold. However, because it is not as narrowly targeted, it is more expensive. Except for those who have no earned income at all, households that would be poor without the program receive more than they need to bring their disposable income up to the poverty line. Also, households that already have enough earnings to escape poverty on their own continue to receive credits until their earnings reach double the poverty level.
Still, the taper substantially improves work incentives compared to a simple top-up scheme, since it lowers the benefit reduction rate to 50 percent from 100 percent. Other versions of the taper could make work incentives even stronger. Under the U.S. government’s earned income tax credit, the poorest families with children receive a cash credit of more than one dollar per dollar earned, making their benefit reduction negative. The benefit reduction rate becomes zero and then positive as income increases, until benefits are eventually phased out altogether.
Friedman maintained that integration of a negative income tax with the existing system of income taxation would minimize costs of administration because it would not require a separate bureaucracy. The problem of fraudulent under-reporting of income would not completely disappear as long as the benefit reduction rate was greater than zero, but tax administrators already have to be on the lookout for unreported earnings by people at all income levels, and have developed tools for dealing with the problem.
Cutoffs and cliffs
Tapering benefits gradually as income rises maintains work incentives, but it does so at the cost of making the income support program more expensive and less well targeted. Some programs deal with this problem by adding a cutoff beyond which households are no longer eligible for benefits at all. The next diagram shows a simple version of such a cutoff. Here, the benefit reduction rate is just 25 percent rather than 50 percent as in the previous example, but there is a cutoff at double the poverty level, beyond which benefits abruptly fall to zero. A flat-rate income tax of 20 percent applies to still higher incomes.
The problem with this scheme is that it maintains work incentives for households with very low earned incomes but introduces a severe disincentive, or “cliff,” at the cutoff point. For example, a household with earned income of $50,000, double the poverty level, receives $12,500 in benefits, giving it disposable income of $62,500. However, one more dollar of earned income makes the household ineligible for the transfer, so that its disposable income falls to $50,000 and change. Earned income has to rise by $15,625 to return disposable income to $62,500.
Benefit cliffs like this one create especially strong disincentives for second workers in a household. For example, imagine a household where one spouse earns 150 percent of the poverty income, or $37,500. Under the program we are looking at, household disposable income, including a $15,625 transfer benefit, would be $53,125. If the other spouse now gets a full-time job that earns 100 percent of the poverty level, or $25,000, bringing total income before taxes and transfers to $62,500, while household disposable income will rise to $60,000, after paying 20 percent tax on earned income over $50,000. The $25,000 gross income of the second worker yields just $6,875 after taxes and benefit reductions. Childcare, transportation, and other work-related expenses could easily eat up the entire gain.
Marginal tax rates, cliffs, and work incentives of current income support programs
High effective marginal tax rates and benefit cliffs like those of our examples are not just theoretical possibilities. They occur in many existing income support programs.
Estimating effective marginal tax rates under the many overlapping income support programs in the United States today is a daunting task. One reason is that eligibility, benefits, and cutoffs vary greatly according to family structure, age, and place of residence. Another reason is the way different programs interact with one another.
The general rule is that taxes on earned income and the benefit reduction rates of various programs are additive. For example, if a household faced a 7 percent payroll tax on earned income, a 20 percent benefit reduction rate for food stamps, and a 30 percent benefit reduction rate for Medicaid it would have an effective marginal tax rate of 7 + 20 + 30 percent, or 57 percent.
A paper by Elaine Maag, C. Eugene Steuerle, Ritadhi Chakravarti, and Caleb Quakenbush, all of the Urban Institute-Brookings Tax Policy Center, makes a heroic effort to estimate effective marginal tax rates for families of various incomes and other characteristics in all fifty states. The following diagram from the paper captures the complexity of the undertaking:
Three conclusions of the study are particularly noteworthy:
- Effective marginal tax rates are moderate for families with earned incomes below the poverty level. For incomes below half the poverty level, effective marginal tax rates for some families are actually negative because of the earned income tax credit.
- Effective marginal tax rates are much higher for families whose earned incomes fall in the range from the poverty level to twice the poverty level. For them, effective marginal tax rates are typically over 50 percent. Rates over 70 percent are not unusual, and rates over 100 percent occur in some cases.
- Effective marginal tax rates are especially high for secondary earners in two-earner households. If childcare, transportation, and other work-related expenses are taken into account, it often does not pay at all for a second member of a low-income household to take a job.
A more recent report from the Congressional Budget Office confirms these earlier findings, especially the existence of a “poverty trap” that imposes the highest disincentives on families at they approach earned income levels that would allow them to become truly self-sufficient.
In short, the existing income support system of the United States seems to combine some of the worst features of the stylized alternatives that we illustrated earlier. Despite their considerable cost, they leave more than 12 percent of the population below the official poverty threshold, even today, when unemployment is near a historical low. They are not tightly targeted. In an effort to maintain work incentives, many of them provide benefits to households well above the poverty level.
Nonetheless, because of the additive nature of benefit reduction rates for multiple programs, many households, especially those just above and below the poverty level, face cliffs and high effective marginal tax rates that undermine incentives to work. What is more, in contrast to the relative administrative simplicity of our stylized examples, the multiple programs of the real world, each run by its own bureaucracy, result in very high administrative expense.
The UBI alternative
With all this in mind, let’s apply the same analytical approach to a UBI. The next diagram shows how one version of a UBI would work. The line U1 assumes a benefit equal to the poverty level and a 20 percent flat rate tax on all earned income in excess of the poverty line.
A UBI as shown by line U1 would score well by three of the four criteria by which we evaluate transfer programs:
- It would be effective in raising household incomes at least to the poverty level.
- It would provide substantial work incentives. Because there is no reduction of benefits as earned income rises, it would avoid the problems of cliffs and high effective marginal tax rates for low-income households and second earners. No one would pay any taxes on their UBI income. People with earnings below the poverty line would face no benefit reductions or taxes. People whose earnings exceeded the poverty line would pay some taxes, but their marginal tax rates would not necessarily be more than they do now.
- It would be administratively efficient. It would require no verification of any personal characteristic or behavior other than the existence of the beneficiary. The tax system would continue to operate as it does now for people above the poverty line, with no increase in its administrative expenses.
Unlike other income support programs, however, a universal basic income, by its nature, would be completely untargeted. To its supporters, that is its essential virtue. Precisely because it is universal and untargeted, it minimizes disincentives to work and facilitates administrative efficiency. To its detractors, however, universality is a fatal flaw that would make UBI unaffordable, by which they mean it would require tax increases in excess of what they deem acceptable.
But would a UBI really be unaffordable? True, it would be a large-scale fiscal operation. Providing a grant of, say, $6,250 per year to each individual — enough to put a family of four above our assumed $25,000 poverty line — would require benefit payments on the order of 9 percent of GDP. But taxes would have to rise by that much only if the UBI were simply layered on top of today’s system of taxes and transfers. That is not the only option. Here are two ways to make a UBI affordable without raising taxes.
One way to make a UBI affordable would be to make sure that the UBI replaced all of today’s income support programs, rather than being added on top of them. That would mean more than just eliminating programs for low-income families like SNAP, TANF, and housing subsidies. It should also mean getting rid of all of the income subsidies now showered on middle- and upper-income households, including all of the deductions, credits, exclusions, preferences and loopholes that are part of the tax system. If the purge of benefits for the well-off were thorough enough, it could potentially cover the entire cost of a UBI.
Alternatively, if the plan to finance the UBI by eliminating benefits for the well-off fell short of its goal, it would be possible to reduce the size of the UBI itself, shifting it down to a position like the line U2. That would mean that the UBI would no longer be perfectly targeted. It would eliminate extreme poverty, but it would leave a small percentage of families (fewer than now) slightly below the poverty line.
The bottom line
Economists do not claim, and cannot claim, that a UBI would avoid all trade-offs. In order to maintain work incentives and minimize administrative costs, a UBI abandons the attempt to target benefits only on the neediest. Also, it encounters a trade-off between a benefit high enough to lift even the poorest out of poverty and the aggressiveness with which it eliminates benefits for high income families. Still, although it is not perfect — no income support policy can ever meet all four of our criteria in full — a UBI is clearly more effective and more efficient than the failed system we have now.