Unintended Effects of Safety Nets on Incentives

2012 January 24
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    As a country, most want good safety nets for the poor.  Inherent with providing them is a provision for phasing them out as the income of the recipients increases.  This phase-out inherently reduces the incentive to work hard to earn more.  In the extreme, the phase-out of safety-net benefits could equal the increase income resulting in zero benefit for trying to improve.  The disincentives are clearly unintended consequences of providing the safety net. 

    Unfortunately, the components of the safety net appear to be separately considered without understanding their overall effects including unintended consequences including the disincentive for seeking a higher-paying job. 

    The continuation of this post builds on work available on the internet. 

Don Nordeen
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Continue reading Unintended Effects of Safety Nets on Incentives.

• Key Words:  safety net, taxes, working poor, marginal tax rate

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Unintended Effects of Safety Nets on Incentives (continued)

Introduction

    The unintended consequence of high marginal "tax rates" (combined actual marginal tax rate minus the actual reduction in safety-net benefits) is inherent with safety nets for the poor.  Suppose for example, the intent to provide $20,000 in safety-net benefits for a family of four without any income.  The benefits are intended for the poor with no benefits if the income becomes, say, $40,000 per year — the 33rd percentile income according to 2009 census data.  The result would be a effective marginal "tax rate" of 50% (decrease in benefits of $20,000 divided by increase in income of $40,000).  Even if the income for full phase-out is $60,000 — the 50th percentile income, the effective marginal "tax rate" is 33%.  The examples below show that high effective marginal "tax rates" are realistic. 

See What is the safety net for the poor? for a description of the many elements of the safety net. 


Examples

    The table in the reference provides data from which to calculate the effective marginal tax rate (increased taxes minus decreased benefits).  Below is a copy of the table in the reference with added lines that show some of the incremental effects.

      The table below is "from Tyler Durden of ZeroHedge.com. Please note that this study assumes a head of household with one worker plus family (thereby the earned income tax credit is applied to the minimum wage worker)."

Money Earned in a Year	$3,625	$14,500	$30,000	$60,000
Payroll and Federal Income Taxes	(278)	(1,225)	(4,574)	(13,034)
Childcare Cost	(2,400)	(9,600)	(9,600)	(9,600)
Mississippi Income Tax	(109)	(725)	(1,500)	(3,000)
Earned Income Tax Credit (EITC)	1,450	5,020	2,163	0
Food Stamps (SNAP)	6,312	6,312	0	0
National School Lunch Program (NSLP)	1,800	1,800	0	0
Temp. Assistance for Needy Families (TANF)	2,040	0	0	0
Medicaid and CHIP	16,500	16,500	10,890	0
Section 8 Rent Subsidy	1,450	4,350	0	0
Utility Bill Assistance (LIHEAP)	1,240	845	0	0
Total Economic Benefit	31,630	37,777	27,379	34,366
Added for this weblog
Net Tax minus Benefits	-$28,005	-23,277	2,621	25,634
"Disposable Income" after Tax and Benefits (from above)	31,630	37,777	27,379	34,366
Overall "Tax" Rate (Net Tax divided by Money Earned)	-775.55%	-160.53%	8.74%	42.72%
Marginal "Tax" Rate on Increased Disposable Earnings		43.48%	167.08%	76.71%

    The results may be dependent upon the assumptions affecting the line items in the table.  However, the general trends are likely to be similar — albeit with different numerical results.  Including more columns with increments of $10,000 in "Money Earned in a Year" would be helpful.  The larger payroll tax with increased money earned provides an increase Social Security retirement benefit, and therefore should likely not be included in the calculations.  State benefits are not included.  The basis for the child care costs is also not defined.  The Appendix provides the same table, but with the Payroll and Federal Income Taxes eliminated. 

    Note the disincentives for increasing earnings.  Increasing "Money Earned in a Year" from $14,500 to $30,000 results in a decreased "Disposable Income" of $10,400.  So why work hard to improve.  Note also that increasing "Money Earned in a Year" from $30,000 to $60,000 results in an increased "Disposable Income" of only $7,000.

    Note also the large marginal "tax" (increased tax minus decreased benefits) divided by increase in "Money Earned in a Year".  This is a major public policy challenge.  Providing a safety net for the poor inherently involves a reduction in safety benefits as money earned increases.  With large benefits, the result is a large marginal "tax" rate (increased taxes minus decreased benefits). 

    The sad part is that the elements of the safety net are added one by one without considering the overall effect.  The table above looks at the overall effect.

    Further analyses are in order.  See Effective Marginal Tax Rates on Low Income Households | EPI Study for one such analysis, which draws similar conclusions that the effective marginal tax rates for the working poor are high.  

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Appendix — Results with Elimination of Payroll and Federal Income Taxes

    The Appendix provides the same table, but with the Payroll and Federal Income Taxes eliminated.  This assumes that almost all of the Payroll and Federal Income Taxes are Social Security Taxes.  The Social Security benefits are related to Social Security taxes paid.
   

Money Earned in a Year	$3,625	$14,500	$30,000	$60,000
Payroll and Federal Income Taxes
Childcare Cost	-2,400	-9,600	-9,600	-9,600
Mississippi Income Tax	-109	-725	-1,500	-3,000
Earned Income Tax Credit (EITC)	1,450	5,020	2,163	0
Food Stamps (SNAP)	6,312	6,312	0	0
National School Lunch Program (NSLP)	1,800	1,800	0	0
Temp. Assistance for Needy Families (TANF)	2,040	0	0	0
Medicaid and CHIP	16,500	16,500	10,890	0
Section 8 Rent Subsidy	1,450	4,350	0	0
Utility Bill Assistance (LIHEAP)	1,240	845	0	0
Total Economic Benefit	31,908	39,002	31,953	47,400
Added for this weblog
Net Tax minus Benefits	-28,283	-24,502	-1,953	12,600
“Earnings” after Tax and Benefits
Overall “Tax” Rate	-780.22%	-168.98%	-6.51%	21.00%
Marginal “Tax” Rate on Increased Disposable Earnings		34.77%	145.48%	48.51%

    The results are numerically different, but the trends are the same.  The marginal "Tax" rate on increased earnings is still very large. 

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• History:  Changes are usually identified in the text with the date which facilitates searching by date. Edits are usually noted by add and delete changes. 
• 2012 Jan 24 — Initial Post
• Links:   Unintended Effects of Safety Nets on Incentives at [http://curntbk.blogspot.com/2012/01/unintended-effects-of-safety-nets-on.html]

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