In a negative income tax system, people earning a certain income level would owe no taxes; those earning more than that would pay a proportion of their income above that level; and those below that level would receive a payment of a proportion of their shortfall, which is the amount their income falls below that level.
Typically, this is proposed to be implemented as a flat tax combined with a fixed government payment. For example, if the flat tax rate is 25% and a government payment of $10,000, then:
The motivation for such a tax would be to implement a single system which accomplishes both the funding of government and the social goal of ensuring a minimum level of income. In the presence of a NIT, inasmuch as this social goal is reached, it potentially removes the need for minimum wage, food stamps, welfare, social security programs and so on, while requiring a fraction of the administrative effort, and avoiding the pitfalls and perverse incentives which exist in systems with overlapping aid programs.
While minimum wages risk pricing some jobs out of the market, a NIT does not disrupt low-wage markets.
The proliferation of aid programs which an NIT replaces can present perverse incentives, wherein a raise to a higher level of income results in a net loss in income, due to a loss in aid, thus discouraging low-wage workers from seeking higher-paying employment. This is known as the welfare trap. A worker under a NIT always gets the same portion of each marginal dollar earned, so there is always an equal incentive to work.
A negative income tax would reduce administrative overhead, since the large bureaucracies responsible for administering taxation and welfare systems could be eliminated. The resources saved by eliminating these bureaucracies can then be spent on more productive activities.
A negative income tax is also expected to have a positive influence on the cycle of economic "boom and bust".
The main drawback cited by critics is one commonly found in almost any income-based tax system: it requires considerable reporting and supervision in order to avoid fraud. Another concern is that the incentive to commit fraud may be increased with an NIT, since the monetary reward for fraud could be larger than a taxpayer's total tax liability. Critics claim that the added expense of policing fraud would more than offset the reduction in administration resulting from the cancellation of current welfare services.
Another criticism is that the NIT might reduce the incentive to work, since recipients of the NIT would receive a guaranteed minimum wage equal to the government payment in the absence of employment. A series of studies in the United States beginning in 1968 attempted to test for effects on work incentives. The studies showed minimal disincentives, but were difficult to analyze, as the monetary benefits were rarely as generous as those already received through the traditional welfare system. These results lead to an apparent dilemma of maintaining the benefits of existing programs through an NIT without creating significant disincentives and while restricting coverage to any manageable portion of the population.
Milton Friedman proposed a model in which a specified proportion of unused deductions or allowances would be refunded to the taxpayer. If, for a family of four the amount of allowances came out to $10,000, and the subsidy rate was 50% (the rate recommended by Friedman), and the family earned $6,000, the family would receive $2,000, because it left $4,000 of allowances unused, and therefore qualifies for $2,000, half that amount. Friedman feared that subsidy rates as high as those would lessen the incentive to obtain employment. He also warned that the negative income tax, as an addition to the "ragbag" of welfare and assistance programs, would only worsen the problem of bureaucracy and waste. Instead, he argued, the negative income tax should immediately replace all other welfare and assistance programs on the way to a completely laissez-faire society where all welfare is privately administered. The negative income tax has come up in one form or another in Congress, but Friedman opposed it because it came packaged with other undesirable elements antithetical to the efficacy of the negative income tax. Milton preferred to have no income tax at all, but said he did not think it was politically feasible at that time to eliminate it, so he suggested this as a less harmful income tax scheme.
The effort for reporting and supervision can be very significantly reduced. A flat rate income taxation with tax exemption implements a negative income tax as well as it maintains an actual tax rate progression at extremely low administrative cost: This is achieved by paying a tax on the tax exemption to all taxpayers, e.g. in monthly payments. The tax on the tax exemption is computed by applying the nominal flat tax rate to the exemption. The tax on the income is drawn directly from the source, e.g. from an employer. The tax on income is computed by applying the nominal flat tax rate to the income.
This simple method results in an effective progressive rate taxation (although the tax rate for the taxes drawn at the source is flat) which is positive once the income exceeds the tax exemption. If, however, the income is less than the tax exemption, the effective progressive rate actually becomes negative without any involvement by any tax authority. As for the positive progression, only very high incomes would lead to an actual tax rate which is close to the nominal flat tax rate.
The tax on tax exemption also can be understood as a tax credit, which is paid back once an income has reached the level of the tax exemption. This level marks the point where paid taxes and the tax credit are equal. Above that point the state earns taxes from the taxpayer. Below that point the state pays taxes to the taxpayer.
Flat tax implementations without the provision of a negative income tax actually need an additional effort in order to avoid negative taxation. For such a tax, the exemption only can be paid after knowing the earned income. Flat tax implementations with negative income tax allow to pay the tax on the tax exemption independent of the amount of the actual income.
- From 1968 to 1979, the largest Negative Income Tax social experiment in the US was undertaken The four experiments were in: