Chapter 10: Entitlement and Taxation

A chapter of Globalisation and Welfare State

Keywords: Regulation & Taxation; Social Policy;

How should social security beneficiary who has some additional income be treated? There are numerous institutional arrangements but for economic purposes the crucial question is summarized in the `effective marginal tax rate’ (EMTR). Consider a beneficiary (or indeed any other person) who obtains an extra dollar of income, perhaps from working, perhaps a return from investments or a private pension. The additional dollar may be taxed, there may be a surcharge, the benefit may be abated or treated as taxable income, some other benefit may be reduced …. The possibilities are numerous. The economist focuses on how much additional income the beneficiary has in the hand (called `disposable’ income because that is what the individual has to spend), irrespective of the institutional arrangement to reduce it. Suppose the amount is X cents (say, 60 cents). Then the EMTR is 100-X percent (e.g. 40 percent). (1)

For an ordinary income recipient, not in receipt of any welfare benefits, the EMTR is exactly the same as the conventional income tax rate If I earn a dollar, and the government takes 33 cents, leaving me 67 cents in the hand, the marginal tax rate is 33 percent. The term `marginal’ refers to the additional dollar. (2)

While one might argue that a beneficiary should be treated the same as anyone else, there has almost always been a higher EMTR for beneficiaries – for two main reasons. First is the problem of identification of entitlement. Someone entitled to an unemployment benefit may earn some market income. The situation is not so unusual. The unemployed may nevertheless be able to find some limited work while the sick or invalided, or solo mother may be capable of doing some work. We may even be pleased at their supplementing of their income, while the work itself may be therapeutic. However if they were taxed at exactly the same rate as everyone else, the unemployment beneficiary could work full time and end up with a higher disposable income than the ordinary worker. The higher EMTR, which reduces their additional income faster than the ordinary worker, prevents this from happening.

The problem occurs because there is ambiguity in social security entitlement, arising from there being some humanity in the system. A procrustean official could categorize people only as either not-employable (with no other income) or in-work (and with other income). In practice we recognize there are those who ought to be somewhere between these two ends of the spectrum, partly on benefits, partly at work. This is further complicated if there are unemployed who are employable but there is a lack of full time work. For therapeutic reasons they may be better doing some work, and indeed that work may directly, or via the acquisition of skills and a work record, lead to a full time job. The same applies to the sickness or invalid beneficiary, especially if the situation is temporary, while it is sensible for the domestic purpose beneficiary whose children are growing up – perhaps at school – to take up part time work as a stage towards full economic independence when the children are independent.

There is a second reason for the need for a higher beneficiary EMTR relative to the non-EMTR. Benefits are expensive to the public purse, especially if their level and categorical entitlement is reasonably generous. Generous benefits mean higher taxes on others. I demonstrate this by a simple example.

There is a proposal for everyone to receive a universal minimum income (UMI) for paid out of the public purse. This is a very popular idea, since it avoids all the difficulties of categorizing some people as worthy of a benefit, and some as not. An individual’s market income is then taxed, and the tax is used to fund the UMI plus other government expenses. Unfortunately the rule that generous benefits generate high tax rates applies to this otherwise attractive scheme, with – as we shall see – a vengeance.

In order to not be too complicated consider an example. In the 1995/6 (March) year the mean market income was almost $20,000 per adult, which is total personal market income of $54.4 billion shared equally between 2.74 million adults. (This is much lower than the average wage of $32,100 p.a. because not every adult earns income). Suppose the UMI was set at $7,200 a year (or $138.46 per week), which is the rate for the after-tax unemployment benefit for a single adult. (But note many other beneficiaries were entitled to a higher benefit level, and the unemployed might be in receipt of further supplementary and housing assistance.) The total cost of the UMI would be $7,200 times the adult population of 2.74 million, or $19.7 billion.

We fund this with a flat rate income tax on all personal market income, assuming there is no behaviourial response. Since the total tax base was $54.4 billion, so the tax rate to raise the cost of the UMI would have to be or 19.7/54.4 or 36.3 percent, higher than the current official top income tax rate. (Many beneficiaries pay a higher EMTR.) Now you may think this income tax rate is tolerable, but observe that the scheme makes no provision for child support, and there is no public spending on education, the environment, government administration, health care, law and order, the military and so on.

To make the scheme more realistic, let us assume that
– the government needs to raise $4.5 billion to spend on its other activities. (It spends a lot more on such things, but it also raises revenue from corporation tax, indirect tax, and in miscellaneous ways) (3), and
– each child gets half the adult UMI.

Neither assumption is outrageous, but the resulting average tax rate, without a behaviourial response, is almost 50 percent. (4) The rate would be higher if the base UMI were raised (say to the $152.10 of the basic retirement pension, or if other supplements such as special needs grants, housing assistance, and other supplementary grants were added to the scheme.)

Can such a high income tax rate be avoided? Note that this is an average tax rate, so we might be able to cunningly devise a variable one. This would not be a matter of just putting up the tax rate on high incomes and lowering it on low ones, because there are not enough people on high incomes. Indeed in order to tax the last dollars people receive at a lower rate we would need to do exactly the opposite. This in fact actually happens. Beneficiaries often face extraordinary high EMTRs as a result of their benefits abating out on top of income tax paid – up to and even over 100 percent, so that any extra income they earn gets (almost) entirely expropriated by the state.

The trick would be to design a system of EMTRs, which were high for an individual’s low income relative to their earning capacity, but as their earning capacity fell their EMTR would fall, and be modest in the range where they were deciding their labouring and investment decisions. However, because individuals have different earning capacity – compare that of a solo mother who can work a few hours while her children are at school with the chief executive of Telecom gets $1.5 million a year – each EMTR would have to be individually designed, which is impracticable.

Given the inability to fine tune the EMTR, the problem shifts to the ratio of the UMI to the average income. To simplify, if one sets the after-tax UMI as a proportion “t” of the after-tax average income, then the required income tax rate on market income to fund the UMI is t, too (assuming other revenue covers other government spending). (5) A less generous UMI, will lower the required income tax rate.
(The average EMTR could be lowered if a group could be excluded from eligibility. This is actually what happened while there was full employment, because (as explained in chapter 2) anyone who was employable was able to get a job and hence not given the unemployment benefit. Just suppose that everyone in New Zealand who was actively seeking a job was able to have had one in 1995/6, and so this system could have been applied. That would mean that 1.74 million New Zealanders would not be eligible for the guaranteed minimum income, and the average income tax rate would be about 33 percent. Such a strategy is not practicable given the level of unemployment, but as discussed in Part V it indicates we need not totally despair.

Do we need to worry about high EMTRs? When we were calculating the required average tax rate, we had to assume that there would be no behaviourial response to the changes in the EMTRs. The advocates of the UMI offer an almost inconsistent account of the situation. They argue that the current high EMTRs on beneficiaries discourage them from seeking work and become more independent of their benefit. Thus there are positive income generating benefits from lowering their EMTRs.

But if that is true, will there not be negative effects on current (mainly) full time workers, when they face the higher marginal tax rates? (For what is happening is, in effect, is a rejigging the EMTRs people face, lowering them for beneficiaries and raising them for others.) Will the positive effects of the behaviourial responses offset the negative effects? The issue is crucial since if negative effects predominates, the tax base will fall, and the tax rate have to rise, with further negative effects.

Certainly it would be unwise to assume there will be little behaviourial response of the negative kind. Here are some possible responses to higher tax rates:
– workers and self employed may shorten their hours worked, arguing they are not receiving sufficient to make it worth their while to work the extra hours;
– the self employed (and workers) may recoup the loss of income in higher charges (and wages), the resulting price rises leading to a fall in the real value of the UMI.
– individuals may migrate because they get paid more (after-tax) overseas. (That this is possible is a consequence of globalization.);
– students may obtain lower vocational qualifications because they do not think it worth investing their time (which implies a loss of earnings), effort, and expense into getting a better one because the after-tax return is not high enough;
– households may save less because the return is lower;
– investors may invest off shore where they can get a better returns;
– tax payers may rearrange their affairs in order to reduce tax liability, either legally (avoidance) or illegally (evasion);
– however, if an individual has a given after-tax target income, they may work longer hours if their EMTR goes up. (We sometimes miss this target income effect because they focus on a tradeoff of the intangible benefits of hours of leisure against the financial return from hours of work. However, as the unemployed will relate, leisure may not be much fun unless there is income to purchase goods and services which enhance it. The possibility of an extra half-day on the golf course is not that valuable if one cannot afford the green fees.)

All but the last of these offsets, at least in part, the positive behaviourial response of people whose tax rate falls and work more (although they too may have a target income, and work fewer hours if they can obtain the after-tax income more easily).

There is no compelling analysis which indicates which of these effects are significant, so we do not know what would be the net impact for a change in the incidence of tax rates. Anecdote overwhelms thoughtful analysis, and can be contradictory. A US survey of whether higher taxes were a disincentive, found those respondents who worked the longest hours were more likely to say “yes”. Perhaps they had an incentive to argue the case for lowering their tax rates, because they could hardly work longer hours to increase their incomes.

One suspects most people’s assessment of the behaviourial response to different tax rates (whether an on average higher but more even EMTR schedule would lead to positive or negative net outcomes) correlates with their own personal situation (whether they would be better or worse off), together with their views on income inequality (whether they support more or less inequality).

If I had to guess, I would observe that the employed tend to have skills in far shorter supply relative to the economy’s demand compared to those of beneficiaries. This suggests that the net behaviourial response of a high average EMTR would be lower aggregate earnings. Even so I am inclined to think their may be gains from evening out the very high EMTRs on beneficiaries, even if this meant slightly higher income tax rates on the better off.

Yet lowering the overall EMTRs on beneficiaries is constrained unless the income of modest earners is also raised. Economists explore this interaction via the “replacement ratio”, which, ideally, is the ratio of the benefit to what the beneficiary could earn as a full time worker. If the ratio is high, there is not much income incentive for the beneficiary to find a job, since they will work full hours and not obtain much money. Suppose a person was capable of an after-tax wage of $207.35 for a 40 hour week (the minimum wage in 1995/6). At the time the adult unemployment benefit was $138.46 (after tax), so by losing the benefit and working an extra 40 hours, the individual gets an extra $68.89 a week (some of which will be needed for employment related expenses). The after-tax remuneration rate would be $1.72 per hour (or 27 percent of the paid wage, an EMTR of 73 percent). There is not much incentive to work with this replacement ratio of 138.46/207.35, or 67 percent.

Note that a sufficient raising of the minimum wage to reduce the EMTR is unlikely to be practical. Suppose the individual was to earn $3 an hour after-tax (the actual minimum wage was about $4.60 on this measure). Then the weekly wage for a 40 hour week would have to be about $326 a week, so that an unemployment beneficiary would get an additional $3 an hour in the hand from working full time. This sort of minimum wage does not seem very practical.

Alternatively we might ask that given the after-tax minimum wage of $207.35 a week, how low would the unemployment benefit have to be to give an after-tax return of $3 an hour? The answer is a benefit of $87.37 p.w., which again does not seem practical, if we are trying to give the unemployed a reasonable standard of living while they seek another job. Once more we are caught in the bind of a high replacement rate (with its notion of a decent minimum income) leading to a high EMTR.

The illustrations are based upon the assumption is the minimum wage to compare with the unemployment benefit. Many workers can claim a much higher remuneration. Given a choice between a high remuneration and an unemployment benefit, there is not the same EMTR disincentive. The minimum wage rate for which a person will work is called the “reservation wage”. The ratio of the unemployment benefit to the reservation wage is the relevant replacement ratio. Unfortunately the reservation wage varies from person reflecting such factors as the willingness to work, personal circumstances, and marketable skills.

We pick up the themes of this chapter in Chapter 15, as the government of the 1990s wrestled with wage and benefit relationship in an attempt to reduce the EMTRs. But in some ways it is trying to square the circle. A decent minimum income for everyone and low EMTRs seem impossible unless there are very high levels of employment. Note that economic growth may not resolve it, because higher average incomes are likely to lead to high benefit level. As long as their is ambiguity of entitlement, not least that of the existence of unemployment, it is difficult to see how EMTRs can be reduced.

Next Chapter Ch 11: The Growth of Inequality

1. For some purposes, it may be appropriate to adjust for indirect taxation, such as GST. However that complicates the exercise, and is unnecessary for the didactic purposes here, nor for the general themes being explored.
2. If the EMTR varies, then the average tax rate is an average of the EMTRs. And can be quite complicated to calculate in relation to the EMTRs.
3. I have also assumed that it maintained the budget surplus of $3.3 billion. This is to minimize the behaviourial response, since a different budget surplus might affect other incomes and prices.
4. The levy needs to raise
– $19.7b for the adult UMI;
– $ 2.9b for the child UMI;
– $ 4.5b for other spending;
a total of $27.1b, which is 49.8 percent $54.4b.
5. Suppose total market income is Y, and the population is A adults and C children, where a child is treated as a proportion π of the Adult.
The average income is given by y = Y/(A + πC).
To fund a UMI of u (after tax), the total revenue required will be (A + πC)*u.
The average tax rate, t, will have to be (A + πC)*u/Y, or
t = u/[Y/(A + πC)]
= u/y.