Social insurance can be valuable but expensive

Social insurance, in the form of a traditional welfare policy or a negative income tax, is very expensive. The actual cost to the government is many times the original poverty gap. But this insurance is also very valuable.

By ASHER MEIR
July 9, 2010 06:26
Social insurance can be valuable but expensive

money corruption 298.88. (photo credit: Courtesy: SXC)

The government recently decided not to support an increase in the minimum wage, but it did decide to support an expansion of the Negative Income Tax program. I oppose the minimum wage, but let’s compare traditional welfare programs and the negative income tax and see why both are very expensive.

Here is a totally illustrative example, based on a hypothetical Israel of 100 families. The numbers are not based on actual figures; they are meant to give an illustration of how these programs work.

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The usual first step in designing a welfare program is to decide what the minimal level of support is. The Torah talks about providing the poor person with “enough for his needs,” but every society has to decide what that is. Suppose that NIS 3,000 a month is the minimum needed to support a family of four in humane conditions. (It is certainly a very small amount.) Let’s take as our benchmark a situation where there is no welfare policy. Everyone works to the best of their ability and most people earn at least NIS 3,000. Suppose that 96 out of 100 families earn NIS 3,000 and four out of 100 earn an average of NIS 1,500.

The shortfall between the current situation and the “minimum support” ideal is very small: We would pay 4 percent of families an average of NIS 1,500, meaning a total poverty gap of NIS 6,000. The whole program would cost only NIS 60 per family per month.

Suppose the government decides to solve the problem by promising to subsidize the income of poor families until it reaches NIS 3,000. These families now have zero incentive to earn; their marginal tax rate is 100% since every shekel they earn translates into one less shekel in government support. Immediately the “poverty gap” has increased from NIS 1,500 per family to NIS 3,000 per family.

But in fact the situation is worse; people making NIS 4,000 to NIS 5,000 a month will find it advantageous to quit their jobs and go on welfare. Going to work is expensive; it means you have to pay for commuting to work, child care, house care, prepared meals and so on. For many people, especially those with low-paying jobs, going to work is quite unpleasant. Perhaps eight out of a 100 families will now be without income.

We have now doubled the amount of support we need to pay for each family and doubled the number of families receiving support. The hole we need to fill is now eight families at NIS 3,000 per family, or NIS 24,000 – NIS 240 per family per month. And now there are fewer families to pay: 92 instead of 96. So a traditional “income supplementary” welfare program costs many times the original “poverty gap” it set out to close.

What about the negative income tax? It is intended to maintain the incentive to work by gradually phasing out benefits. A typical system would have a marginal tax of 40%. So if a person earns nothing, he would receive benefits of NIS 3,000. If he earns NIS 1,000, we want him to keep 60%, or NIS 600. His new income is NIS 3,600 – meaning we must pay him NIS 2,600 of welfare to supplement his NIS 1,000 labor income.

It is obvious that the hole we need to fill will grow much more slowly than before. Assuming we started with a progressive income tax with very low income taxes for low earners, we have now raised the marginal tax on the poor to 40% instead of zero. People will earn somewhat less. But by no means will we drive low earners out of the labor force entirely. If the original poverty gap was NIS 6,000 (NIS 1,500 for each of four families), it will now be perhaps NIS 8,000 or NIS 9,000 for these families.

But how will families that aren’t poor be affected.

The number will be much greater. Following the logic of a negative income tax, a family that earns NIS 3,000 should be allowed to keep 60%, or NIS 1,800. Their total income should now be the NIS 3,000 benchmark plus NIS 1,800 of their earnings. Government benefits are now NIS 1,800 for such a family.

Along the same lines, we find that families continue to get benefits until they earn NIS 7,500 a month.

Only then is the 40% tax equal to the full amount of the original benefit. In other words, a negative income tax with a base level of support at NIS 3,000 and a tax rate of 40% will be paying benefits to families earning over NIS 7,000 a month. This is a very large fraction of the economy: NIS 7,500 a month is not very far from median income. Only families earning above NIS 7,500 will pay any taxes.

So while traditional welfare policies have a huge effect of driving people out of the workforce, they have a limited effect on driving people out of the tax base.

The negative income tax has a small effect of driving people out of the workforce, but a much larger effect of driving people out of the tax base.

I believe this trade-off is worth the cost. Keeping people out of work is a total loss, and it is a persistent one.

Many people will stay out of work indefinitely. Furthermore, I suspect we already have a de facto negative income tax because people are working under the table while receiving government benefits. A negative income tax would reduce the cost of declaring income and drive much income aboveground.

Social insurance, in the form of a traditional welfare policy or a negative income tax, is very expensive. The actual cost to the government is many times the original poverty gap. But this insurance is also very valuable.

This is what guarantees that you and your children will never lack for basic needs such as food or shelter.

The trick is finding the least harmful way of providing this insurance. The negative income tax is not a cureall, and it has characteristic shortcomings that traditional welfare systems lack. But I believe it is the best solution for Israel.

ethics-at-work@besr.org Asher Meir is research director at the Business Ethics Center of Jerusalem, an independent institute in the Jerusalem College of Technology (Machon Lev).


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