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A thought experiment about welfare

June 3, 2013

Imagine a free-market economy with no government welfare. Some people earn high incomes and others earn low incomes. Now consider that some kind hearted bureaucrats come along and want to introduce a government policy to help the low-income earners. How should they do it? Let’s consider two options.

Option A is where the government introduces a very specific payroll tax that only applies to businesses that employ low-income earners. The lower the employee income, then the higher the payroll tax. Businesses that only employ high-income earners do not have to pay anything. Obviously, this tax will hurt businesses that concentrate on low-skill activities (cleaners, retail sales) but it will not hurt businesses that concentrate on high-skill activities (law firms, accountants). Because of the tax on low-skilled businesses, some of those businesses close down, others decide to employ fewer people, and others decide to shift towards high-skill activities… so some low-skilled workers lose their jobs.

The money raised from this tax is then paid as a subsidy to low-income earners, including to people who have lots of assets and people who are from rich families. While the tax caused some low-skilled people to lose their job, those people do not receive any of the subsidy. The subsidy only goes to people who have kept a low-income job.

Option B includes a less targeted tax but a more targeted subsidy. In this version, the tax rate is spread  among all firms, including the high-skill businesses. With a broader base comes a lower rate, so the tax on low-skill businesses is relatively low compared with option A. Because of the relatively lower tax rate, more businesses survive and more low-skilled workers keep their jobs. The money raised from this tax is then targeted to people who are genuinely poor. Less money is given to people with lots of assets and rich families, and therefore more money is available for the people who really need the money.

Which of these systems is preferable?

One benefit of option B is that the tax system is relatively more efficient, resulting in more jobs, faster economic growth, and therefore faster incomes growth in the future. It is also arguably more equitable since the pain is spread more equally among all businesses, including high-skill businesses who get special treatment in option A. Another benefit of option B is that it targets the benefit more directly at those people genuinely in need of help, while option A ignores some of the people most in need while giving extra money to low-income people with lots of assets and rich families.

The main “benefit” from option A is that it allows rich families to avoid paying tax in their high-skilled jobs, while their children are able to pick up subsidies when they have low-skill jobs. It is hard to pinpoint any other clear benefits from option A compared with option B.

And yet option A remains very popular today.

Of course, option A is exactly the same thing as the minimum wage, but with different words. The minimum wage acts as a tax on low-skilled businesses but it does not hurt high-skill businesses since they already pay above the minimum wage. The cost on low-skilled businesses destroys low-skilled jobs, creating more unemployment. The benefits of the minimum wage go to low-income people, even if they have lots of assets or rich families… but the benefits do not go to those people who have lost their job. In study after study it has been shown that the minimum wage is bad economic policy and bad social policy. The main benefit of the minimum wage is that it helps politicians to get re-elected by appealing to populist rhetoric.

For anybody who wants to look past the populist rhetoric and consider how to actually help the poor, it makes much more sense to switch from option A to option B. The tax-transfer system is a more efficient, equitable and transparent system for fighting poverty. Using transfers instead of the minimum wage means that more people are able to keep their jobs, gaining valuable experience, social connections and self-esteem. A low-income job today is often a stepping stone to a high-income job in the future; while the main cause of poverty is unemployment.

At the same time, using the transfer system means that benefits can be more accurately targeted to the genuinely poor. Low-income earners with no assets or rich family could receive both their work income as well as a subsidy from the government to ensure they have a “guaranteed minimum income”. They would have just as much money as they receive under the minimum wage system, but without all of the associated costs.

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