An Economic Miracle Cure? The Case For A Negative Income Tax In Ireland

This post has been updated and moved to the blog’s new domain, conductunbecoming.ie, and you can find it here.

Ireland is in the middle of what can only be described as a complete economic meltdown, with a recession to the tune of 8% of GDP, unemployment reaching into double digits, and a catastrophic decay in the public finances. Attempts to deal with these problems have unfortunately been limited to tinkering around the edges with marginal changes in the tax rates and limited cuts in public expenditure. The recent mini-budget has continued with this approach, and there have been very few proposals that have gone much further than creative accountancy when it comes to the budget, and little more than platitudes regarding a reduction in the unemployment rate, let alone anything that seriously addresses the collapse in GDP.

There is, however, a little known miracle cure that could do the trick for the Irish economy. It’s a relatively simple idea that could create 300,000 jobs, save the Government €2 billion, bring down the cost of living, dramatically increase Irish competitiveness and turn the corner towards economic growth. Sounds too good to be true? Perhaps it is, because nobody’s ever actually tried it.

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The idea is to bring in something called a Negative Income Tax. This works, as you might expect, sort of like the opposite of a normal income tax. Instead of just taking away some of the earnings of people above a certain income, the government would also simply give extra money to people below a certain income, in effect ‘topping up’ their salaries. The idea has been floating around economic circles for quite some time, and has been proposed in many shapes and sizes, perhaps most famously by Milton Freidman, who took it to a rather extreme form where it would replace all other forms of welfare. It’s never made that jump from theory to practice, though, and there are a number of reasons why.

Before I get to that, though, I’ll give a quick run through existing tax systems for comparison.

The simplest form of income tax is called the flat tax. This is where every person is charged the same percentage of their salary in tax. So, with a 30% flat tax, a person earning €10,000 would pay €3,000 in tax, and someone earning €80,000 would pay €24,000 in tax. Here’s a diagram of how a 30% flat tax would affect people on different salaries:

flattax

The blue line shows what someone would take home if there were no tax at all (ie their entire salary), whereas the red line shows what they would actually take home after a 30% flat tax. The shaded pink area is the revenue that the government receives from the tax.

The flat tax is popular partially due to its simplicity, but also in large part because it doesn’t disincentivise work as much as a progressive income tax would. It’s been largely replaced by progressive taxation, however, because it gives no special treatment to those on lower incomes who are likely to be more heavily affected by the tax.

The progressive income tax is probably the most common form of income tax in the developed world. It operates by charging different tax rates depending on how much the citizen earns. For example, tax could be levied at a rate of 20% on all earnings below €40,000, and at a rate of 40% on all earnings above that, such as in the following diagram:

progtax

This is generally favoured because it places less of a burden on low-earners, and taxes high-earners more heavily, and is hence considered fairer. Libertarians would argue that in doing this it disincentivises work amongst high-earners (by reducing the amount of take-home pay they get), and hence reduces overall economic activity, but in most places it’s accepted as the fairest way to distribute the tax burden. It can also be organised with any number of tax bands, and sometimes completely exempts those on the lowest incomes.

Of course, even exempting low-earners from tax altogether doesn’t necessarily leave them with enough money to live, and those without any job would be literally out on the street. Hence the combination of a minimum wage, to make sure everyone who works is guaranteed a certain standard of living, and unemployment benefits, to give those who can’t find work a means to get by. These two policies are used the world over to help out those less fortunate in life, and are widely accepted to be the best way to go about it. The only problem is that, as well-meaning as they are, they don’t really make all that much sense.

Take the following example: a country has a minimum wage of €20,000 a year (not taxed) and unemployment benefits of €10,000 a year. A company wants to hire a new employee, but can only afford to pay €15,000, and an unemployed man would take the job (as he’d be €5,000 a year better off), but can’t. In this scenario, everyone is unhappy; the company has no employee, the man has no job and the government has to pay out €10,000 in benefits. It’s clearly not an optimal solution to the situation.

What happens, though, if the government agrees to this; the company pays this man €15,000, and the government ‘tops up’ his salary by €5,000? The man gets €20,000 a year, which is €10,000 better than being on benefits, and high enough to meet the minimum wage. The company can employ the man they want and the government saves €5,000 a year. This is a better solution for all involved, it boosts employment and benefits the economy. This is negative income tax, but no country has ever actually implemented it. Why?

The principal concern with any system of negative income tax is disincentivising work. Why would the man in the example work harder to bring his salary up to €20,000 if the government would just take away their ‘top-up’ and he’s left with exactly the same amount as he had before? Even if they left him with some of the top up, would it be enough to convince him to put the extra work in? And if the government do have to give these ‘top-ups’ to low-paid workers, can they afford it? The answers to the second and third questions can be yes, but as we’ll see there isn’t necessarily an easy solution.

The classical implementation of negative income tax is to give everyone a fixed sum, and then levy a flat tax on all earnings. Here’s an illustration of such a scheme with a €10,000 lump sum and a 33% tax:

negflattax

Here the green area is the negative tax that the government is paying out to those on lower incomes, or the ‘top-up’ on their salaries. There are quite a few benefits to this over a normal flat tax, in that it is ‘progressive’ in the sense that it favours those on lower incomes, but it retains the lowered disincentive to work that the flat tax promises. It also eliminates the need for a minimum wage (and the market distortions that go with it) by boosting low incomes. There is a big problem, though, and that’s the cost of the scheme to the government.

The break-even point on the example above is €30,000. This is where the €10,000 lump sum is cancelled out by €10,000 of taxes on what they’ve earned. But what if €30,000 is the median wage? This would mean that fully half the workforce would actually be net beneficiaries of the tax system, and the other half would have to cover these payments as well as all other government spending. This simply isn’t sustainable, but the only ways to improve the balance is either to drastically reduce the lump sum payment, which would defeat the purpose of helping low-wage workers, or drastically increase the tax rate, which would increase the disincentives that flat taxes are designed to avoid.

Most of the times that a negative income tax has been discussed it’s been in the context of a scheme like the one above, with all the problems that it entails. There is, however, the option of applying the negative income tax to a progressive tax system like Ireland’s. This means giving negative tax only to those who really need it, low taxation on middle incomes, and higher taxation above that. Consider the following tax scheme:

negprogtax

Here we’ve got a negative tax scheme for those who earn less than €20,000, calculated as €10,000 minus half their earnings. From €20,000 to €40,000, earnings are then taxed at 20%, and at 40% above that. This sort of scheme is what we’re going to have to look at here in Ireland, because we’re in exactly the sort of scenario where it would bring about the biggest benefits, a scenario that no country has ever really been in before. Have a look at the situation we’ve found ourselves in:

  • 11% unemployment and rising: As big a problem as this is in itself, every one of these is also claiming unemployment benefits off the state, which feeds into:
  • Double-digit budget deficit: This means that a Keynsian-style attempt at economic stimulus to create jobs and boost growth simply isn’t feasible, as the government simply can’t afford it.
  • Internationally high wages: Years of economic boom left us with some of the highest wages in the world, which now seriously hamper our competitiveness, and our ability to rebound with export-led growth.
  • High minimum wage: As desirable as a decent minimum wage is in times of high employment, it’s now aggravating the unemployment situation and causing problems for both our international competitiveness and our own cost of living. Furthermore, any attempt to reduce it (even in line with deflation) would be politically disastrous.
  • High cost of living: In line with our high wages, we also have a very high cost of living by international standards. We’re starting to see deflation, but it’s still a big problem.
  • Common currency: For all the benefits a common currency brings (look at Iceland without), being unable to control monetary policy means that the government can’t attempt to devalue their way out of the deficit.
  • 8%+ GDP contraction: This is the biggie. With a 3% downturn last year, and a definite continuance of the recession into 2010, we’re already in a full-blown depression by most economists’ measures. If it weren’t for Iceland’s complete collapse, Ireland in 2009 would stand a very good chance of seeing the highest single-year decline in GDP of any developed county since World War 2. It is simply not possible to overstate the scale of the economic decline, and big moves, not just tinkering around the edges, need to be made to address it.

No country has ever experienced the same combination of economic, budgetary and employment crises so suddenly from such a high peak, so any actions that really can save us have never been used before, because they’ve simply never been needed before. A scheme like negative income tax may seem radical, not just because of the fact that it’s never been implemented, but because it requires wholesale change in the way our taxation and welfare systems operate. Radical, however, is exactly what we should be looking for right now, because it’s the only kind of policy that actually stands a chance.

And as radical as negative income tax may be, its potential benefits are just too big to ignore:

  • Unemployment down to 3-4%. By removing the minimum wage, businesses would be able to make big increases in the number of low-paid jobs, and there should be a large take-up because the government top-up ensures any employment (even very low-wage) is preferable to the dole.
  • €2 billion in government savings. The state currently pays out somewhere around €10,500 a year to each person on unemployment benefits. With unemployment rising higher and higher, the welfare bill is growing massively exactly when the government can least afford to pay it. By shifting people from unemployment benefit to subsidised work, the amount the government has to pay out can be significantly reduced. A back-of-a-paper-envelope estimate puts this saving in the region of €2 billion a year, although it could be even larger compared to future unemployment rates, and doesn’t take into account the savings that could be made in reduced administration of social welfare.
  • Reduction of cost base for businesses. High wages are a significant contributor to business costs in Ireland, which in turn affects their ability to compete in world markets. Allowing wage costs to drop below the minimum wage would make businesses more competitive and boost economic growth.
  • Reduction in cost of living. High costs in Ireland are significantly affected by the high minimum wage. By bringing wages down at the low end of the market, the cost of living can be reduced considerably. We’re already seeing cost of living decreases, but a quick, sharp drop in prices is necessary to facilitate lower wages across the board, and help restore the country’s competitiveness.
  • Mitigating the long-term effects of unemployment. Most of those on the unemployment register today have been out of work for under a year, meaning that given the opportunity, they would have little difficulty fitting back into the workforce. Fast-forward a few years, though, to when the recession has finally subsided, and Ireland could have 10% to 15% of it’s workforce in long-term unemployment. Even if jobs start to be created at that stage, people who have been out of work for 3 or 4 years will find it very difficult to rejoin the workforce and settle into a new job. This will not only be very difficult for all those involved, but severely hamper the economic recovery when it does come around. By keeping as many people in employment as possible, a negative income tax could prevent this eventuality and make sure the work force is in good shape to take advantage of the eventual upturn.
  • A kick-start to the economic recovery. Each of these factors make a contribution towards economic recovery. The benefits to an increase in employment are obvious, and the money saved by the government can reduce the need for further tax rises or spending cuts. Furthermore, decreases in costs and wages are a vital prerequisite to making ourselves internationally competitive again and attracting inward investment. It’s impossible to put a figure on how this would affect the recession, but the benefits could be decisive.

Of course, as with any scheme, there are possible drawbacks. The most notable of these are the potential disincentives created for low-income workers. Taking the example I gave above, those on negative tax are in a situation where, for each extra euro that their salary increases, their real income only goes up by 50 cent. The argument is that this disincentivises workers from seeking out higher wages, and hence keeps wages artificially low, costing the government more in negative tax. While work disincentives are a strong argument against high taxation on high earners, I don’t believe the same can be said for those in the lowest income categories. The fact is that salaries between €10,000 and €20,000 are not much to live on, and I would fully expect that, even with the reduced returns, such workers would continue to compete for higher earnings.

A further argument could be made against the potential administrative complexity of such a scheme. The UK set up a system of “working tax credits” a number of years ago which gives some individuals and families lump-sum payments depending on their circumstances (although the name is rather misleading, as it’s not actually implemented as part of the tax system). The system has been widely discredited as an administrative disaster, as huge numbers of eligible people aren’t aware that they can make claims, and many of those that do have been over-paid and have to give the money back. Furthermore, the cost of keeping the system up and running is quite considerable.

The important distinction between welfare models like that one and a negative income tax is that the negative income tax isn’t administered as a welfare payment, but within the tax system itself. Currently, when you receive a PAYE slip, your employer will have deducted the appropriate income tax and PRSI and will pay it to the government on your behalf. Similarly, if you are on negative income tax, your employer will top up your paycheck to the appropriate amount, and then claim it back from the government themselves. In fact, the majority of businesses will have many more positive-tax employees than negative-tax ones, meaning that they will simply deduct your payment from their overall tax bill, and the administration required will be little more than accountancy.

It would be foolish to claim that implementation of a negative income tax would be a complete cure to the nation’s economic woes. A wide variety of measures will have to be introduced, some more palatable than others, to put Ireland on the road to its eventual recovery. Exactly what each of those measures are and why they are needed is a long and complex discussion that will have to be left to another day, but for the moment there’s a simple and effective, if radical reform that can make a big difference. What we need to do is move the debate away from just tax hikes and spending cuts, and start talking about whole new ways to do things. In the state the country’s now in, we can hardly afford not to.

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1 Response to “An Economic Miracle Cure? The Case For A Negative Income Tax In Ireland”


  1. 1 Ciaran Daly May 1, 2009 at 3:38 pm

    On the one hand you’ve argued for a once-off devaluation which involves wages cuts and on the other a negative income tax. So wages would be cut and then increased again but with the negative income tax, you’re taking away the value of the devaluation and redistributing income.


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