We need a Negative Income Tax, not a Living Wage

The new Living Wage rate was announced today. I’ve written a bit about the Living Wage already. If it’s private, it’s probably not a big deal, although it could still lead to unemployment. I suspect it’s done by big firms that don’t have many low-skilled workers as a PR move but I quite like PR moves that involve paying low skilled people more. And I worry that people will generalize from those big firms to assume that the whole market could bear a mandatory Living Wage, which is almost certainly untrue and would be very harmful to many of the people it’s supposed to help.

What’s more interesting is the problem of low pay in general. Even though unemployment has fallen a lot in recent years in the UK, real wages have barely risen at all. Even as wages do begin to rise on average, it’s possible that wages for low skilled workers may not as jobs for them are outsourced to cheaper countries. The ASI has proposed raising the personal allowance (including National Insurance threshold) to the minimum wage rate, but this doesn’t do much good for part-time workers or currently-unemployed people who would earn below the minimum wage if we scrapped that, as I think we should.

So low pay may be a problem without any clear solution, for which most popular ‘solutions’ don’t actually work.

But there may be a fix that does work – a Negative Income Tax or a Basic Income. As I’ve written before these are actually very similar even though one is almost exclusively supported by right-wingers and the other almost exclusively by left-wingers. As ever in politics, we’re speaking different languages.

A Negative Income Tax is a form of income top-up that only looks at an individual’s income, not whether they are in work or not, and tops that income up automatically if they are earning less than a given amount. The extra money is withdrawn at a tapered rate, so that for every pound you earn from work, you lose (say) fifty pence in top-up, ensuring that workers always have a clear incentive to demand higher wages, and that work always pays more than joblessness for unemployed people.

This would replace lots of existing working age benefits, including Jobseekers’ Allowance, council tax relief, the Employment and Support Allowance and tax credits. You could probably implement a decent one without increasing total expenditure. The exact rates can be determined by running trials across the country.

A Negative Income Tax like this would almost certainly be a boon to people on low pay, and would avoid most of the problems that minimum wages and current welfare schemes face.

Indeed the main objection may simply be that it is redistributive. That’s where I break with many of my fellow libertarians – I want free markets because they make poor people’s lives better, and I am OK with redistribution if it’s done in a market-friendly way that makes poor people’s lives better too. If this sounds surprising, remember that this puts me in the same boat as Milton Friedman (who campaigned for a Negative Income Tax) and FA Hayek, and indeed in the same utilitarian philosophical camp as Ludwig von Mises.

I suspect low pay will continue to be a problem for many years, maybe becoming even worse as automation renders some people permanently unemployable. It is necessary but not sufficient to simply rebut other people’s bad ideas.

In the Negative Income Tax we have a policy that can actually go a big way to solving the problem, and hopefully replace some of the harmful policies we have right now. Rhetorically, I think we free marketeers need more positive solutions to policy problems, and if we could get over our squeamishness about endorsing certain forms of ‘good’ redistribution, we may be able to surprise people into listening to and maybe even agreeing with us. If low pay is indeed the long-term problem that it seems to be, the Negative Income Tax’s time may finally have come.

The Negative Income Tax and Basic Income are pretty much the same thing

I’ve been talking about the Negative Income Tax lately, and equating it with the idea of a Basic Income. I think most of the policies’ respective advocates would deny that they’re the same policy. In this post I’m going to outline why that’s incorrect and I’m happy to say that they’re basically the same thing.

For the uninitiated, a Negative Income Tax is a form of welfare that replaces most existing welfare schemes with a single payment that supplements the income of the unemployed and low-paid. The payment is withdrawn as your earnings increase, ideally at a gradual enough rate that increasing your earnings (and hence reducing leisure time) is always worthwhile.

An example: a £5,000 basic payment at a 50% marginal withdrawal rate (this means that for every additional pound earned, the worker will receive 50p less in NIT payments). Someone with an income of zero would receive an NIT payment of £5,000, or just under £100/week. If they took a job that paid £5,000/year, they would receive a top-up of £2,500/year; that paid £7,500, a top-up of £1,250/year. Once they reached £10,000/year, they would receive nothing in NIT.

This idea was supported by Milton Friedman, among others, and has a reasonably strong pedigree on the right. Even libertarians who object to income redistribution in principle usually concede that a Negative Income Tax is the least bad form of welfare, because it is administratively simple and perverts incentives less than most welfare schemes. It is particularly appealing to many liberals and libertarians because it is unpaternalistic.

A Basic Income, on the other hand, is usually conceived as a flat payment to everybody irrespective of circumstance. This leads to a very big problem: assuming it replaces most forms of welfare as an NIT does, a basic income high enough for unemployed workers to subsist on would simply not be affordable to pay to everyone. A policy that ideally would be designed to help the poor ends up being a very expensive subsidy to people who do not need extra money.

Advocates of the Basic Income recognize this, and their solution is typically to use the tax system to ‘claw back’ the payment from relatively high earners. So everyone gets the money, but it is withdrawn according to earnings.

In practice, that’s more or less the same as a Negative Income Tax – the only difference is whether the withdrawal takes place at the ‘front’ of the payment (as with the NIT), or the ‘end’ (as with the Basic Income). Strange as it may seem, the policies advocated by Milton Friedman and the Green Party are the same in all but the technical detail.

But even if there is a surprising amount of agreement in terms of the kind of welfare we’d like to see, the detail may be more difficult to agree on. How much should a ‘basic income’ be? When should it begin to be withdrawn, and at what rate?

Questions like this are, I think, likely to be where what breaks up this (unholy?) alliance. But maybe not. Traditional policies like the minimum wage probably do more harm than good, and, rightfully, the question of how to improve the lives of the low paid does not seem to be going away. It will take compromise, but in the Negative Income Tax / Basic Income, we may have an answer.

An alternative ‘Agenda for Hope’

Owen Jones has written a nine-point ‘Agenda for Hope’ that he argues would create a fairer society. Well, maybe. I’m not convinced by many of them. Then again, it would be quite surprising if I was.

But it got me thinking about what my nine-point agenda would be — not quite my ‘perfect world’ policies, but some fairly bold steps that I could just about imagine happening in the next couple of decades. Unlike Owen’s policies, few of these are likely to win much public support. On the other hand, most of the political elite would think these are just as wacky as Owen’s too.

Nine policies to make people richer and freer (and hopefully happier):

1) The removal of political barriers to who can work and reside in the UK. Removing all barriers to trade would increase global GDP by between 0.3% and 4.1%. Completely removing barriers to migration, though, could increase global GDP by between 67% and 147.3%. Those GDP benefits would mostly accrue to the poorest people in the world. We can’t remove these barriers everywhere but we can show the rest of the world how it’s done. Any step towards this would be good – I suggest we start by dropping the net migration cap and allowing any accredited educational institution to award an unlimited number of student visas.

2) A strict rule for the Bank of England to target nominal GDP instead of inflation, replacing the discretion of the Monetary Policy Committee. Even more harmful than the primary bust in recessions is what Hayek called the ‘secondary deflation’ that comes about as people, fearing a drop in their future nominal earnings, hold on to more of their money. That reduces the total level of nominal spending in the economy which, since prices and wages are sticky in the short run, leads to unemployment and a fall in economic output. NGDP targeting prevents those ‘secondary deflations’ and would make economic busts much less common and harmful. In the long run, we should scrap the central bank altogether and replace it with competition in currencies (see point 9, below).

3) Significant planning reform that abolished the Town and Country Planning Act (which includes the legislation ‘protecting’ the Green Belt from most development) and decentralised planning decisions to individuals through tradable development rights (TDRs). This would give locals an incentive to allow new developments because they would be compensated by the developers directly, allowing for a reasonably efficient price system to emerge and making new development much, much easier. The extra economic activity from the new home building alone would probably add a couple of points to GDP growth.

4) Legalisation of most recreational drugs and the medicalisation of the most harmful ones. I think Transform’s outline is pretty good: let cannabis be sold like alcohol and tobacco to adults by licensed commercial retailers; MDMA, cocaine and amphetamines sold by pharmacies in limited quantities; and extremely dangerous drugs like heroin sold with prescriptions for use in supervised consumption areas. The sooner this happens, the sooner producers will be answerable to the law and deaths from ‘bad batches’ of drugs like ecstasy will be a thing of the past. Better yet, this would bring an end to drug wars like Mexico’s, which has killed around 100,000 people in the past ten years.

5) Reform of the welfare system along the lines of a Negative Income Tax or Basic Income Guarantee. As it is, the welfare system disincentivises work and creates dependency without doing much for the working poor. A Negative Income Tax would only look at people’s incomes (not whether they were in work or not in work), reducing perverse incentives and topping up the wages of the poorest earners. This would strengthen the bargaining position of low-skilled workers and would remove much of the risks to workers associated with employment deregulation. Of course, the first thing we should do is raise the personal allowance and National Insurance threshold to the minimum wage rate to give poor workers a de facto ‘Living Wage’.

6) A Singaporean-style healthcare system to replace the NHS. In Singapore, people have both a health savings account and optional catastrophic health insurance. They pay a portion of their earnings into the savings account (poor people receive money from the state for this), which pays for day-to-day trips to the doctor, prescriptions, and so on. The government co-pays for many expenses but the personal cost disincentivises frivolous visits to the doctor. For very expensive treatments, optional catastrophic health insurance kicks in. This is far from being a pure free market system but it is miles better (cheaper and with better health outcomes) than the NHS. (By the way, if you really like the NHS we could still call this an ‘NHS’ and still get the superior system.)

7) A school voucher system and significant reform of the state education and free schools sectors. This would include the abolition of catchement areas and proximity-based admission, simplification of the free schools application process, and expansion of the free schools programme to allow profit making firms to operate free schools. These reforms, outlined in more detail in two ASI reports, would increase the number of places available to children and increase competition among schools to drive up standards.

8) Intellectual property reform. As both Alex Tabarrok and Matt Ridley have pointed out, our IP (patent and copyright) law is too restrictive and seems to be stifling new innovation. Firms use patents as barriers to entry, suing new rivals whose products are too similar to their own. In industries where development costs are high but imitation costs are low, like pharmaceuticals, patents may be necessary to incentivise innovation, but in industries like software development where development can be cheaper than imitation, patents can be a terrible drag on progress. Tabarrok recommends that we try to tailor patent length in accordance with these differences; as a sceptic about our ability to know, well, anything, I’d prefer to leave it to private contracts and common law courts to discover.

9) Last but not least, the removal of the thicket of financial regulation and the promise of bailouts for insolvent banks. Known as ‘free banking’, this system of laissez-faire finance has an extremely strong record of stability – though bank panics still occurred in free banking systems, they were much less severe and rarely systemic. Only once the government started to intervene in the financial system to provide complete stability did things really begin to go wrong: deposit insurance, branch-banking restrictions, and other prudent-seeming regulations led to extremely bad unforeseen consequences. The financial crisis of 2008 probably owes more to asset requirements like the Basel accords, which heavily incentivised banks to hold ‘safe’ mortgage debt over ‘risky’ business debt, than anything else. Incidentally, the idea that having a large number of local banks is somehow better than having a few large banks is totally wrong: during the Great Depression, 9,000 of America’s small, local banks failed; at the same time not one of Canada’s large banks failed. The small banks were more vulnerable because, unlike the big banks, they were undiversified.

Now, if only there was a think tank to try and make these dreams a reality.

There’s no such thing as a free minimum wage hike

Paul Kirby, who was head of the No. 10 Policy Unit until last year, has a long post calling for a “dramatic, historic increase” to the minimum wage, bringing the levels from the current £6.10/hour to £10/hour in London and £8/hour in the rest of the country. It’s a bold post, but ultimately most of his arguments fail. In this post I try to address the key points he makes in favour of a hike.

Low wage earners are, overwhelmingly, providing services for domestic consumers within the UK economy. They work in shops, cafes and hotels. They cut our hair, they clean our houses, they look after our kids and they care for our elderly.  They are not  in manufacturing, competing on the price of their labour with other countries. What they do has to be done in this country. Nor is it tradable with other countries. If the Minimum Wage increases, it impacts equally on all of an employer’s competitors, so there is no disadvantage.

Even though nobody can switch to a cheaper hairdresser in India, they can get their hair cut less often, or have their homes cleaned less frequently, or send their children to creches with fewer minders per child or their parents to care homes with fewer carers. Kirby is assuming that demand for domestic services is inelastic – that is, it does not change much according to price. Obviously, this may differ between different services, but in without evidence to the contrary (Kirby gives none) it does not seem reasonable to assume that people’s demand for services will stay the same even if the prices of those services rise.

Bear in mind that a minimum wage increase would only affect the bottom of the market, where you would expect customers to be the most price-sensitive. The economic evidence suggests that increases in the minimum wage lead to slower job growth, particularly for young workers and in industries with a high proportion of low-paid staff.

Raising the lowest wages does not mean that employers simply have to, or will, just cut jobs or working hours to keep the wage bill constant. The evidence is clear that employers find a variety of solutions.  Firstly, they restrain pay growth for their better paid staff. Secondly, they increase prices to consumers. Thirdly, they improve productivity and get more out of each hour that they are paying for. And then they squeeze their profits. Through productivity gains, they either earn more revenue or cut the amount of labour they need.

Employers do not try to ‘keep the wage bill constant’. They try to make a profit on the labour they hire. If hiring an extra manager led to extra profits, it wouldn’t matter that doing so also increased the overall wage bill. A minimum wage imposes a price floor on labour, so any worker whose total productivity is less than the minimum wage floor represents a net loss to their employer – which a profit-maximising firm will respond to by firing the worker. It makes no difference whether or not that firm has ‘restrained pay growth’ for its other workers: if an employee is loss-making at the lowest wage a firm can pay them, a profit-maximising firm will fire them. (Or simply not hire additional workers who would be loss making on net.) Even if firms can only tell the average productivity of their workers, because of information problems, they will demand less labour in total.

On the possibility of raising prices to make the worker profitable, see the previous point: if demand for the service is price inelastic, this might work, but it’s quite a claim to say that this is the case for most minimum wage-supplied labour.

Wages are not the only cost of labour to firms, either. Firms may reduce costs in response to minimum wage increases by cutting back on perks like lunch breaks and sick leave, as Starbucks did after it agreed to pay additional corporation tax in 2012.

Increasing low pay has a limited impact on the overall costs of most businesses. In some sectors, very few earn less than the living wage, e.g only 6% in manufacturing. Even in hotels and catering, which is one of the biggest sector for the Minimum Wage, only 17% of jobs are below the living wage and raising the Minimum Wage to the Living Wage would only add 6% to the wage bill. This is the highest impact for any sector. More importantly, labour is only a proportion of all costs, e.g. 25-35% for restaurants.

Is a 2.1% increase in costs for labour-intensive firms not something to be concerned about? The fact that ‘most businesses’ would not be affected seems beside the point. (The reverse of this is true too: if Kirby’s other points were correct, would his suggested minimum wage hike be a bad idea because it would affect “only” 17% of workers?)

There is no real evidence of any minimum wages in the world adversely effecting employment levels.

This is totally wrong. In 2006 Neumark and Wascher reviewed over one hundred existing studies of the employment impact of the minimum wage. Of these, two-thirds showed a relatively consistent indication that minimum wage increases cause increases in unemployment. Of the thirty-three strongest studies, 85 per cent showed unemployment effects. And “when researchers focus on the least-skilled groups most likely to be adversely affected by minimum wages, the evidence for disemployment effects seems especially strong”.

Few people stay on low-wage jobs for their whole lives: minimum wage work is usually a stepping-stone to something better where employees can acquire human capital. There is evidence that suggests that minimum wages deter young workers from acquiring these skills that allow them to get better jobs in the long run. Note also that minimum wages have been used explicitly to kick away the ladder for minorities: by whites in pre-Apartheid South Africa; by anti-Hispanic campaigner Ron Unz in California; and by, er, Polly Toynbee in a recent Guardian column.

Tyler Cowen reminds us to make sure our views of sticky wages and minimum wages are consistent: if “worker-imposed minimum wages” (sticky wages) lead to unemployment, as most Keynesians (among others, including me) believe, why would “state-imposed minimum wages” not also do so? (“Have you no respect for the law (of demand)?”, asks Will Wilkinson.)

Given that we know that minimum wage increases usually cause some unemployment, why take this chance when we could just give money to poor people directly? As we’ve been saying for years, the difference between the current pre-tax minimum wage and the post-tax “living wage” is roughly as much as a minimum wage worker pays in income tax and national insurance: in other words, if that worker didn’t pay tax, they would be earning a living wage. It looks as if the personal allowance will soon rise to the minimum wage level, but the national insurance contribution threshold needs to rise too.

But let’s go even further: if we replaced the tax credit and welfare systems with a Negative Income Tax (or Basic Income – call it whatever you want), we would top-up the wages of low-paid workers directly. Jeremy Warner calls for this in the Telegraph today, and I outlined something similar a few weeks ago. Yes, I’d like all the standard supply-side deregulations as well, but a Negative Income Tax would act as an insurance policy against the potential down-sides of such deregulations, strengthening workers’ bargaining power and addressing the fears of those who worry that deregulations will hurt some workers.

I understand that many Conservatives are coming to see a minimum wage hike as a political ‘free lunch’ – a popular and surprising way of showing an interest in the welfare of the poor that does not affect the government’s balance sheet. I hope this is not true. Contrary to Kirby’s claims, there are good empirical and theoretical reasons to think that raising the floor on the price of labour will cause more unemployment. And unemployment destroys lives. There are lots of things we can and should do to help the poor right now. Raising the minimum wage isn’t one of them.

The ideal welfare system is a basic income

The British government spends more on welfare than it does on anything else apart from healthcare. The benefits system is arcane and unwieldy, a mish-mash of disparate attempts to address different social problems in a piecemeal fashion. It creates perverse incentives for those on it, such as people stuck in a ‘benefits trap’ where they lose almost as much money in benefits by working as they are earning, and distorts entire markets by inflating prices, as housing benefit does to the housing market.

Most people agree that the system is broken, though solutions differ. The Universal Credit is a fundamentally good idea that is failing because of the difficulty of implementing successful piecemeal reforms to a system as complicated as benefits in the UK, and will ultimately probably not succeed in the way its architects intend because it doesn’t go far enough. Other aspects of the government’s welfare policies, like the work programme, are completely wrong-headed – telling other people how to live their lives is a bad idea because the government is extremely ignorant. That ignorance doesn’t change just because the person being told what to do is on benefits.

The ideal welfare system is a basic income, replacing the existing anti-poverty programmes the government carries out (tax credits and most of what the Department for Work and Pensions does besides pensions and child benefit). This would guarantee a certain income to people who have no earnings from work at all, and would gradually be tapered out according to earnings for people who do have an income until the tax-free allowance point, at which point they would begin to be taxed.

For example, we could set a basic income of £10,000/year by using a cut-off point of £20,000/year, and withdrawal rate of 50%. The basic income supplement would be equal to 50% of the difference between someone’s earnings from work and the £20,000 cut-off point. A person with no earnings would get a basic income of £10,000/year; a person who earned £10,000/year would get a supplementary income of £5,000; a person on £15,000/year would get a supplementary income of £2,500; and a person on £20,000 would get nothing (and begin paying tax on the next pound they earned).

These numbers are representative: no need to tell me that £10,000 is too low or too high. What matters is the mechanism.

This has also been called a Negative Income Tax, usually by advocates on the right like Milton Friedman, but language aside the concepts are basically the same. As a side-note, I think basic incomes that are not tapered out are a complete waste of money, redistributing lots of money to people on high and middle incomes unnecessarily. It amazes me that this anti-progressive approach seems to be popular among some on the left. The exception would be if this flat-rate payment replaced the entire welfare state, as Tim Harford mentions in his column today and Charles Murray proposed some time ago.

Like the current benefits system, this would provide a safety net. But ‘benefits traps’, where people lose as much in benefits as they earn from work, would be eliminated. A basic income system like this would be at least as clear as the PAYE income tax system is, and substantially clearer than the current benefits system. The dog’s breakfast of welfare schemes that currently exist – all to address the symptoms of poverty, rather than the root – would be abolished, and with it the jumble of unanticipated and often undiscernable interactions between schemes that lead to perverse outcomes.

Best of all, a basic income is the least paternalistic welfare scheme possible. Instead of pushing would-be computer programmers into work as Poundland assistants, a scheme like this would leave decisions entirely up to the individuals involved. The discovery process that each of us is engaged in would continue, and now without mass decision-making by a central state authority.

I don’t know what amount a basic income like this should actually be set at. That would be an interesting and useful debate — what do we need for a basic standard of living? What appeals to me is the principle. Ditching most of the DWP, creating a welfare system that never discourages work, and letting people live their lives as they choose? Now that’s a welfare programme I could get behind.