Back to Dmytro Taranovsky's home page
Economics Term Paper
Last Modified: May 10, 2001
Submitted to Mr. Chitale for class Principles of Economics-Micro
at Howard Community College
The United States of America is a rich country with gross domestic product per person (GDP per capita) equal $26,980 as of 1995 (Case and Fair, page 522). However, many people live in poverty, and some are without homes. The government (both federal and state) pursues an inconsistent policy of rhetorically encouraging work while at the same time paying welfare to only those who do not earn much money from work, and by spending much of its budget on transfer payments, yet not giving any money to some homeless people. The paper resolves the inconsistency by providing a system that encourages useful work while reducing and eventually eliminating poverty.
Economic cost to a person of an action is a measure of decrease of pleasure needed to achieve the action. Cost includes non-monetary items such as tiredness from being at a job.
Many taxes are paid for the income. The amount a worker receives after all taxes are paid is called disposable income. The amount of money employer pays for employment (including all taxes) is called payroll expense. Total income tax is payroll expense minus disposable income. FICA taxes, although not officially called "income tax", from economical point of view have the effect of an income tax. Because of deductions and exemptions, poor people usually do not pay the official income tax. However, they pay 6.20% of their income as the social security tax and 1.45% as Medicare tax for a total of 7.65%. (Source: "2000 social security") Not appearing on a tax form for the employee is the matching contribution of the employer (7.65% of the income of the employee) for a total of 2*7.65%/(100%+7.65%)=14.2% of the payroll expense.
This tax and not the formalities of to whom the tax is assigned matters because the employee cares primarily about the net money he/she receives, and the employer cares (holding worker quality to be fixed) primarily about the net amount of money to pay.
Marginal income tax rate can be defined as the additional income tax divided by increase in income. If such definition were used, marginal income tax for the poor would be about 15%, which is quite low.
However, such calculation does not count the loss of welfare benefits to the person. In real terms, marginal tax rate is 1-(change of total economical income due to work)/(change in payroll tax expense). Because the total income is much more relevant than the distribution of income by source, the definition in this rather than the previous paragraph should be used.
Income is best defined through the equation: increase in net worth = income -consumption. Net worth is assets (not counting one's body) minus liabilities. Consumption refers to all spending including waste. (Case and Fair, page 433)
Defined this way, income includes welfare benefits such as social security receipts, temporary assistance to needy families, unemployment compensation, reduced medical cost due to Medicare and Medicaid, need-based public housing at sub-market costs, food stamps, and college need-based financial aid.
Welfare benefits that are not monetary still provide subjective utility and, thus, are counted. For example, while food stamps are not dollars, they provide food, and families that have enough food can simply sell the stamps to obtain monetary income. Unfortunately, benefits that are not monetary are frequently not neutral and can, thus, adversely affect choices made by poor households. For example, a household can select public housing even when a private apartment is more suitable because public housing is subsidized while the government does not subsidize private housing.
For the participants in public housing, rent is about 30% of their income. ("Basics of Public Housing") Thus, it provides a 30% real marginal tax rate for those who select it (the poor people).
Food stamps supply cost of food for poor people. The benefits are computed based on income: 30% of net income (gross income minus 20% deduction and some other deductions) is spent on food. (The stamps are supposed to cover the difference between the actual cost and this value.) Thus, food stamp program provides 30%*(1-0.2)=24% income tax. If salary increases by $100, benefits decrease about $24, which is the same as tax increase by $24. Despite the financial discouragement of work by food stamps, work (any type will satisfy) is a requirement for most of food stamps distribution. Source of data: "An Introduction about the Food Stamp Program".
Based on the data, real marginal tax rate is (2*7.65%+24%+30%)/(1+7.65%) = 64.4%. Thus, the regressive nature of welfare spending creates high real marginal tax rate for poor people. The calculation does not include some "welfare" benefits, Medicaid benefits, need-based college financial aid, and other factors that increase the rate. Some of the benefits are under condition of searching for work: While the government discourages income from work (see below for explanation), much of the aid is cut off for failing to find a job in a timely manner.
An institution that acts as welfare system (though it is not usually recognized as such) is the prison system. Criminals (many of whom are not eligible for normal welfare payments) are sent to prison where they have to be provided (according to the Supreme Court) adequate nutrition, living arrangements, and proper medical care. Lack of proper welfare system combined with a good prison system encourages crime for poor people. Crimes are inefficient for the society. Moreover, prisons are inefficient because inmates are not allowed to leave even when the society would benefit from such action. A guaranteed minimum income for those who are not prisoners will reduce the incentive to commit crimes and, thus, will reduce crime.
The high real marginal tax rate creates inefficiency by distorting the decision on whether to work. Ideally, a person should work if the opportunity cost of working is less than marginal revenue product of the job. A person will be hired if and only if additional payroll expense (MPE) is less than marginal product revenue (MRP): MPE<MRP; in other words, employers will hire when the benefits of hiring exceed the costs. A person will work more if and only if marginal income (MI) is greater than marginal opportunity cost of the job (MC): MI>MC. (The person sacrifices leisure and rest to get a job.) Marginal income is (1-real marginal tax rate)*MPE: MI = (1-R)*MPE. Combining the equations, (1-R)*MPE>MC, MPE>MC/(1-R), MRP>MC/(1-R),
MRP/MC>1/(1-R). This equation is the condition for employment in a market system. For example, if real marginal tax rate is 64%, then 1/(1-R)=2.77, and a person will not work even if the benefit (to the employer) of work is twice (or even 2.7 times as large as) the opportunity cost of work.
The inefficiency is proportional to the amount of work forgone because of it (roughly proportional to R), and the net inefficiency per unit of work forgone (roughly proportional to R.) Thus, the total inefficiency is roughly proportional to R2.
Moreover, such rates are grossly unfair to those who work hard forty hours per week and receive only slightly more economic income than those who do not work at all. People should be rewarded for being valuable to the society.
Consequently, real marginal tax rates for low-income people should be lowered. Current accounting system for income taxes and welfare is confusing: Estimating real marginal tax rate requires several pages of economical analysis, and people are typically misled by the 'official' income tax rates. The system should be simplified as follows. Because, at cetera paribus, utility for one person is not more important than for another person, and because in a democratic government system every person has the same number of votes, welfare benefits should be given equally to all people. All taxes on income should be united into a single income tax, given to the employee.
Then, more equitable marginal tax rates should be given. For simplicity (to reduce administrative costs), to reduce tax avoidance (due to different tax rates), and for equity, income tax should be a flat rate tax. The amount of tax and welfare benefits should be selected to make government budget approximately balance. Welfare benefits should not be taxed because they are the same for all people, because taxation of welfare benefits simply reduces the effective benefits, and because making stated and actual benefits equal simplifies decision-making.
Most of the other welfare receipts should be eliminated because of inefficiency. For example, social security system for old people encourages able and productive old people to retire instead of benefiting the society through work. Medicare should be replaced by private insurance (with some regulation of medical insurance companies if needed). The money for retirement savings and medical insurance can come from the income received as welfare.
The value of the benefits should be such as to satisfy the basic needs of the vast majority of poor people. The basic needs are: sufficient food to satisfy the nutritional needs (food is cheap, a surplus of farmers exists in the USA, nutritional food improves productivity and health), clothing (sufficient in amount to prevent suffering from cold, and of sufficient quality to prevent repudiation by the public and prospective employers), housing (a small room as in college dormitories is enough), and opportunity for advancement (access to books and part-time access to computers with internet access will suffice). The basic needs are distinguished from additional wants that are not necessary. For example, a person may want Playstation 2 for entertainment but can clearly live normally without it.
To become successful adults, children need to satisfy their basic needs. For example, education is necessary for almost all jobs. Proper nutrition is needed for good health. Additionally, children are human beings and their sufferings are as important as sufferings of other people. Moreover, children are not responsible for their poverty since they should not (according to the laws) work for a living. Therefore, no efficiency incentives exist to keep children poor. No child should live in poverty. Yet, 21.2% of children live in poverty as of 1995 (Case and Fair, page 413). The reform would give children same benefits as adults and should eliminate poverty in children. The money will be allocated to the child, or to the extent the child is incompetent, to the parents; or to the extent the parents are incompetent, to the state government on behalf of the child.
Should taxes rates be progressive rather than flat because it is unfair to tax the poor as much as the rich? If the tax rate is flat, the rich pay much more than the poor-a person with yearly income $1 million pays 100 times as much as a person of income $10,000. At the same time, both receive approximately the same government services. The frequent concern above is based on the confusion between flat rate tax and flat amount tax.
Is guaranteeing at least a subsistence standard of living an incentive not to work because people will survive regardless of whether they work? A system of minimum guaranteed benefits through programs like food stamps, public shelter, and prisons already exists. It has to exist because the poor need (where the need is measured in utility rather than dollars) resources much more than the rich, and because poor have the same number of votes as the rich. The reforms proposed should increase the amount of work that people will do.
Since families will receive additional benefits if they have children, will families have too many children to obtain more benefits? As stated above, no child should live in poverty. If a woman is pregnant and the expected result (a child) is desirable, then the woman made the right choice, even if for the wrong reasons. If the expected result is undesirable, the woman should be forced to have an abortion to prevent the undesirable result and, thus, improve the society. Such policy (or a good alternative to it) will fully address the concern. It should be implemented gradually to avoid controversy.
Will the reforms provide money for people to use drugs? (Drug, as used in this paper, is a substance that not only harms its user, but that can make the user addicted to it.) A solution to give benefits under a condition not to use the drugs is cruel because most addicts are psychologically unable to stop usage. Instead, the government should force all drug addicts to undergo treatment. A proper treatment program will save hundreds of billions of dollars for drug usage and fully address the concern.
Will the redistribution program increase size of the government and cause bureaucratic inefficiency? On the contrary, some government programs will be eliminated, and welfare will be streamlined as providing money to the poor. Simply writing checks to people does not require many government workers.
Will the reform greatly increase total government spending? The welfare benefit is in place of other programs and, thus, the required increase in government spending is not too large (currently half of government budget are transfer payments; that part will be replaced). The increased efficiency and the reduction of poverty will cause people to work more (and, thus, pay more taxes). The change will allow increased government spending to coexist with lower tax rates without budget deficits.
Will replacing the transfer programs with a single program eliminate useful functions of the government? The transfer programs are like the proposed program plus inefficiency. However, one of the most important functions of government is to subsidize activities (such activities are called positive externalities) where cost is smaller than benefit to the society but larger than revenue to the firm. That function will remain fully intact. Part of its funding will come on negative externalities-if marginal cost to the society of making a product is greater than marginal cost to a firm, the firm should be required to pay the difference as tax. Such tax will reduce usage of harmful products.
Can the reform have unpredictable results? The reform should occur gradually to determine the optimal welfare system without risking a depression. Gradualism will allow precise determination about which current welfare programs should remain.
The government should set up a single flat rate income tax (in addition to taxes on land and negative externalities). The tax should be used to supply welfare payments equally to all people, and to fund positive externalities (including public goods). The welfare will promote efficiency and will reduce human suffering. In several decades, it should cause elimination of poverty in the United States and eventually full satisfaction of basic human needs on Earth.
"2000 Social Security FICA Tax Rates". Online. Internet. Accessed: May 5, 2001. Available: http://fsc.fsonline.com/portal/ss-2000.html
"An Introduction about the Food Stamp Program". Online. Internet. Accessed: May 7, 2001. Available: http://www.fns.usda.gov/fsp/MENU/ABOUT/ABOUT.HTM
"Basics of Public Housing". Online. Internet. Accessed: May 1, 2001. Available: http://www.law.emory.edu/PI/ALAS/pubbasics.html
Case, Karl E., Fair, Ray C. Principles of Microeconomics. Fifth Edition. Upper Saddle River, New Jersey: Prentice Hall, 1999.