The concept of an Effective Flat Tax was introduced in the NSB Major Reform Proposals: RSA+HSA+EFT.

The Effective Flat Tax (or EFT) is a critical piece of the 3-piece NSB reform plan. This is because, when integrated with Retirement Savings Accounts (RSAs) and Health Savings Accounts (HSAs), a completely flat “tax & save” rate is achieved as seen in Table 1. The effective tax rate, where effective means that the perceived rate that money is withheld from each worker, is the same for everyone regardless of income.

Economists refer to the tax rate that you pay for the next dollar that you earn as your marginal tax rate. Depending on your income, your marginal tax rate can vary considerably. For example, if you make $14,000 per year you pay about a 2% tax on your next dollar earned. If you make $90,000 per year you pay a 40% tax on your next dollar earned.

This creates a set of bizarre incentives. Outside of the tax code and other government interventions into people’s lives, Adam Smith’s invisible hand is at work: Market forces create incentives for self-interested people to better themselves economically. But the income tax code, with these odd variations in marginal tax rates, interferes with these market forces. The tax code creates speed bumps in the path to upward mobility for citizens, especially the poor.

Low income workers get tax credits through the program called the Earned Income Tax Credit. Via the EITC, the lowest income workers actually have a negative marginal income tax rate. The government pays these workers tax money (a credit) rather than visa versa. As you make more, they pay you less. Thus, your marginal tax rate rises rapidly as you make more per Figure 1 below (Figure 1 is from the new tax study from AEI).

Rapid increases in the marginal tax rate, as you increase your income, discourages work. For low income workers, the more you make the higher your marginal tax rate gets. At a certain point, rather than get a tax credit, instead you have to begin paying taxes.

The lowest income workers experience a change in the marginal tax rate from -40% to +20% when going from incomes of roughly $5000 to $25,000. Steep increases in marginal tax rates, as your income increases, result in negative incentives toward earning more. This incentivizes low income workers to work less hours, work less hard to gain raises, and work less diligently to build a good work record. These are the exact opposite of the key behaviors that they need to better themselves economically.

Since the late 1960s, low income Americans have been steadily losing ground by nearly every social indicator. Labor force participation rates have dropped, unemployment has gone up, out-of-wedlock pregnancies have risen steadily, single parent households have become widespread, and crime in the inner cities is a nightmare.

The welfare state has grown steadily since the Great Society programs were launched in the 1960s. And as funding for them grew rapidly, all of the social problems that they were supposed to address have gotten worse, instead of better. Policy makers, and especially liberals (let’s refer to them as welfare-liberals in regards to social policies) have been feckless in attempts to remedy these problems with adjustments to the anti-poverty welfare state. To them, it seems that if we just added a few more well-designed welfare programs, then these problems will start to fade away. (On the contrary, the most promising policy of the last three decades has been the recent welfare reforms that place time limits on how long a recipient can receive certain welfare benefits.)

If you put in place programs to solve problems, and the problems actually get worse - how can you ever define when a program is worthwhile? Operating on the principle of blind faith - that these programs are actually doing some good - is no way to formulate government polices. These are real people’s lives that policy makers are monkeying with, not lab rats.

One of these welfare programs is the EITC. It started in 1975 as a new way to efficiently and directly give money to low income workers; it just uses the IRS to send them checks. It is now the largest federally funded anti-poverty welfare cash assistance program in the US. Concerns about the rapid increase of marginal tax rates negatively impacting the life decisions of poor people have been downplayed or ignored. The social engineers were confident that this was not much of a problem - just like they were (and still are) confident that the total collection of anti-poverty welfare programs has no significant negative impact on the lives of the poor.

The EITC, for low income workers, creates what researchers call a “negative substitution effect”. People cut back work hours to get the EITC cash benefit. In the process they substitute cash that they would have earned from work with a government subsidy. But by being a less productive worker, they damage their long term prospects toward upward economic mobility. It diminishes their skill development and value as “human capital” in the marketplace.

Furthermore, the EITC contains significant marriage penalties. If two working people marry, they may lose their EITC income. Undermining families, and creating more single parent families, is the most devastating problem caused by the anti-poverty welfare state. Single parent families are the leading cause of poverty in the US.

The degree to which the anti-poverty welfare state has hurt the poor is still a hotly debated topic. Liberal sociologist Peter Rossi distilled his vast experience in evaluating programs into what he called the Iron Law of Evaluation: “The expected value of any net impact assessment of any large-scale social program is zero.” So, that leads us to one view: they are just a big waste of time and money.

But another view is that these welfare programs cannot be declared innocent because the funding of these programs was exactly coincident in time with all of the spreading problems among the poor. And as the funding increased, the problems got worse. Those that argue that these programs are of significant net benefit to the lives of the poor would seem to have an uphill battle. None the less, these programs are all on auto-pilot, silently motoring along with vast accumulated inertia.

You can debate to what extent marginal tax rates and welfare state benefits jointly create perverse incentives for the poor. But one way to end the debate and concern about the impact of steep changes in marginal tax rates, as low income workers earn more, is to simply implement a policy where everyone has the SAME effective marginal tax rate.

This will clearly end any perverse incentives acting on the poor that impact their motivations toward upward mobility. If anything is needed in US social policies toward the poor, it is to begin taking the guesswork out of whether policies work or not.

As mentioned in the NSB Major Reforms, one benefit of these reforms is that universal health care coverage is achieved by way of mandatory Health Savings Accounts (HSAs). So instead of getting EITC cash, that has a negative influence on work and marriage, the poor instead get health care coverage that they can count on - and they do not lose it if they make too much money (unlike Medicaid). And HSAs do not include any of the work or marriage disincentives of the EITC.

The underclass is growing steadily in America, and this should be a major concern. Single parent families and welfare dependency (remember the EITC is key part of the welfare system) is a growing problem, and not just among blacks as many people think. Hispanic communities in cities are now experiencing the same problems and whites may not be far behind. In the welfare-heavy UK, the white underclass is becoming a major problem. Crime in the UK, primarily by whites, has now surpassed the US crime rates.

Will America not try to seriously deal with these problems of cultural decay spreading among low income Americans? This decay may begin significantly spreading into the middle class. Sweeping these problems under the rug is not a solution. Simply putting more of the underclass in prison has been one effective strategy, but that is no kind of long term solution. Will we not try to reverse the perverse set of incentives that the government has put in place, incentives that evidence tells us is destroying normal family life and continues to rip up the social fabric in poor communities?

Even if we are unsure how to reform or cut back all the various programs of the welfare state, one solid first step of reform is to completely flatten the effective marginal tax rate for everyone, regardless of income. This can be achieved by the NSB proposal of the Effective Flat Tax.

The clock is ticking. America had better stop ignoring these problems soon, or our grandkids may inherit a depressing place where social decay exists on a grand scale.

This entry was posted on Sunday, May 15th, 2005 at 12:03 pm and is filed under Health Savings Account (HSA), Social Security, Taxes and a Flat Tax. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site. For Trackbacks to this post, use URL: http://nospeedbumps.com/wp-trackback.php?p=146