Negative Income Tax For Dummies

Personal Allowances

The UK income tax system ostensibly gives all income tax payers an identical allowance which exempts the first slice of an individual’s market income from income tax. This exemption is known as the personal allowance and is set by parliament each year. For the current year it stands at £11,500.

Basic Rate (20%) Tax Payers

The personal allowance typically reduces the amount of income tax a basic rate tax payer must pay on their market income by £2,300 pa. However, if a basic rate tax payer’s market income is below £11,500 p.a. they do not receive the full benefit of the annual personal allowance. This is arguably a weakness with the UK’s current income tax arrangements.

Example

Susan earns £10,000 p.a. Her tax-free personal allowance is £11,500 p.a. This means she currently pays no income tax and her disposable income (ignoring her National Insurance Contribution) is £10,000.

Comment

If Susan had no personal allowance she would have paid income tax of £2,000 (£10,000 x 20%).  The personal allowance has saved Susan £2,000. Had Susan earned £11,500 in the year she would have saved £2,300 in income tax. Because she had only £10,000 of income to offset against her personal allowance of £11,500 Susan has £1,500 of unused personal allowance remaining. In the UK personal allowances can not be carried forward to be utilised in following years. Nor can personal allowances normally be transferred  to someone else or be traded –  it’s a case of use or lose.   

Is there a better way of administering income tax whereby surplus personal allowances would not be wasted if they remain unused at the end of a tax year? An answer to this question is “Yes, negative income tax”.

Negative Income Tax

Giving a taxpayer an annual personal allowance of £11,500  costs the government up to £2,300 in lost tax revenue. In Susan’s case, because her market income is below £11,500, the cost to the government of Susan’s personal allowance is £2,000 in lost tax.

Negative income tax departs from the current income tax system by paying out the value of the personal allowance (the tax shield) in cash to each and every qualifying citizen. To  help fund this apparent largesse, income tax would be collected and calculated without reference to personal allowances.

In Susan’s case, income tax of £2,000 would be deducted by her employer and remitted to HMRC. Susan’s net pay from her employer would therefore be £8,000.  Susan, along with all qualifying citizens, would receive from HMRC an annual amount equal to the value of her tax shield (£11,500 x 20%)  The following table summarises:

Tables

At the year end Susan’s income is £300 higher than her gross market income. This £300  is the value of her surplus personal allowance (£1,500 x 20%). So effectively Susan has been allowed to claim back the value of her unused personal allowance as a “refund” from HMRC. 

Cost

In Susan’s case, HMRC has paid out to Susan £300 more than she has paid to HMRC. So HMRC has a deficit while Susan has a surplus. So how will HMRC fund its deficit? 

Firstly, because Susan is on a low income there is a probability that she is on a means tested benefit, such as the dreaded Universal Credit, to augment her low market income. The benefits agency (DWP) may reassess Susan’s financial circumstances and adjust her award to take account of Susan;s additional source of non-market income. So the government may claw back all or part of Susan’s increased income to eliminate its deficit at HMRC.

Secondly, although Susan has a surplus with HMRC, many taxpayers will have a deficit. It is only qualifying citizens with market incomes below £11,500 who will be receiving more from HMRC than they pay in income tax.  Many taxpayers will be paying income tax far in excess of the £2,300 they will be receiving each year from HMRC. Deficits and surpluses would offset  each other

Purposes of Negative Income Tax

Firstly, to make the income tax system fairer. Currently, those with a market income of above £100,000 do not receive a personal allowance. Introducing a non-means tested negative income tax would enable policy makers to restore the tax shield to high income recipients. 

Secondly, to provide an enhancement to low incomes,  albeit a modest one.

Thirdly, to give every qualifying citizen a guaranteed, obligation-free income, although a small one. It should help individuals to better absorb and weather the shocks that humans are heir to, including those shocks administered by DWP.

Unlike Universal Basic Income (UBI), the purpose of NIT is not to replace contingent benefits, although some means’tested benefits may be reduced as a consequence of NIT’s introduction.

Qualifying Criteria

Every natural person of working age AND registered to vote in UK elections should qualify, irrespective of income. Qualifying individuals would include job seekers, students, disability benefit claimants, employees, self-employed persons, stay-at-home parents, rough sleepers, and prisoners (subject to voting rights). People of state pension age would be excluded.

Summary and Conclusions

The aims of the particular NIT scheme discussed are modest. The scheme is specific to the UK’s income tax system. The scheme provides an opportunity to equalise treatment of different income groups in respect of the operation of personal allowances, otherwise referred to as a tax shield. The parameters of the proposed scheme, that is the NIT rate and the size of the personal allowance, are under the control of the UK parliament and can be altered to suit. The scheme shares features of Basic Income, eg, it is obligation-free, it is not means tested, its coverage is universal (subject to fraud safeguards), and it supports active enfranchisement of disengaged voters. It also provides a small cushion against  loss of income and failure of the social security system. Although modest, the benefits would be real and in excess of its costs. 

Appendix 

The impact of Negative Income Tax on higher and additional rate taxpayers

Higher Rate (40%) Taxpayers

 

Example

Stephen has an annual market income of £80,000

Stephen 1

Stephen 2

Stephen would pay £2,300 more under this particular NIT scheme than he does under the current income tax system. This is because HMRC is paying out at 20% x £11,500 while the lost personal allowance brings in 40% x £11,500 to HMRC.  HMRC is in surplus.

 

Additional Rate (45%) Tax Payers

For annual incomes above £150,000 the income tax rate rises to 45% and no personal allowance is available. 

Example

Frances has an annual market income of £170,000

Frances 1

 Frances 2

Frances would pay £2,300 less under this particular NIT scheme. This is because in the current income tax regime taxpayers with market incomes above £100,000 have had their personal allowances completely withdrawn. The receipt of NIT of £2,300 from HMRC consequently would reduce tax payable in cases such as this. 

Image

Basic Income and Welfare

Background

A recent Guardian piece by Declan Gaffney asserts that a Universal Basic Income could not replace the UK’s social security (or welfare) system. The piece can be read here:

http://www.theguardian.com/commentisfree/2015/dec/10/finland-universal-basic-income-ubi-social-security

A basic income that replaced the UK’s social security system would need to be so generous that it would disincentivise the jobless from looking for work. Hence a punitive social security system that relies on sanctions is necessary because otherwise the jobless will not look for work. In short, such a Basic Income would make life too comfortable for the lazy and workshy.

Well perhaps this is true. given Declan’s assumption of a universal and unconditional basic income intended to replace the social security system. Such a basic income would need to be very generous and might well have the effect that Declan fears. A valid  inference of Declan’s fine piece is that Basic Income is a nice idea but infeasible; so let’s keep means tested and contingent benefits. and rely on Universal Credit to provide the right balance between carrot and stick.

Should the idea of Basic Income be abandoned?

Given Declan’s point, that UBI could not, or should not, replace the social security system, is Basic Income simply a nice but impracticable idea?

I agree that it would be too expensive for basic income to replace all social security, at least in the UK’s circumstances. UK housing costs, for example, are far too high and would need to fall massively before a Basic Income could be anywhere near sufficient to cover housing costs. Until such time as the high cost of housing in the UK  is addressed, a system of means tested benefits for housing costs will be needed.

Similarly, the social security system also provides contingent benefits, that is benefits which compensate for disability, unemployment, old age, and child rearing. It would not make sense for a uniform basic income to be set at a level  which covers contingent costs  of minorities – it would be far too expensive. In any case, the National Insurance Fund insures against some of these contingencies via contributions.

So Declan says (and others say) that the current social security system accommodates the variegated needs of the population and that a basic income is unnecessary and inadequate. However, I do not believe Declan’s argument is dispositive.  A modest basic income scheme, that is, one which does not seek to replace all social security benefits, is a practical  and worthwhile option.

Proposal for a modest basic income

A hat tip to Mike Gist (@mgist) who suggested that I calculate the net tax liability at different income levels before and after introduction of a basic income. I have done this analysis for the tax year 2015/2016, assuming an annual personal allowance of £10,600, which, to help fund the scheme, would be scrapped. So post tax income after implementation of basic income and after scrappage of the personal allowance is being compared with post tax income before scrappage of personal allowance. Tax credits have been excluded from the analysis.

The analysis shows that no one, whatever their income level would be left worse off if annual basic income were to be set at £4,240. Below is a graph of the results.

  1. The graph shows that for market incomes of below £45k (approx) tax payers would be better off post tax after abolition of annual personal allowance under basic income of £4,240 p.a.
  2. For incomes between £45k approx and £100k, there is no gain or loss. For incomes over £100k there is a gain which stabilises at £4,240 when income reaches £120k approx.
  3. The gain for incomes over £100k arises because personal allowances are currently restricted or non-existent at this level. Scrapping the annual personal allowance as per the scheme thus causes all income levels to be treated equally with respect to personal allowances.

Basic income simulation

Other points

  1. The analysis shows that the cost of even this modest scheme will exceed the current (pre-scheme) income tax take. To establish the cost of the scheme it is necessary to know how many people will gain how much for all income groups.
  2. A basic income set at £4,240 is sufficient to replace Job Seekers’ Allowance for the unemployed, and Working Tax Credits for those in work. Hence the aggregate spend on JSA and WTC can be deducted from the additional cost calculated in point 1.
  3. The basic income would replace working tax credits without the cliff edges and complexity that the existing system contains.
  4. The graph’s U shape is caused by the kinks in the current income tax schedule, and not by the properties of the basic income scheme itself. The withdrawal rate is a constant 20%. There is thus a strong incentive for workers at lower pay rates to increase their market earnings.
  5. The scheme has been formulated with the same parameters as are used in the existing income tax regime. That is the bands and rates (20%, 40%, and 45%) on which income tax is charged are identical as those which are in current use.
  6. Some of the annual gains of £4,240 accruing to 45% tax payers (those earning more than £150k p.a.), could, if a government had a mind to, be taxed away by raising the rate to 50%.
  7. The scheme should be acceptable to the electorate since there are no losers.

Summary and conclusions

An ambitious basic income scheme, that is, one that seeks to replace all social security benefits, is probably incontrovertibly infeasible.

However, because an ambitious scheme may be infeasible this is not necessarily a good ground for rejecting the concept of Basic Income completely. A modest scheme may be both feasible and worthwhile.

A modest scheme, as outlined above, could replace Job Seekers’ Allowance and Working Tax Credits. Withdrawal rates would be at the basic rate of income tax of 20%.

A need for other social security benefits would continue. Incentives to work could be improved by addressing housing costs which are currently so high that without Housing Benefit support it does not pay people to work.

Replacing Job Seekers’ Allowance and Working Tax Credits with an unconditional basic income removes the threat of starvation (which JSA sanctions represent) as an instrument of government policy.  Starving people is wrong and most people would agree that starvation should not be used by governments as a weapon against civilian populations.

Acknowledgements

@mgist for his suggestion that inspired the analysis

@cjfdillow for his comprehensive descriptions of how basic income works.

All errors are mine.

Appendix:

Calculation of post-tax income 

Appendix Basic Income calculations.png

 

 

 

 

Beware the ideas of IDS

Introduction

I am a proponent of Negative Income Tax (NIT). I am because it can deliver social security via a basic income, because it is simple and cheap to administer, and because it is libertarian.

In this piece, I try to set out why implementing NIT in Britain does not require any radical surgery to the existing income tax system. I also point out that the disincentive effects of NIT are comparatively low. I suggest that the sanctions regime currently in vogue would be inappropriate under a fully developed NIT. I also briefly explain why the cost of implementing NIT, at least at first, is likely to be close to zero.

What is NIT?

It’s a very simple idea. For those individuals whose incomes fall below the personal allowance, the tax authority, instead of charging income tax, makes a reverse payment to top up the individual’s income. One of its original architects, Milton Friedman, thought the payment should be universal,  unconditional and be made without moral judgement. His idea was to replace complex and judgemental social security systems. The logic of income tax automatically and progressively claws back negative income tax payments when an individual’s income exceeds their personal allowance.

How would IDS and his followers view NIT?

Despite the libertarian origins of NIT, the IDS school of thought would seek to bring NIT, were it to be implemented in Britain, within the currently fashionable sanctions regime.  IDS  has already expressed his intention to bring in-work benefits within the sanctions regime. It is hence reasonable to suppose that IDS would wish a NIT system to be conditional and to include it in his beloved sanctions regime too. It is pretty clear from the high level of  coercion embodied in Universal Credit that IDS does not share the libertarian values of NIT.

How would a negative income tax look in Britain?

Surprisingly perhaps, it would look similar to the current income tax system in Britain – most people would notice no change to their income tax charge and to their net pay. Income tax, whether through deductions at source or through end of year self-assessment would operate as now,  without change to method or amount. Only individuals with incomes below the personal allowance would notice any difference.

Only a comparatively simple tweak to HMRC’s software would be needed to implement NIT. NIT would be simple, cheap and low risk to implement. Because radical surgery to the existing system would not be needed, a government should not find practical objections to NIT implementation.

So how would NIT differ from the current income tax system?

At the moment, the first £10,600 of an individual’s annual income is tax free – individuals pay income tax only on their annual income in excess of £10,600. The starting rate of tax for incomes above the £10,600 threshold is 20%. For the purpose of this explanation it is not necessary to consider the higher income tax rates (40% and 45%) as these are unaffected by NIT. In fact, NIT will make no difference to the income tax charge for anyone whose income exceeds £10,600, whether their marginal income tax rate is 20%, 40%, or 45%. Only those whose income is below £10,600 will be affected by NIT.

Example:

Freda’s annual income is £8,000.

Her tax charge under the current system is 20% x (£8,000 – £10,600) = – £520, which, because it is negative, means HMRC will not seek to collect income tax from Freda. So Freda pays no income tax and her post-tax income is £8,000.

In contrast, under NIT the negative result of -£520 produced by her tax computation  would trigger a payment to Freda of £520 from HMRC. Her post tax income would hence be £8,520 (£8,000 + £520). In effect, Freda’s wage is being topped up by the state through the tax system.

NB. 20% x (£8,000 – £10,600) can be written as 20% x £8,000 – 20% x £10,600

So why not stick to tax credits currently operated by HMRC?

The NIT calculation is very simple and should logically be preferred to the complex strictures and administrative expense of the tax credit schemes currently operated by HMRC. A further point is that IDS’s intention is to bring in-work tax credits into the benefits sanction regime via Universal Credit.  This will add further complication to an already over-complicated system.. An NIT could ease the burden on Universal Credit, which is already creaking under the weight of its own complexity. The implementation proposed here is modest and cautious. Over time, increasing confidence would hopefully impel a government to implement NIT comprehensively, perhaps with a view of complete replacement of other social security benefits.

Would a negative income tax have disincentive effects?

IDS et al hold that low income earners are discouraged from increasing their earned incomes because they are in receipt of tax credits and other means tested benefits. Increased use of sanctions (the withdrawal of benefits) has been IDS’s chosen method of countering these putative disincentive effects.  NIT would be perceived by IDS to have disincentive effects given the evidence. IDS et al would thus argue that receipt of NIT should be conditional and subject to sanctions should a recipient be perceived as “free-riding” on the revered tax-payer. IDS is not a libertarian.

The withdrawal rate, (the amount by which the state top-up is reduced for each additional £ of income) is  equal to the 20% starting rate of tax. This is far lower than the 65% withdrawal rate aimed for by Universal Credit. The NIT implementation proposed here thus compares favourably to IDS’s Universal Credit.. This suggests that sanctions should not be necessary to “motivate” NIT recipients to increase their incomes

How much would NIT cost?

Confining NIT (at least to start with) to recipients of market incomes and to pensioners then the answer is not much. This is because their benefits and tax credits would be reduced by the amount equal to the NIT payments received by them. NIT would be payable only where market incomes and pensions fall below £10,600, so many people would not be NIT recipients, The total social security bill and tax take would be identical as between the current arrangements and NIT.

So why implement NIT then?

A modest and cautious implementation has been recommended here so that the costs and risks of failure are low. Over time, more benefits of NIT can be captured. These benefits include

  1. reduced administration costs;
  2. better incentives;
  3. increased flexibility;
  4. a basic income;
  5. simplicity;
  6. reduced benefit costs;
  7. a more constructive role for DWP;  and
  8. less state coercion

Using the tax system to deliver a living wage

In a previous post, I proposed a formula for calculating income tax that would provide for a  negative income tax. I did so because I believe a negative income tax system would be simpler, fairer, more humane, technically more feasible , and cheaper to develop than the current Universal Credit project being rolled out by Her Majesty’s government. A negative income tax would be administered by HMRC and have at its core the following formula for calculating income tax:

T(n) = m∑Y(n) – c∑H(n) – ∑T(n-1)

where

m is the single marginal tax rate;

c is the hourly value of the tax shield

∑Y(n) is the cumulative market income received by the end of period n

∑H(n) is the cumulative hours worked by the end of period n

∑T(n-1) is the cumulative income tax paid by the start of period n.

Comments

The proposed tax system has a single marginal tax rate. The choice of this rate is a political as well as a technical decision (i.e., achieving the desired behavioural effects) An individual’s hourly tax-free pay is given by the grossed-up tax shield (c / m).

In this post, I want to show how a negative income tax system can deliver what many describe as a “living wage”. The figure of £10 / hour has been mooted as a living wage. I shall hence assume this figure for the living wage  in my illustration.

Prologue

In this post, I will incorporate the UK’s national minimum wage (NMW), currently £6.50 per hour, into the model.

I will also use a marginal tax rate of 40%, a tax rate which is both comparable to and competitive with existing UK income tax rates (20%, 40%, and 45%). Hence m has been set to 40% or 0.4 in my illustrations.

I will assume a working week of 35 hours and an individual’s weekly hours will be capped at this level.

I will also show how the model can be used to generate a basic income. I will briefly set out my views on whether a basic income should be conditional or unconditional.

Calculating the tax shield

In this section, I will show how negative income tax can transform the minimum wage of £6.50 / hour into a living wage of £10.00 / hour.  To achieve this, the value of the tax shield (c) must be calculated with reference to the minimum wage and to the living wage of £10.00. The value of the tax shield (c) must be set so that the hourly negative tax payment makes up the difference of £3.50 

Ignoring the summations in the above f ormula (they are not necessary here), we have

T = m x (£6.50) – c = – £3.50

T= 0.4 x £6.50 – c = – £3.50

c = £6.10

The tax formula that transforms the hourly national minimum wage of £6.50 to an hourly living wage of £10 will thus be

T(n) = 0.4 x ∑Y(n) – £6.10 x ∑H(n) – ∑T(n-1)

or on a week 1 basis, the hourly tax charge will be:

T = 0.4 x £6.50 – £6.10

= – £3.50 (negative,  as required)

Illustration

Lenny earns the adult minimum wage. He works 35 hours per week. His pay slip will show:

Market income (35 hours x £6.50/hour)                                       £227.50

Negative income tax  (35 hours x £3.50)                                     £122.50

Take home pay (35 hours x £10 hour)                                         £350.00

 

Lenny now receives £10 per hour.

Incentives

The hourly post-tax income of someone whose market income is £10 would be transformed to £12.10.

T= 0.4 x (£10.00) – £6.10 = – £2.10 (negative)

Hence that individual would take home £10 – (- £2.10) = £12.10 for every hour worked at or below the 35 hour weekly cap on hours. So although the “differentials” between market incomes have narrowed the higher paid worker still receives more per hour than the minimum wage worker.

Tax free allowance

The break-even hourly income with an hourly tax shield of £6.10 and a marginal tax rate of 40% is £15.25. This means a worker with an hourly income of £15.25 will neither pay income tax nor receive a tax payment. This is equivalent to an annual tax free allowance of £27,755 (compared to the current allowance of £10,000 p.a.). Individuals with a a market income of above £15.25 per hour or £27,755 per annum would pay income tax of 40% on the excess.

Basic income

The parameters used in the formula produce an amount 0f £6.10 per hour for those who have no market income. This could be taken to be a basic income payable to anyone whose market income is zero.

T = 0.4 x £0.00 / hour – £6.10 / hour

= – £6.10 per hour (negative)

The issue is whether this fortunate by-product of negative income tax should be conditional or unconditional.

Unconditional basic income

An unconditional basic income would credit every citizen with 35 hours. The basic income would thus be received by every citizen of working age.  The basic income would amount to £213.50 (35 hours x £6.10 per hour).

Hourly income with unconditional basic income and living wage of £10/hour

Hourly income with unconditional basic income and living wage of £10/hour

Conditional basic income

A conditional basic income would credit some groups with 35 hours a week but not others. For example, the disabled, the infirm, and those with caring responsibilities could be credited.  This would automatically trigger a payment at HMRC of £213.50 to individuals falling in these groups. The unemployed would be credited with hours only to the extent of their hourly contributions to society via voluntary work and / or participation in counter hysteresis activities (such as internships, work placements, or work programmes).

Hourly income with a conditional basic income and a living wage of £10/hour

Hourly income with a conditional basic income and a living wage of £10/hour

Conditional or unconditional basic income?

My main concern is that every UK citizen should have access to honest and adequate income. For disadvantaged groups, income accessability, particularly with increased benefit conditionality, can often be an issue.

Provided plentiful opportunities for voluntary work and / or opportunities to engage in counter hysteresis activities are made available to physically and mentally capable individuals without a market income then basic income should be conditional along the lines described above. A reasonably generous income of £213.50 per week would accrue to such individuals if their engagement in these activities was for 35 hours a week. Lesser contributions would be rewarded proportionately.

Summary of the model

Basic income = £6.10 /hour. May be conditional or unconditional. Could replace unemployment benefit.

Minimum wage (statutory)  = £6.50 / hour.

Living wage (assumed) = £10.00 /hour.

Break-even wage = £15.25 /hour.

Marginal tax rate = 40%

Maximum hours of credit = 35

Some final points

The withdrawal rate for someone transiting from unemployment to minimum wage work is about 43% (0.4 x £6.50 / £6.10). This is substantially better than the proposed withdrawal rate of 65% planned for Universal Credit.

However, the withdrawal rate rises as the starting hourly wage rate rises. At a starting rate of £15.25 per hour the withdrawal rate is 100%. It is unlikely that such a high withdrawal rate would be a disincentive to accept work at this wage rate.

It seems likely that a negative income tax designed with the parameters outlined in this post would lead to a lower overall income tax take for the government. Some of this might  be due to a lower marginal tax rate of 40% for top earners compared to their current 45% and because the tax free allowance is more generous than the current £10,000 annual allowance. For this reason, it may be better to use income tax as a means of correcting the inequalities that arise from distortions in the labour market (eg directors effectively setting their own pay) rather than as a means of raising revenue.

Capping the corporation tax deductibility of market incomes to £27,779 per employee (the annual tax free allowance) may also help to mitigate reductions in the income tax take.

The redistribution of income arising from this variant of a negative income tax system is likely to have a stimulative effect on the economy. Poorer workers with a high propensity to consume relative to richer workers should increase demand and hence economic activity.