Perverse Tax Policy (the disincentive effect Universal Basic Income)

By David Henderson. 

"Some commenters on my recent post on the Universal Basic Income (UBI) seemed to claim that there would be no big effect on most people because the UBI they received would be taxed back. So, according to this argument, the net effect on most people would be approximately zero. But some basic economics says that that’s false.

Imagine the government gives you $10,000 per year but tells you that once your overall income reaches $40,000, you will lose $1 of that $10,000 for every additional two dollars you earn. That means that on top of your regular marginal tax rate you pay (which includes the federal income tax rate, the state income tax rate, and the payroll tax rate), you will pay an implicit tax rate of 50%. That will have a strong disincentive effect.

Moreover, one of the ways economists think about incremental taxes is to divide the effect into an income effect and a substitution effect. The income effect is that additional taxes make you poorer and so you “demand” less leisure: you work harder. The substitution effect is that the price of leisure has fallen and so you “demand” more leisure: you work less. Which outweighs which is an empirical issue. For married women, the substitution effect typically is much stronger than the income effect, so they work less when marginal tax rates rise.

But the UBI introduces a new wrinkle. The $10,000 that everyone gets increases people’s real income and, therefore, increases their demand for leisure.

So the overall effect of the UBI that is phased out is made up of three components: (1) the income effect due to the UBI which reduces work: (2) the income effect due to the phasing out, which increases work; and (3) the substitution effect due to the phasing out, which strongly reduces work when the phaseout is on the order of $1 lost for every $2 earned.

A way to reduce this strong disincentive effect is to phase out the UBI more slowly. For example, the government could reduce the UBI by $1 for every $3 earned past a total income of $40,000. Then the added implicit marginal tax rate would be “only” 33.3 percent. This has two added problems, though. First, it makes the UBI more expensive than otherwise because everyone whose total income is between $50,000 and $80,000 nets some portion of a UBI. Second, it subjects a much wider swath of people to the implicit marginal tax rate.

Giving people money and then taxing it back as you earn more is particularly perverse tax policy."