May 24, 2005

Milton Friedman, Meet Sweden

Readers of this little blog have probably picked up on the fact that I know very little about economics. Fortunately, that has never stopped me from writing about the subject. So here we go. I've been reading Peter Lindert's Growing Public—an economic history that looks at the relationship between social spending and growth. In particular, Lindert suggests that the net economic cost of big welfare programs might well be virtually zero. Heartening stuff for lefties like me. More on that big picture argument later—it's fascinating, and I'll try to lay it out when I understand it fully—but now it's time to talk about welfare and work.

As we've learned from, um, Milton Friedman, certain forms of means-tested welfare essentially act as a tax on work for the poor. Starting in 1935, for instance, the original "welfare" program, AFDC, created what amounted to a 100 percent marginal tax rate on earnings for single mothers with children. It makes sense: if a mother on welfare were to get a job, she'd lose all those welfare dollars, food stamps, medical care, subsidized housing, child care subsidies, etc., and make very little back from her paycheck. Where's the incentive? Well, that marginal rate was scaled back in 1967—by allowing the working poor to keep more benefits—but then reinstated under the Reagan administration, which wanted stricter means-testing for all welfare programs. Eventually, under Clinton, the Earned Income Tax Credit was expanded considerably, which lowered the marginal rate for people who get low-paying jobs—because people could "keep" more of their foregone welfare benefits. The British, too, are experimenting with something similar, the Working Family Tax Credit. In theory, this should spur more low-income people into finding work.

Of course, there's no free lunch here. Eventually the Earned Income Tax Credit is phased out at some income level, so in effect, the marginal tax rate for work is simply pushed up into the middle classes. Now Lindert notices two things: One, this is essentially how the European welfare states work, by not strictly means-testing their benefits, and two, that no one's figured out whether shoving the marginal tax rate "up" into the middle class is actually better for the economy than strictly means-testing benefits. What's interesting, though, is that conservatives have always argued that taxes plus welfare are bad because they place high marginal tax rates on both the wealthy (for making that extra million) and on the poor (for getting a job). As Galbraith wryly summarized the "doctrine of the eighties": "the rich were not working because they had too little money, the poor because they had much."

But Lindert points out that European welfare states actually follow this conservative assumption pretty closely. These high-budget states tend to have very low taxes on capital and property—lower than in the United States or Japan—thus decreasing the marginal rates for the very wealthy. In particular, European states tend to shy away from double taxation on dividends. Bush's dream! But on the other end of the income spectrum, the universal benefits of the European welfare state also tend to decrease the marginal tax rate on the poor, essentially taking away the incentives to get off the dole and find a job. As it turns out, it's the middle class that gets saddled with the tax burden here. What's hilarious about Lindert's book is that his research seems to suggest that conservative economic theories are basically right, and that that's what explains why European welfare states work so well. Definitely more on this book later.
-- Brad Plumer 5:36 PM || ||