Would a UBI Reduce Work Incentives? Some Answers from Econ 101

More than half of all U.S. college students take a basic economics course. A lot of them hate it. The course is full of graphs and charts. That would be bad enough, but what makes it worse is that the graphs in a typical Econ 101 textbook are about boring stuff — whether a farmer should grow beans or peas, whether a student should eat pizza or burritos for lunch. Who cares?

But, what if we put those Econ 101 tools to work on something we do care about — something like a Universal Basic Income? Then things could get interesting. Read on to see how we can use some basic econ graphs to answer one of the most frequently asked questions about basic income: Would a UBI reduce work incentives?

How our welfare system kills work incentives

We can begin by showing how our current welfare system kills work incentives. Welfare as we know it is based on means testing. The concept of means testing, as applied to programs like SNAP, TANF, and Medicaid, is that if you are really poor, the government gives you benefits, but if you try to work and get ahead on your own, the government takes your benefits away. Not surprisingly, that is not the way to encourage work.

Rather than go through the incentive effects of existing programs one by one (I’ve done that elsewhere), this post will keep things simple by looking at a generic means-tested income support (MTIS) policy.

Figure 1 shows what happens if we introduce our MTIS into a labor market that previously had no income support programs at all. (Hat tip to Robert Moffitt for some ideas about how to draw these figures.)

 The horizontal axis in Figure 1 represents earned income while the vertical axis shows disposable income, that is, earned income plus benefits. To keep things simple, we will assume no income or payroll taxes on earned income. The dashed 45-degree line shows that earned and disposable income are the same when there are no taxes or income support. The solid red line shows the relationship between disposable and earned income with MTIS in force.

The generic MTIS policy has three features:

• A minimum guaranteed income, G, that households receive if they have no earned income at all.
• A benefit reduction rate (or effective marginal tax rate), t, indicated by the angle between the 45-degree line and the red MTIS schedule. As the figure is drawn, t = 0.75, that is, benefits are reduced by 75 cents for each dollar earned.
• A break-even income level B, beyond which benefits stop. Past that point, earned income equals disposable income.

Despite its simplicity, the generic program illustrated in Figure 1 is sufficient to support our first important proposition:

Proposition 1: Any means-tested income support program will unambiguously reduce average work effort.

The numbered arrows in Figure 1 show why. Begin with Arrow 1, which shows how the program affects your work incentives if your earned income is initially below the break-even level.

First, you can see that regardless of how much you work, you will receive some benefit from the government, so your disposable income will rise. Other things being equal, people tend to “spend” part of their increased income on increased leisure, in the form of shorter hours, longer vacations, a longer time in school, earlier retirement, or longer breaks between jobs. Economists call that the income effect of a higher income.

Second, the income support program changes the trade-off you face between additional work and additional earned income. Suppose your best available job pays $10 per hour. Without the MTIS, one more hour of work brings you $10 of added disposable income. With the MTIS, one more hour of work raises your disposable income by only $2.50, because the $10 you earn is offset by a loss of $7.50 in benefits. In effect, the program reduces the “price” (more properly, the opportunity cost) of leisure, so you are more likely to substitute leisure for work and the disposable income it brings in. Economists call that the substitution effect of the program.

Below the break-even level of income, the income and substitution effects work in the same direction, so there is an unambiguous incentive to work less. Some people might stop working altogether. Some might reduce their hours, take longer vacations, or spend more time between jobs. Whatever the specifics, the average response will be a reduction in work hours.

Next, suppose your initial earned income is higher than the break-even level. If it is far above B, the program will probably not affect your work effort at all. Suppose, though, that your initial income is only a little above the break-even level. In that case, you may be tempted to cut back your hours of work by enough to qualify MTIS benefits. Arrow 2 shows that possibility. If you follow the arrow, you give up a little bit of disposable income, but you gain quite a bit more leisure — a trade-off between work and leisure that is better than you faced before the MTIS program came into force. Not everyone will take advantage of this opportunity, but if at least some do, while others do not change their work habits, then the average work effort of people whose initial incomes were higher than B will decrease.

In short, introducing a MTIS into an economy where previously there was no income support will tend to reduce the work effort of most people whose incomes were initially below the break-even point and of some with incomes just above break-even. Average work effort for the population as a whole will decrease.

Sweetening the program

Next, consider the effects of “sweetening” the MTIS by increasing the minimum guaranteed income or reducing the benefit reduction rate. Figure 2 shows the effects of both changes together. The old program is the same as shown in Figure 1. The new program has a higher minimum guarantee G2 and a lower benefit reduction rate of 0.5, shown by t2, instead of the original benefit reduction rate of 0.75 for t1.

The arrows show three possible cases.

First, suppose your initial earned income is below B1, the break-even level for the old program. You now have an increased incentive to work because you get to keep 50 cents of each dollar you earn, rather than 25 cents as before. At the same time, however, your income will be higher, which by itself, will give you an incentive to work less. Since the two effects work in opposite directions, whether you work more or less will depend on whether the income effect or the substitution effect is stronger. The relative strength of the two effects has been widely studied, with the preponderance of evidence pointing to a larger value for the substitution effect than for the income effect. In that case, the substitution effect will prevail, so that average work effort will increase, as shown by Arrow 1, even if some individuals work less.

Second, suppose that your initial earned income is just slightly higher than the new break-even level B2. In that case, you might decide to cut back your work hours by enough to qualify for benefits, as shown by Arrow 2. Not everyone will do so, and the higher their incomes are relative to the break-even level, the less likely it is that they will reduce work. Still, there are likely to be at least a few people in this situation who will reduce work effort.

Third, suppose your initial earned income is between B1 and B2 — too high to qualify for the old program but low enough to qualify for the new one. In that case, the new, more generous, MTIS will increase your disposable income, which, by itself, would cause your work effort to decrease. At the same time, you now face the 50 percent benefit reduction rate of the new program, whereas before you faced no benefit reductions at all. The substitution effect of the benefit reductions provides second disincentive to work. With both effects working in the same direction, you have a double reason to reduce your desired level of work, as shown by Arrow 3.

Taking the three cases together, we can see that formally speaking, the effects of sweetening the MTIS are ambiguous. Some people (Arrow 1) will increase their work effort, while some (Arrows 2 and 3) will reduce theirs. It would not be at all surprising if the negative effects on work to outweighed the positive effects, but we can’t be sure on theoretical grounds alone. Ultimately, the average response for the whole population will depend on the number of people in each group and the relative strength of the income and substitution effects. We can formalize this result as follows:

Proposition 2: The effects on work effort of “sweetening” a means-tested income support program by raising the minimum income guarantee, lowering the benefit reduction rate, or both, are ambiguous.

Replacing a MTIS with a UBI

Now we come to the heart of the issue we set out to discuss. What will be the effect on work incentives if we replace a pre-existing means-tested income support program with a UBI that is not means tested at all? Figure 3 illustrates this possibility. The MTIS is the version from Figure 1, before sweetening. The UBI grant, Gu, is set at a level slightly below the minimum guaranteed income under the original MTIS, Gm. (We will consider the effects of a change in the relative levels of Gu and Gm shortly.) The benefit reduction rate for the UBI is zero, so the UBI schedule is parallel to the original earned income line and lies above it by the amount of the UBI grant, Gu.

The arrows show four possible responses, depending on the original level of income.

First, suppose that your original earned income is below the crossover point of the UBI and the MTIS schedules. Now you have two incentives to work more: you can now keep more of each added dollar you earn, and at the same time, unless you increase your work effort, you face a decrease in your disposable income. For this group, the substitution and income effects work together to encourage work effort, as shown by Arrow 1.

Second, suppose your original earned income is a little above the crossover point of the MTIS and the UBI schedules. As in the first case, the substitution effect is strong because you are no longer subject to the 75 percent benefit reduction rate of the MTIS. At the same time, you face a negative work incentive from the income effect, since your income will rise a little even if you don’t work more. However, the income effect is likely to be weak, because it applies only to the difference between the UBI and the MTIS benefits, not to the full value of the UBI. On balance, it is nearly certain that you will want to increase your work effort, as shown by Arrow 2.

Third, suppose you are one of those people who would have earned an income above the break-even level B if there had been no MTIS, but who cut back your work effort to qualify for the MTIS–the case shown by Arrow 2 in Figure 1. Now that the sweetened program is not offered, you will increase your work effort compared with how much you would work under the MTIS. This variant is shown by Arrow 3 in Figure 3.

Fourth, suppose your earned income is far above the break-even level for the MTIS. In that case, the UBI has no substitution effect at all, so you have no incentive from that source to work more. Since your income will rise by the amount of the UBI, you have a small incentive from the income effect to work less, as shown by Arrow 4. However, the effect on your work effort is likely to be slight, because with a substantial earned income to start with, the UBI means only a small percentage increase.

On balance, replacing a MTIS with a UBI will almost certainly lead to increased work effort. How much depends on the relationship of the UBI grant Gu to the MTIS minimum Gm, and also on the benefit reduction rate of the MTIS. The more generous the minimum guarantee of the MTIS relative to the amount of the UBI and the higher the MTIS benefit reduction rate, the more likely it is that replacing an MTIS with a UBI will increase work effort.

We can summarize these effects as follows:

Proposition 3: Replacing a means-tested income support program with a UBI would substantially increase work incentives for low-income households while having small disincentive effects, if any, for middle- and upper-income households.

Policy implications

The most important implication of the preceding analysis is that we can intelligently discuss the incentive effects of a UBI only if we specify what we are comparing it to.

If we were to introduce a UBI where, previously, there was no income support program at all, the UBI would have no substitution effect. In that case, the UBI would be expected to slightly reduce work effort, even if the income effect is small.

By comparison, adding a UBI on top of the means-tested welfare system that we now have would result in the maximum disincentive to work. The substitution effect of the current high benefit reduction rates would then remain in force, while the UBI would add to the income effect.

The best policy of all would be to replace the means-tested welfare system we now have with a UBI. In that case, the favorable substitution effect of a UBI would be strong and the unfavorable income effects would be weak. In that situation, the UBI could be expected to increase almost everyone’s work effort.

Fortunately, UBI advocates are coming around to the idea that a basic income should replace current means-tested programs rather than simply supplementing them. That is the approach taken, for example, by the Freedom Dividend proposed by Andrew Yang, the entrepreneur and philanthropist who is now a candidate for the 2020 Democratic presidential nomination. In an earlier post in this space, I explained in more detail just which current income support programs can advantageously be replaced by a UBI.

The bottom line: Applying the simple graphical tools from Econ 101 course shows that far from producing a nation of lay-abouts, a properly designed UBI would have a beneficial effect on work incentives.

Photo courtesy of Pixabay.com. Reposted from Medium.com