The Poverty Trap

Income inequality can be either good or bad. Inequality in which the poor who take risks and apply themselves have a good chance of extracting themselves from poverty is good. It means that incentives to be productive are in place. However, inequality in which the poor are a class that effectively stays poor is bad. I’m sure that there are those who would make a psychological point about the poor becoming addicted to handouts and thus incapable of improving their situations. This is for someone else’s blog. Instead, this post is about the economics of how people become trapped in poverty.

How do the poor become trapped in poverty? It is through the actions of well-meaning voters and politicians and self-aggrandizing experts “helping” the poor that the poor are caught in the poverty trap. So it is both an unintended consequence and an intended consequence of “helping” the poor.

It is hard, very hard, to help the poor without trapping them in permanent poverty. When a person feels for the problems of the poor, it is natural to want to help the poor by giving them the thing that they lack whether it is food, housing, medical care, or whatever the big need is perceived to be. At the same time, it is observed that the rich or even the middle class should not just be given the thing, because they can surely afford to buy it. So the next reaction is to institute an income or “means” test. So as one’s income rises, the subsidy declines or disappears entirely. As a result, the program implicitly becomes an adjunct to the income tax. What is important here is that the implicit tax rates of the various programs to help the poor can be added together to get the total tax rate from the programs.

If a poor person receives several of these very common subsidies, the implicit tax rate can even be over 100%. Sometimes just a single program, like unemployment compensation, pushes the implicit tax rate to over 100% if one includes the need to provide child care if one becomes employed. Of course, those who are inclined to see the need for a government program everywhere will recognize the need to provide the poor with child care, still another program with an implicit tax rate. The point is that as tax rates get high, the incentive to get ahead is removed from the system. The subsidy recipient becomes trapped in poverty.

How can a person emerge from the poverty trap? The only way to emerge from the poverty trap is by having a way to leap beyond the subsidies. A person would leap beyond the subsidies by obtaining a significant education or by becoming a sports or entertainment figure of note . . . not very likely. The poor will not gradually extricate themselves, because it does not pay to do so.

Who knows about the poverty trap? It is not well known. The popular press seems to be blissfully unaware. But all economists know about it, or should know about it. As a result, when economists tout such programs, we should be aware that they are cynically serving some end such as providing a permanent political constituency for these programs. The people trapped in poverty become the political base for the programs that hold them captive. The experts who create the poverty trap realize that there is money in poverty. These programs create huge administrative empires. Of course, they must be studied, written about, and taught.

How can the poverty trap be avoided? There are answers to this question, but the answers come in political flavors. Some socialists might say all you have to do is eliminate the income test. That is, all persons will get the “subsidy” regardless of income. Of course, it is silly to imagine that you can subsidize everyone. Somebody must pay for the subsidy. For those who actually pay for the subsidy, the subsidy reduces their ability to direct resources and constrains their choices in directing resources that remain. That is, they get less and what they get is the government standard. In other words, they are taxed to provide the subsidies, the bureaucracy takes a cut, and then they must consume the menu of goods and services provided by the government. The socialist will then institute a high tax rate to level outcomes to taste. Businesses respond to high tax rates by paying workers with perks and by leaving higher tax environments for lower tax environments. High income individuals respond by leaving or by rebalancing their portfolios to reflect tax realities (for example, moving from dividends to capital gains). Net tax payers are more likely to accept the socialist solution in a small, homogeneous country, because there might be more unanimity regarding the menu of government provided goods and services.

A fiscal conservative or a social conservative might say that it is necessary to stop the subsidies perhaps for different reasons. The fiscal conservative might argue that the subsidy expands the relative size of the governmental sector and acts as a drag on the economy, constraining the size of the pie available to the rich and to the poor. The social conservative and big “L” Libertarians might argue that subsidy recipients have no legitimate claim on the subsidy; they merely are expropriating the property of others.

Some libertarians (note the small “l”) would avoid in-kind subsidies, subsidies in the form of specific goods and services, and substitute a negative income tax. That is, you can extend the “flat” tax below the income axis so that taxes smoothly turn into subsidies as income falls. If this is the only subsidy, it is easy to monitor the tax rate and keep it at a reasonable level. Liberals and socialists will not care for this approach, because it does not constrain the choices of the poor. After all, the poor may choose to purchase something that the socialists do not approve of. Cynics looking at the liberal and socialist solutions will point out that, in many cases, in-kind subsidy recipients do not consume the goods they are given (for example, from food stamps to liquor). They find intermediaries that help them convert the goods they get into the goods they want. Of course, the intermediaries are paid for their services causing the subsidy recipients to receive much less in value than what they are initially given. So, the libertarians would say it is just more effective to dispense with the fiction that government can define merit goods that are provided with a subsidy and go directly to a negative income tax.