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The case for NIT+FT in Europe. An empirical optimal taxation exercise

01 Nov 2018-Economic Modelling (North-Holland)-Vol. 75, pp 38-69

AbstractWe present an exercise in empirical optimal taxation applied to a Negative Tax with Flat Tax reform for a sample of eight European countries: Austria, Belgium, France, Germany, Ireland, Italy, Luxembourg and the United Kingdom. Two popular approaches to empirical optimal taxation are the structural analytical approach and the non-tructural “sufficient statistics” approach. This paper presents a different approach that combines structural microeconometric modelling, behavioural microsimulation and numerical optimization. For each country, we estimate a microeconometric model of labour supply for both couples and singles. A procedure that simulates the households' choices under given tax-transfer rules is then embedded in a constrained optimization program in order to identify optimal rules under the public budget constraint. The optimality criterion is the class of Kolm's social welfare function. The tax-transfer rules considered as candidates are members of a class that includes as special cases various versions of the Negative Income Tax: Conditional (means-tested) Basic Income, Unconditional Basic Income, In-Work Benefits and General Negative Income Tax, combined with a Flat Tax above the exemption level. The analysis in most cases show that: the General Negative Income Tax strictly dominates the other rules, including the current ones; the Unconditional Basic Income policy is better than the Conditional Basic Income policy; Conditional Basic Income policy may lead to a significant reduction in labour supply and poverty-trap effects; In-Work-Benefit policy is strictly dominated by the General Negative Income Tax and by the Unconditional Basic Income. We also exemplify the possibility of identifying the mapping between the contry-specific “primitives” (social preferences, productivity, public budget constraint, labour supply elasticity and Gini coefficient) and the optimal tax-transfer rules.

Topics: Negative income tax (70%), Optimal tax (65%), Flat tax (63%), Budget constraint (55%), Basic income (54%)

Summary (2 min read)

2. The alternative policies

  • Note that GNIT is by definition more general than the other NIT special cases.
  • Yet it is important to define the optimal design of the special cases: although necessarily not superior to GNIT according to the Social Welfare criterion, they might be more attractive than GNIT according to other dimensions that are not taken into account by the Social Welfare function.

4.1 Household preferences and choices

  • Households can choose within an opportunity set  containing jobs or activities characterized by hours of work h, sector of market job s (wage employment or self-employment) and other characteristics (observed by the household but not by us).
  • The authors define h as a vector with one element for the singles and two elements for the couples,.

D 

  • For couples, i D contains two analogous sets of variables, one for each partner.
  • The parameter estimates of the behavioral models for singles and couples for six countries (Belgium, France, Ireland, Italy.

4.2 Data

  • The datasets used in the analysis are the EUROMOD input data based on the European Union Statistics on Income and Living Conditions (EU-SILC) for the year 2010.
  • The input data provide all required information on demographic characteristics and human capital, employment and wages of household members, as well as information about various sources of non-labour income.
  • The authors apply common sample selection criteria for all countries under study by selecting individuals in the age range 18-65 who are not retired or disabled.
  • Then EUROMOD 4 provides calculations of household-level tax and transfer liabilities given the household characteristics and gross incomes according the existing tax and transfer rules.
  • The target population consists of all private households throughout the national territory in every country.

SMRS e e

  • The simulation results presented in Section 5 are based on 0.05.
  • Absolute indexes are less popular than relative indexes (e.g. Gini's or Atkinsos's), although there is no strict logical or economical motivation for preferring one rather than the other.
  • 7 Blundell and Shephard (2012) adopt a social welfare index which turns out to be very close to Kolm's.
  • Their main motivation for their index seems to be the computational convenience, since it handles negative numbers (random utility levels, in their case).
  • The authors motivation in choosing Kolm's index is analogous.

4.5. Identifying the optimal policies

  • It is important to keep in mind that the simulated policies differ from the current policies with respect to many dimensions.
  • First, the authors simulate policies with a FT, while all the countries included in the present exercise adopt increasing marginal tax rates.
  • In general, while the current systems might be somehow close to CBI or IWB or other versions of NIT-like mechanism, they are much more complicated.
  • The comparison of the reforms to the current system is informative upon the effects of the reformed budget sets, including the effects of the universal and permanent extention to the whole population.
  • It is not directly informative upon dimensionssuch as the administration costswhich are not represented in their microeconometric model.

5. Results

  • The Tablesone for each countryshow, for each of the policies considered, the optimal tax-transfer parameters, the average individual labour supply, the household poverty rate, the percentage of household winners with respect to the current system and the change in the money-metric social welfare as percentage of the average household available income.
  • Labour supply is measured by average annual hours of work (including the zero hours of the non-employed).
  • The poverty rate is the percentage of households with available equivalized income below 60% of the median equivalized income.
  • Let W0 and WP respectively the Social Welfare levels attained under the current regime and under a certain policy.
  • Note that they are monetary measures .

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Islam, Nizamul; Colombino, Ugo
Working Paper
The case for NIT+FT in Europe. An empirical optimal
taxation exercise
GLO Discussion Paper, No. 140
Provided in Cooperation with:
Global Labor Organization (GLO)
Suggested Citation: Islam, Nizamul; Colombino, Ugo (2017) : The case for NIT+FT in Europe.
An empirical optimal taxation exercise, GLO Discussion Paper, No. 140, Global Labor
Organization (GLO), Maastricht
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The case for NIT+FT in Europe. An empirical optimal taxation exercise
Nizamul Islam and Ugo Colombino
We present an exercise in empirical optimal taxation for European countries from three areas: Southern,
Central and Northern Europe. For each country, we estimate a microeconometric model of labour supply
for both couples and singles. A procedure that simulates the households’ choices under given tax-transfer
rules is then embedded in a constrained optimization program in order to identify optimal rules under the
public budget constraint. The optimality criterion is the class of Kolm’s social welfare function. The tax-
transfer rules considered as candidates are members of a class that includes as special cases various
versions of the Negative Income Tax: Conditional Basis Income, Unconditional Basic Income, In-Work
Benefits and General Negative Income Tax, combined with a Flat Tax above the exemption level. The
analysis show that the General Negative Income Tax strictly dominates the other rules, including the
current ones. In most cases the Unconditional Basic Income policy is better than the Conditional Basic
Income policy. Conditional Basic Income policy may lead to a significant reduction in labour supply and
poverty-trap effects. In-Work-Benefit policy in most cases is strictly dominated by the General Negative
Income Tax and Unconditional Basic Income.
Keywords: Basic Income, Negative Income Tax, Optimal tax, Micro-simulation, Welfare
JEL classification: H21, C18
Correspondence to:
1. LISER, Luxembourg (Phone number +352585855507, E-mail: and 2. University of Torino,
CHILD, LISER and IZA, E-mail:
This is part of a research project at LISER that involves Philippe Van Kerm (LISER and University of Luxembourg,
Luxembourg), Nizamul Islam (LISER, Luxembourg), Denisa Maria Sologon (LISER, Luxembourg), Ugo Colombino
(University of Turin, Italy), Lennart Flood (Gothenburg University, Sweden), Francesco Figari (University of Insubria, Italy).
We wish to thank Flavia Coda Moscarola, Francesco Figari and Marilena Locatelli, who provided us the estimation programs,
originally written for Coda Moscarola et al. (2014), which have been useful as a basis for developing our programs for the
estimation of the microeconometric model.

1. Introduction
Since the end of the 2° World War up to the mid-70s, means-tested transfers have been the main form of
income support mechanism in most Western countries. Abstracting from lots of details and variations in
eligibility criteria, level of generosity, population coverage etc., those policies adopted mechanisms that
in this paper in a stylized representation we will call Conditional Basic Income (CBI), where incomes
below a certain threshold are somehow subsidized to the threshold.
For incomes below the threshold,
a marginal tax rate close to (and sometimes greater than) 100% is applied. This introduces a disincentive
to work, especially so for people with a low wage rate. The phenomena of poverty trap, or welfare trap,
or welfare dependence have been observed and to an increasing degree in many countries. Welfare
policies based on CBI-type mechanisms have also been criticized for other possible problems: high
transaction costs and “welfare stigmaeffects leading to low take-up rates, incentives to unde-reporting
of income, errors in setting eligibility, litigation costs etc. (e.g. Friedman and Friedman 1980; Atkinson
2015). Since the second half of the 70s, also as a response to the problems mentioned above, various
reforms have been implemented in many countries: work-fare programs, less generous transfers, policies
targeted towards smaller segments of the population, more sophisticated design of eligibility conditions
and of the timing of transfers, in-work benefits or tax credits in order to strengthen the incentives to work
(e.g. Blank et al. 1999). On the one hand, the reforms have been successful with regards to work
participation incentives. On the other hand, they might have increased the administration and transaction
costs of the mechanisms and to a certain extemt - also the direct cost when it comes to in-work-benefits
or tax credits. Moreover, more complex conditioning and eligibility criteria might paradoxically induce
more effort in trying to overcome the hurdles that limit the access to the policy, rather than in trying to
find a job or a better one, thus encouraging a waste of potentially productive resources. During the last
two decades, three processes have contributed to put the current welfare policies under stress and possibly
to worsen their intrinsic drawbacks. Globalization and technological progress (automation), while
creating big aggregate benefits, also imply massive adjustments in re-allocation of physical and human
resources. Job losses and skill destruction and an increased demand for income support interventions– at
least in the short-medium term – are natural consequences. The “Big Crisisof the last decade obviously
worsened the scenario. More recently, in many countries, a new interest emerged for a reform direction
The qualification “Conditional” in this paper is used as equivalent to “means tested”. In the literature on income support, the
term conditional is also commonly used in relation to policies where monetary transfers are conditional upon the fulfillment
of certain behavioural requirements, e.g. working a minimum of hours, sending children to school etc.

somehow opposed to the one taken since the end of 70s: less conditioning, simpler designs and ultimately
some form of Unconditional Basic Income (UBI), i.e. a policy based on non-means tested trasfers (e.g.
Atkinson 2015, Colombino 2015b, Sommer 2016, Standing 2008, van Parijs 1995). In a similar
prspective, proposals have been put forward for universal share of GDP (Shiller 1998, Raj 2016) or of
the revenue from “common resources(as it is actually implemented by the Alaska Permanent Fund).
Experiments have been done, among others, in India (Standing 2015), Kenia (Haushofer & Shapiro 2016)
and Uganda (Blattman et. 2014) with promising results. Experiments are currently being discussed (in
the Netherlands) and actually run (in Finland, KELA 2016). Other experiments are planned, e.g. one by
the hi-tech incubator Ycombinator in the USA. Although the idea goes back to a philosophical tradition
focusing on ethical-distributive criteria (van Parijs 1995), from the strict economic point-of-view UBI
might be particularly interesting for its possible efficiency properties. It must be noted at this point that
both CBI and UBI are members of a more general class: the Negative Income Tax (NIT). The NIT was
originally proposed by Friedman (1962) as an incentive-improving mechanism with respect to CBI-like
policies. It consists of applying a lower-than-100% marginal withdrawal rate (MWR) to the basic
transfer. In the limit, if the MWR is close to the first MTR applied to incomes above the subsidised level,
the policy becomes indistinguishable from UBI. Thus we have a whole class of income support
mechanisms (NIT) that ranges from one extreme (CBI) to the other (UBI), where each member of the
class is characterized by the degree of means-testing (i.e. the value of the MWR). Another idea pointing
towards simplification, which is often associated with NIT-like income support mechanisms, is the so-
called Flat-Tax (FT), i.e. a proportional tax applied to all personal incomes above an exemption level
(e.g. Hall and Rabushka 1995, Atkinson 1996). Despite the proportional marginal tax rate, the whole
system is progressive in the sense that due to the exemption level or to the guaranteed minimum income
the average tax rate increases with income. Overall, the “package” NIT+FT , besides being simple and
transparent might provide a good equilibrium between progressivity, labour incentives and
administration costs.
In what follows, we adopt an empirical optinal taxation perspective in order to scan the NIT+FT class
and its special cases for the best (social-welfare-wise) policies and compare them to the current tax-
transfer systems in six European countries.

2. The alternative policies
All the income-support mechanism that we consider below are matched with a FT. Overall we consider
very stylized tax-transfer rules. On the one hand, they can be seen as simplified representation of the
rules that are, or might be, actually implemented. On the other hand, they might be viewed as reforms in
the direction of simplification. A Conditional Basic Income (CBI) mechanism essentially works as
follows (Figure 1a). There is a threshold G, the guaranteed minimum income. If your own (gross) income
Y falls below G, you receive a transfer equal to G Y. If your own income goes above G you do not
receive any transfer and pay taxes on Y G. Therefore, your net available income will be G if Y is
smaller than G, or else G + (1 t)(Y G) if Y is larger than G. According to an alternative interpretation
(or implementation), everyone receive a transfer G. For Y < G, Y is taxed away at a 100% marginal tax
rate up to Y = G. For Y > G, Y G is taxed at some marginal rate t.
Figure 1a: Conditional Basic Income (CBI)
This mechanism suffers from the “welfare trap” or “welfare dependence” problem: there is no incentive
to work for an income lower than G. But even a job paying more than G might not be convenient when
accounting for hours to be spent on the job rather than devoted to leisure.
How strong is this effect
Empirically, one might observe people located on the horizontal segment of the budget line since non-pecuniary or
intertemporal benefits from working might make that location attractive.

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Additional excerpts

  • ...For instance, Islam & Colombino (2018), Aaberge and Colombino (2013) and many others adopt a procedure that consists of using a common utility function as an argument of the social welfare function following Deaton and Muelbauer (1980) approach18....


  • ...Islam & Colombino (2018)....


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Abstract: We use a behavioural microsimulation model embedded in a numerical optimization procedure in order to identify optimal (social welfare maximizing) tax-transfer rules. We consider the class of tax-transfer rules consisting of a universal basic income and a tax defined by a 4th degree polynomial. The rule is applied to total taxable household income. A microeconometric model of household, which simulates household labour supply decisions, is embedded into a numerical routine in order to identify – within the class defined above – the tax-transfer rule that maximizes a social welfare function. We present the results for five European countries: France, Italy, Luxembourg, Spain and United Kingdom. For most values of the inequality aversion parameter, the optimized rules provide a higher social welfare than the current rule, with the exception of Luxembourg. In France, Italy and Luxembourg the optimized rules are significantly different from the current ones and are close to a Negative Income Tax or a Universal basic income with a flat tax rate. In Spain and the UK, the optimized rules are instead close to the current rule. With the exception of Spain, the optimal rules are slightly disequalizing and the social welfare gains are due to efficiency gains. Nonetheless, the poverty gap index tends to be lower under the optimized regime.

Cites background or methods from "The case for NIT+FT in Europe. An e..."

  • ...Islam and Colombino (2018) identify optimal tax-transfer rules within the NIT+FT class in eight European countries....


  • ...where z denotes taxable income, h(z) and H(z) are the density and distribution functions, ( ) z  is a social weight assigned to people with income greater than or equal to z and z  is the elasticity of z with respect to (1-T’(z)). However, the optimal z and its distribution (and possibly also z  ) depend on the optimal tax function (.) T . Therefore, in order to be able to compute the optimal taxes we must specify how z, H(z) and h(z) depend on (.) T . In other words, we must go back to Mirrlees (1971) as in Saez (2001) and Brewer et al....


  • ...Sections 3.1, 3.3 and 3.4 hereafter follow the presentation provided in Islam and Colombino (2018)....


  • ...This type of analysis is just sketched and exemplified in Islam and Colombino (2018). A full analysis on a large sample of countries is left for future work....


  • ...Islam and Colombino (2018) develop a systematic procedure that combines microeconometrics, microsimulation and numerical optimization in order to identify optimal rules within the Negative Income Tax + Flat Tax class....


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01 Jan 1962
Abstract: In the classic bestseller, Capitalism and Freedom, Milton Friedman presents his view of the proper role of competitive capitalism--the organization of economic activity through private enterprise operating in a free market--as both a device for achieving economic freedom and a necessary condition for political freedom. Beginning with a discussion of principles of a liberal society, Friedman applies them to such constantly pressing problems as monetary policy, discrimination, education, income distribution, welfare, and poverty. "Milton Friedman is one of the nation's outstanding economists, distinguished for remarkable analytical powers and technical virtuosity. He is unfailingly enlightening, independent, courageous, penetrating, and above all, stimulating."-Henry Hazlitt, Newsweek "It is a rare professor who greatly alters the thinking of his professional colleagues. It's an even rarer one who helps transform the world. Friedman has done both."-Stephen Chapman, Chicago Tribune

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"The case for NIT+FT in Europe. An e..." refers background or methods in this paper

  • ...Also as a response to the these problems, the so-called Negative Income Tax (NIT) was proposed by Friedman (1962) and supported by many authors (e.g. Tobin et al. 1967).3 The typical version of NIT is illustrated in Figure 2....


  • ...…for other possible problems: high burocratic costs, “welfare stigma” effects and take-up costs leading to low take-up rates, incentives to underreporting of income, errors in applying eligibility criteria and litigation costs (e.g. Friedman 1962, Friedman and Friedman 1980, Atkinson 2015)....


  • ...The original NIT proposal made by Friedman (1962) was formulated according to the second interpretation, with t1 typically larger than t2, (convex profile of the tax-transfer rule as in Figure 2)....


Journal ArticleDOI
Abstract: you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We enable the scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that promotes the discovery and use of these resources. For more information about JSTOR, please contact 1. INTRODUCTION One would suppose that in any economic system where equality is valued, progressive income taxation would be an important instrument of policy. Even in a highly socialist economy, where all who work are employed by the State, the shadow price of highly skilled labour should surely be considerably greater than the disposable income actually available to the labourer. In Western Europe and America, tax rates on both high and low incomes are widely and lengthily discussed3: but there is virtually no relevant economic theory to appeal to, despite the importance of the tax. Redistributive progressive taxation is usually related to a man's income (or, rather, his estimated income). One might obtain information about a man's income-earning potential from his apparent I.Q., the number of his degrees, his address, age or colour: but the natural, and one would suppose the most reliable, indicator of his income-earning potential is his income. As a result of using men's economic performance as evidence of their economic potentialities, complete equality of social marginal utilities of income ceases to be desirable, for the tax system that would bring about that result would completely discourage unpleasant work. The questions therefore arise what principles should govern an optimum income tax; what such a tax schedule would look like; and what degree of inequality would remain once it was established. The problem seems to be a rather difficult one even in the simplest cases. In this paper, I make the following simplifying assumptions: (1) Intertemporal problems are ignored. It is usual to levy income tax upon each year's income, with only limited possibilities of transferring one year's income to another for tax purposes. In an optimum system, one would no doubt wish …

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"The case for NIT+FT in Europe. An e..." refers background or methods in this paper

  • ...At least the first simulations based on empirical calibr tions of Mirrlees’ (1971) model suggested as optimal a rule very close to a NIT+FT....


  • ...…Optimal Taxation (TOT) approach that consists of computing optimal policies using theoretical formulas with imputed or calibrated parameters, as many authors have done, e.g. using the theoretical results of Mirrlees (1971) or the more recent ones such as Diamond (1998) and Saez (2001, 2002)....


  • ...First, Mirrlees (1971) and Saez (2001) only cover interior solutions on the part of the agents and therefore only intensiv labour supply responses are considered, while te empirical labour supply literature reveals the importance – when not the predominance – of the extensiv responses....


  • ...This procedure is more flexible than the empirical applications of the TOT provided for example by Mirrlees (1971) or Saez (2001, 2002)....


01 Jan 1980
Abstract: This classic text has introduced generations of students to the economic theory of consumer behaviour. Written by 2015 Nobel Laureate Angus Deaton and John Muellbauer, the book begins with a self-contained presentation of the basic theory and its use in applied econometrics. These early chapters also include elementary extensions of the theory to labour supply, durable goods, the consumption function, and rationing. The rest of the book is divided into three parts. In the first of these the authors discuss restrictions on choice and aggregation problems. The next part consists of chapters on consumer index numbers; household characteristics, demand, and household welfare comparisons; and social welfare and inequality. The last part extends the coverage of consumer behaviour to include the quality of goods and household production theory, labour supply and human capital theory, the consumption function and intertemporal choice, the demand for durable goods, and choice under uncertainty.

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"The case for NIT+FT in Europe. An e..." refers background in this paper

  • ...We follow here a tradition that defines the comparability problem – as far as the empirical research is concerned – as in Deaton and Muellbauer (1980), where the adoption of the CMU approach or of the common utility are legitimate solutions....


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"The case for NIT+FT in Europe. An e..." refers methods in this paper

  • ...We choose Kolm (1976) Social Welfare index, which can be defined as:...


  • ...We choose Kolm ( 1976) Social Welfare index, which can be defined as: ( ){ }i i exp1 ln N k W k µ µ µ − − = − ∑ (8) where 1 is an index of Efficiencyi iN µ µ= ∑ , ( ){ }i i exp1 ln Kolm Inequality Index, N k k µ µ − − = ∑ Inequality Aversion parameter,k = µi = comparable money-metric…...


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Abstract: Selected by the Times Literary Supplement as one of the \"hundred most influential books since the war\" How can we benefit from the promise of government while avoiding the threat it poses to individual freedom? In this classic book, Milton Friedman provides the definitive statement of his immensely influential economic philosophy—one in which competitive capitalism serves as both a device for achieving economic freedom and a necessary condition for political freedom. The result is an accessible text that has sold well over half a million copies in English, has been translated into eighteen languages, and shows every sign of becoming more and more influential as time goes on.

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The authors present an exercise in empirical optimal taxation for European countries from three areas: Southern, Central and Northern Europe.