Is it Fair to 'Make Work Pay'?

Abstract

The design of the income transfer program for the lower incomes is a hot issue in current public policy debate. Should we stick to a generous welfare state with a sizeable basic income, but high marginal tax rates for the lower incomes and thus little incentives to work? Or should we "make work pay" by subsidizing the work of low earners, but possibly at the cost of a smaller safety net? We think it is difficult to answer this question without making clear what individuals are (held) responsible for and what not. First, we present a new fair allocation, coined a Pareto Efficient and Shared resources Equivalent (PESE) allocation, which compensates for different productive skills, but not for different tastes for working. We also characterize a fair social ordering, which rationalizes the PESE allocation. Second, we illustrate the optimal second-best allocation in a discrete Stiglitz (1982, 1987) economy. The question whether we should have subsidies for the low earners or not crucially depends on whether the low-skilled have a strictly positive or zero skill. Third, we simulate fair taxes for a sample of Belgian singles. Our simulation results suggest that "making work pay" policies can be optimal, according to our fairness criterion, but only in the unreasonable case in which none of the unemployed are ever willing to work.

Keywords: make work pay, optimal income taxation, fairness

JEL Classification: D63, H21