Free Market

Friedman’s Mistake

The Free Market

The Free Market 14, no. 11 (November 1996)


In the famed 1995 budget battles between the White House and the Congress, Bill Clinton told a whopper that put him on the rhetorical offensive. He said that Congress’s proposed cuts in a particular program amounted to “raising taxes on the poor.” 

It was classic Clinton: he could oppose a bill that curbed spending while not having to defend programs that should be cut, even as he posed as anti-tax. Spooked by this rhetorical razzmatazz, Congress backed off. 

But was Congress really trying to raise taxes on the poor? At issue is the misnamed Earned Income Tax Credit, a widely misunderstood and hugely expensive program. Congress was attempting to trim it around the edges. How could Clinton get away with calling spending cuts tax increases? 

Part of the confusion arises from the name and the ideological origins of the program. Milton Friedman’s 1962 book Capitalism and Freedom made a surprising concession to the socialists. He said we need “a floor below which no man’s net income...could fall,” a program also called a guaranteed national income. It should be provided through a “negative income tax,” said Friedman, an odd phrase for an outright cash subsidy administered through the tax system. We might as well call a tax a “negative wage.” 

In his program, if a person’s income exceeds exemptions and deductions, he pays a tax. If it falls under, he pays a “negative tax,” i.e. gets a check. The idea claimed to use the tax code to encourage people to get off conventional welfare and live on earned income, while creating no new bureaucracies. And what will keep the program under control? The self-restraint and good will of the electorate. 

But Friedman failed to consider how this system would work in the real world. People undertake adaptive strategies to get on and stay on the dole whenever it’s available. That the program is cheap to administer makes it all the more dangerous. Refuting Friedman, Henry Hazlitt showed that the only way to get people off welfare is to stop the payments. 

Nonetheless, Friedman’s idea eventually made it into law. The year was 1975, and Gerald Ford and the Democratic Congress cooperated in imposing the Tax Reduction Act of 1975. (A list of similarly named bills in the post-war period would suggest that taxes have been declining for decades!) 

Buried in the bill was an end-of-the-year tax credit for low-income taxpayers. It claimed to increase the incentive to work instead of being on welfare (again, this trick is as old as the welfare state itself). It was more than a tax deduction; it was “refundable” up to $400. It was a direct subsidy available whether or not you had paid any taxes at all. 

As Friedman said, the subsidy involves low administrative costs because it is facilitated by the tax return itself. If you are eligible, you say so, and it is made part of your refund check. It looks like a deduction, sounds like a deduction, but is actually welfare. 

There was a notable difference between this particular “tax credit” and other forms of welfare. There was no asset test or net-worth ceiling to qualify (again, just as Friedman had suggested). Having two cars in the driveway, a yacht at the marina, and a private plane at the airport does not disqualify anyone from receiving it. “Low income” and poor, it turns out, are not necessarily the same thing. 

Like many new programs, it was supposed to be temporary, but year by year, Congress extended it on the urging of Ford, Carter, Reagan, and then Bush. And like every other government program, the benefits went up and up. In 1977, the maximum a family could receive went to $500, and a new partial tax credit was given on incomes up to $10,000. It increased again in 1984, for a new maximum of $550. By 1990, it had reached $953. 

Not only that: the program became more expansive. It began to give more money if the recipient had two children instead of one. Also new was an additional credit up to $357 if a child was under one year old. 

It was under Clinton that the program went berserk. In 1993, the maximum refund was up to $1,511, and by two years later had actually doubled, to a whopping $3,110. At the end of 1996, it will reach its highest ever, at $3,564. Also introduced in 1994 was the same tax credit for a single person with no dependents. What began as a $1.2 billion program in 1974 now costs almost $25 billion per year. 

So much for getting people off welfare. It has become an instrument for recruiting new dependents, and massively redistributing income. One does not have to be working to get it. Neither does one have to be poor. A worker can get payments included in his paycheck. As the fastest growing single item in the welfare state, it is becoming the guaranteed national income socialists have long dreamed about imposing. 

With a fraud rate estimated by the General Accounting Office to be as much as 45 percent, it is a lavish perk provided courtesy of hard-working taxpayers. Because it is now a major cornerstone of the welfare state, politicians no longer even talk about eliminating it. It was completely untouched by the 1996 welfare reform. 

After the Republicans took over Congress in 1994, they attempted a very minor reform. They planned to deny the refund to childless workers, repealing a change that had just gone into effect. The largest change was a lower income ceiling at which the partial credit would kick in. Overall, the Republicans offered only a slight change in the rate of increase. 

Clinton went on the offensive to claim the Republicans were increasing taxes on the working poor. He used Washington’s two classic lies to great effect: 1) a reduction in the rate of increase is a cut, and 2) there is no distinction between a tax credit and an outright subsidy. Republicans, who have used these lies for their own purposes, never developed an effective response to Clinton’s absurdities. 

One clue to the true nature of the program is that the government wants people to use it. “The measure of our success,” said IRS commissioner Fred Goldberg in 1993, “is if every family entitled to this credit claims it and gets every dollar they (sic)are due.” Have you ever heard of the government advertising a real deduction—like the home office deduction—much less longing for more people to use it? 

The only way to reform this program is first to expose it as the welfare redistribution program that it really is. It should not be called the Earned Income Tax Credit; it should be denounced as the Unearned Income Transfer Payment, and immediately abolished. So long as that solution is not contemplated, the program will grow without limit, drawing more and more people into the ranks of the government s dependents. Such is the price of intellectual compromise.



Vance, Laurence M. “Friedman’s Mistake.” The Free Market 14, no. 11 (November 1996).

All Rights Reserved ©
What is the Mises Institute?

The Mises Institute is a non-profit organization that exists to promote teaching and research in the Austrian School of economics, individual freedom, honest history, and international peace, in the tradition of Ludwig von Mises and Murray N. Rothbard. 

Non-political, non-partisan, and non-PC, we advocate a radical shift in the intellectual climate, away from statism and toward a private property order. We believe that our foundational ideas are of permanent value, and oppose all efforts at compromise, sellout, and amalgamation of these ideas with fashionable political, cultural, and social doctrines inimical to their spirit.

Become a Member
Mises Institute