Under the negative income tax all individuals are guaranteed a minimum standard of living by being awarded a grant, and the grant is reduced as their earnings rise (though by less than one for one). Alternatively, under wage subsidies, for each dollar of earnings up to some level, the government pays each person a refundable tax credit for each dollar earned up to some level. This tax credit is then phased out after reaching a maximum, so the credit goes to zero for middle-income taxpayers.

a. Compare the work incentives of the wage subsidy and the negative income tax for the entire income distribution. Use a diagram and explain.

b. Assume that the poverty line is fixed at $20,000. Design a negative income tax to combat poverty by choosing a basic grant level and an implicit tax rate at which this grant is reduced as incomes rise. What are the trades-offs involved in setting grant level and tax rate? What are the exigency and equity effects of choosing different grant levels and tax rates? How will the program affect people with different incomes?

c. Now consider the possibility of using categorical welfare grants. Under categorical welfare grants all individuals possessing certain characteristics are guaranteed a minimum standard of living, and the grant is taken away one for one as income rises. How should the government choose the right categories for targeting grants to some welfare groups?

d. What are the advantages and disadvantages of categorical grants relative to negative income tax?