There are two different arguments against the welfare state. One, which we described earlier in this chapter, is based on philosophical concerns about the proper role of government. As we learned, some political theorists believe that redistributing income is not a legitimate role of government. Rather, they believe that government’s role should be limited to maintaining the rule of law, providing public goods, and managing externalities.

The more conventional argument against the welfare state involves the trade-off between efficiency and equity, an issue that we first encountered in Chapter 7. As we explained there, the ability-to-pay-principle—the argument that an extra dollar of income matters more to a less well-off individual than to a more well-off individual—implies that the tax system should be progressive, with high-income taxpayers paying a higher fraction of their income in taxes than those with lower incomes.

But this must be balanced against the efficiency costs of high marginal tax rates. Consider an extremely progressive tax system that imposes a marginal rate of 90% on very high incomes. The problem is that such a high marginal rate reduces the incentive to increase a family’s income by working hard or making risky investments. As a result, an extremely progressive tax system tends to make society as a whole poorer, which could hurt even those the system was intended to benefit. That’s why even economists who strongly favor progressive taxation don’t support a return to the extremely progressive system that prevailed in the 1950s, when the top U.S. marginal income tax rate was more than 90%. So, the design of the tax system involves a trade-off between equity and efficiency.

A similar trade-off between equity and efficiency implies that there should be a limit to the size of the welfare state. A government that operates a large welfare state requires more revenue than one that restricts itself mainly to provision of public goods such as national defense. A large welfare state requires higher tax revenue and higher marginal tax rates than a smaller welfare state.

Table 18-8 shows “social expenditure,” a measure that roughly corresponds to total welfare state spending, as a percentage of GDP in the United States, Britain, and France. It also compares this with an estimate of the marginal tax rate faced by an average single wage-earner, including payroll taxes paid by employers and state and local taxes. As you can see, France’s large welfare state goes along with a high marginal rate of taxation. As the upcoming Economics in Action explains, some but not all economists believe that this high rate of taxation is a major reason the French work substantially fewer hours per year than Americans.

One way to hold down the costs of the welfare state is to means-test benefits: make them available only to those who need them. But means-testing benefits creates a different kind of trade-off between equity and efficiency. Consider the following example: Suppose there is some means-tested benefit, worth $2,000 per year, that is available only to families with incomes of less than $20,000 per year. Now suppose that a family currently has an income of $19,500 but that one family member is deciding whether to take a new job that will raise the family’s income to $20,500. Well, taking that job will actually make the family worse off, because it will gain $1,000 in earnings but lose the $2,000 government benefit.

This feature of means-tested benefits, which makes a family worse off if it earns more is known as a notch. It is a well-known problem with programs that aid the poor and behaves much like a high marginal tax rate on income. Most welfare state programs are designed to avoid a notch by setting a sliding scale for benefits. With a sliding scale, benefits diminish gradually as the recipient’s income rises rather than come to an abrupt end.

Even so, the combined effects of the major means-tested programs shown in Table 18-3, plus additional means-tested programs, such as housing aid, that are offered by some state and local governments, are to create very high effective marginal tax rates. For example, one 2005 study found that a family consisting of two adults and two children that raised its income from $20,000 a year—just above the poverty threshold in 2005—to $35,000 would find almost all its increase in after-tax income offset by loss of benefits such as food stamps, the Earned Income Tax Credit, and Medicaid.