A low-distortion tax incentive to relocate from low-urbanized regions

Summary of the proposal

The recent ascent of right-wing populism in much of the developed world has taken politicians, pundits and experts completely by surprise, and they have so far been at a loss to know what to do. Yet, it is obvious that something needs to be done — and fast — to address the perception among the bottom third of the population (whether true or exaggerated) that they have been left behind by globalization. This essay puts forward a tax break on the income tax, retirement tax and public medical insurance tax for people who relocate from the rural areas and small towns to larger urban areas, and increase their income in the process. The key reason for this proposal is that some people may be staying in rural areas or small towns because of sentimental attachment to the places or fear of relocating, and providing them with a monetary incentive in addition to the increased income may motivate them to relocate. The proposed measure is low-distortionary since it is based on a bottom-up approach and labor reallocation via genuine market signals.


The recent victories in Europe and the United States of nationalist populist political movements were largely driven by resentment among the parts of the population that perceive themselves (whether justifiably or not) to have been left behind by the modern globalized economy. This fact has drawn a lot of attention to the ways in which the grievances of those people may be legitimate and could be addressed without undermining the fundamentals of maintaining relatively free and prosperous societies.

The stand-out fact about most of the people who supported Brexit in the UK and Donald Trump in the US, and support Marine Le Pen in France is that they tend to be geographically concentrated in low-urbanized areas that were previously largely relying economically on manufacturing. With increasing automatization and globalization, many production lines have become obsolete or uncompetitive which led to a loss of many manufacturing jobs and associated decrease in the vitality of the service sector. Hence, a lot of discussion has centered on the potential ways of recreating the jobs in question (often through highly damaging protectionist measures of various kinds) or giving direct financial aid to struggling people (through a basic income guarantee, for instance).

However, one of the things that seems to have been largely overlooked is that the deplorable living conditions of many of the people living in economically depressed areas may be the result not just of the external forces that those people were powerless to counteract. Rather, in many cases, people may just be failing to make the rational choice of leaving the depressed area that they live in and move to an area with superior economic opportunities.

In a recent article for Reason Magazine,[1] Ronald Bailey explores his home county in the state of West Virginia, which is the poorest county in the US. According to the research he cites, nearly 47% of personal income in the county is attributable to the federal social transfer programs. The availability of welfare may, coupled with sentimental attachment to the place and community, as well as fear of novelty, overpower the motivation people may have to seek better opportunities in more urbanized areas.

To make a caveat, there is no reason to believe that the majority of people who succumbed to nationalist populism of the Trump’s variety are economically disadvantaged people living in the extremely depressed regions like the McDowell County. As documented by Nate Silver,[2] the level of education of a county’s population is a far better predictor of how it voted at the November, 9 election than the income level. A recent study by Resolution Foundation also persuasively challenged the idea that globalization has left a substantial part of the population in the developed world behind.[3]

However, there are important caveats to this general point. First, while people who vote for populists may mostly not be experiencing economic hardship themselves, they might witness areas with a lot of people who do, and the availability bias will make them think that the trouble is far more widespread than it actually is. In addition, there may be territories where relatively decent income levels have been sustained through redistribution and government subsidies to uncompetitive enterprises rather than genuinely productive activities. The Eurostat’s map of European regions by GDP per capita seems to lend credence to this idea.[4] In France, for instance, one region (around Paris) is enormously more productive in GDP terms than any other French region. The situation is similar with London vis-à-vis most other UK regions, Madrid and Basque Country vis-à-vis most other Spanish regions, and so on. Getting some people to move away from the relatively unproductive regions may thus lead to large welfare improvements

Welfare dependence may be associated with other problems. Being on welfare may damage the recipients’ sense of self-esteem. In some contexts, welfare dependence may lead to drug abuse, although there does not seem to be a strong correlation in general.[5] As Tyler Cowen noted in a recent article,[6] the very West Virginia discussed above seems a serious substance abuse problem that appears to make it stand out far more among the U.S. states than its poverty rate. In such cases, it seems to be not just the government welfare transfers that play a role but also the expectations that people have about their lives and surroundings.

This essay puts forward a proposal “Embrace the City” (ETC) that could substantially contribute to resolving the problem of people staying in economically depressed regions because of irrational attachment to them or fear of relocating and starting a new life from scratch, or other reasons. The proposal does not involve any coercive measures, only a low-distortionary tax incentive.

A Tax Incentive To Relocate

The biggest issue with incentivizing relocation of people from the depressed low-urbanized areas to highly urbanized areas has to do with the famous economic calculation problem. The modern economy, involving production of millions of interrelated goods and services requiring perhaps billions of inputs, is so complex that there is no plausible way for any person or group of persons to figure out which cities require which people to relocate to them. In such circumstances, artificially incentivizing relocation may result in wrong people relocating or the right people relocating to a wrong city, or the right people relocating to the right city at a wrong time, etc.

This implies that for a tax incentive not to be heavily distortionary, it has to rely on price signals (including wages) in a bottom-up manner. This means, for example, that an incentive should not be given to whole categories of people but instead be based on the proven capacity of their relocation decisions to create more value.

The measure proposed here (ETC) achieves this through tying the exercise of a tax benefit to the individual decisions to relocate through a market-price-based proof. What is proposed is that an individual from a depressed region who decides to relocate to a more fortunate region be eligible for a tax break of a short duration of up to the amount by which her wage in the new region exceeds her previous wage. From the economic standpoint, if a person finds and sustainably retains a job that pays her more money than her previous one, this very probably means that her labor has now been reallocated to a more valuable use. The reason for this is that entrepreneurs will usually only pay more for the factors of production, including labor, if they believe that they can more profitably employ them.

In order to minimize potential fraud, ETC will only apply after the person who relocated spends a certain period of time in the new region (e.g. six months) and only to people whose new and old wages are reasonably verifiable. It is also important to make sure that the employers do not receive any tax benefits from employing the relocating individuals. Otherwise, it is possible for businesses to hire people where the hiring does not actually make business sense on its own, which would make the measure proposed here substantially more distortionary. Finally, a reasonable floor should be set on the wage increase amount that qualifies for the tax break to ensure that it is substantially higher than the estimated administration cost per applicant.

The specific taxes with respect to which the targeted tax break would be given are the personal income tax and the employee contributions to retirement and public medical insurance. The exact duration of the tax break is to be determined on the country-by-country basis and will probably involve the considerations of fiscal position of a given country, the estimated number of people who could take advantage of the scheme, etc. But it should not be very long-term so that the scheme does not become a drain on the government budget.

To ensure that the proposal target the bottom third of the population, the current wage ceiling should be established, perhaps somewhat above the given country’s poverty line for individuals.

A rough estimate of the potential budget deficit impact based on the US example

In order to see that ETC would not have too much negative impact on countries’ fiscal positions, let us consider a rough estimate of an implementation of such a measure for the U.S. The U.S. poverty line threshold for individuals is $12,082.[7] Let us suppose that the relocation tax break’s current income ceiling is set at $13,000 and the duration is two years. According to the US Census Bureau,[8] by the end of 2015, 13.5% of Americans had incomes below the poverty line. Suppose that 15% have income below 13,000. Of those, however, a substantial percentage are minors and other dependents. Hence, suppose that 7.5% of the U.S. population are below the poverty line. It is certain, though that not all of those people live in rural areas or relatively small towns. Let us assume that two-thirds of that figure, or 5% of the population, will be eligible. This means that the proposal under consideration could concern around 16 million people.

Suppose that out of those 3 million make use of this proposal, relocate and on average increase their incomes by $10,000 per year. Their income tax upon relocation will not change until they hit $37,561 per year, which is unlikely to happen fast, so we can assume no change in the income tax rate for them, which currently stands at 15%. Also, all the U.S. employees currently pay 6.2% in social security contribution and 1.45% in the Medicare contribution.[9] If we sum all the three rates, the result is 22.65%.

The increase in wage ($10,000) exceeds the overall withholding ($5,209.50), thus according to the proposal herein, the relocating individuals will be able to keep the whole amount of withholding under the three taxes. This means that if the tax break duration is two years, 3 million people will not pay $31.25 bln. in taxes during two years, which constitutes an addition to the deficit of 0.17% of GDP. Even if we assumed that after the tax break has expired there will be no deficit reduction because of higher incomes, this is clearly not a very high price to pay in terms of fiscal sustainability.

Why limit the proposal to people relocating to more urbanized areas?

It may reasonably be asked at this point what the justification is for reducing the proposed tax break scheme to people who will prove that they found a more gainful employment through relocating to more urbanized areas.

Although it is true that people being able to receive higher employment incomes will tend to indicate that they are now creating more value for others, this is not necessarily always true. For instance, a programmer working in a high-tech startup may for some time receive less than if she were employed by an established enterprise just because highly innovative projects involve a lot of risk.

Perhaps more important are human capital considerations. Some domains of employment may have relatively high initial remuneration but few opportunities for professional growth, whereas the opposite may be the case for other domains. Since we care not about economic efficiency in a simplistic static sense (with fixed means and needs) but about the ability of the economy to serve evolving human needs better over time, we can’t just say that what matters is for every employee to receive the highest possible wage at the moment.

Let us now consider how ETC will fulfil the criteria of boosting economic freedom and improving the welfare of the bottom third.

How ETC will increase economic freedom for all

In line with what was mentioned in the introduction, the perception among people in rural areas and small towns that they have been completely left behind by globalization may result not so much from the objective failure of their incomes to rise as much as those of the urbanites, as from the changes that have to do with the decreasing population density in small towns and the rural areas. As it declines, it may be less profitable to run service businesses like cinemas and restaurants, and this may be contributing to the sense of reducing welfare that people who inhabit those places may have. Getting people to relocate from such areas will lead to these people having less sense of resentment towards the modern open and dynamic economic order. Hence, it will be more difficult for populist demagogues like Donald Trump or Marine Le Pen to target them to promote protectionist measures or industrial policy to bring back the lost manufacturing jobs.

Another important issue that deserves to be reiterated here is that although incomes in small towns and rural areas may not have stagnated, they have probably been disproportionally sustained by government welfare. The big downside of welfare is the indignities associated with it, as well as probably substance abuse in some places.

In a more general sense, to the extent that the proposed initiative renders people wealthier, it will tend to make them more receptive to future proposals aimed at increasing economic freedom. First, much of people’s aversion to economic freedom and competition probably arises from deep-seated fears about the downsides such as getting fired from one’s job or getting seriously ill. In this regard, getting more people to move into bigger urban areas will tend to strengthen the effect of more wealth because it may be easier to find a new job or to even change one’s occupation in a larger urban area. This hypothesis is supported by the U.S. data cited by the US Department of Agriculture[10] showing that, following the latest economic crisis, the employment levels have topped the pre-crisis levels in metropolitan areas but remained depressed in the nonmetropolitan ones.

A question may, however, be posed whether relocating, for instance, 3 million Americans via the proposed scheme will have much of an impact. There are two major responses to it. First, the fact that this avenue will be available to everyone who manages to find a higher-paying job in a larger urban area will demonstrate to people living in what was called “the flyover country” that the government has not forgotten them, despite what they could believe. Secondly, the departure of further people from some of the depressed areas may make those areas even less attractive, which can motivate more people to leave them and thus create a snowball effect.

Herein of course, lies the risk that, if the proposal herein succeeds in getting a substantial number of people to relocate, this could actually increase the resentment of those who will still choose to stay behind. This possibility has to be acknowledged but the rhetorical position of the governments and political parties supporting it will be relatively advantageous because they will be able to say that the opportunity to improve one’s lot is, in principle, available to everyone. The implementation could also engender the much-needed debate about the intrinsic value of rural and small-town communities and ways of life in general. This debate should be approached carefully but the idea that should be promoted is that communities and ways of life are only valuable to the extent that they improve and enrich people’s lives, and those that qualify do not need to be propped up through government restrictions, transfers and subsidies.

How will ETC boost the welfare of the bottom third?

The key way in which the proposed measure improves the welfare of the bottom third is straightforward. People who will be the beneficiaries of the tax break will get to keep more of their hard-earned money, and higher income is correlated with other measures of well-being, including a host of psychological outcomes.[11] For some people living in economically depressed areas, taking advantage of ETC and moving to more urbanized areas may also mean ceasing to be unemployed or finding a full-time job.

Secondly, as was mentioned in the preceding section, relocating to areas with higher population densities will tend to improve people’s access to higher-quality services such as restaurants, bars, cinemas, etc., and will tend to broaden their horizons. They will generally tend to feel less left behind by modernity. Thirdly, and perhaps no less importantly, in line with Tyler Cowen’s article cited above, moving to the cities may liberate people from the damaging culture centered around nostalgia for the mythical past that can’t be brought back. Cities can show them that there was no better time to live than today.

[1] Bailey, R. Stuck. Reason Magazine. December 10, 2016. Accessed January 9, 2017. http://reason.com/archives/2016/12/10/stuck.

[2] Silver, N. Education, not Income, Predicted Who Would Vote for Trump. FiveThirtyEight. November 22, 2016. Accessed January 9, 2017. http://fivethirtyeight.com/features/education-not-income-predicted-who-would-vote-for-trump/.

[3] Giles, C. and Donnan, S. Globalization ‘not to blame’ for income woes, study says. Financial Times. September 12, 2016. Accessed January 9, 2017. https://www.ft.com/content/93f2d4ba-7901-11e6-97ae-647294649b28.

[4] GDP at regional level. Eurostat. March 2016. Accessed January 9, 2017. http://ec.europa.eu/eurostat/statistics-explained/index.php/GDP_at_regional_level.

[5] Pollack, H. A. Key Research Findings: Substance abuse trends among welfare recipients. Substance Abuse Policy Research Program. Accessed January 9, 2017. http://www.saprp.org/pm_keyResFind.cfm

[6] Cowen, T. US Economic Problems Also Partly Cultural. Charleston Gazette-Mail. December 31, 2016. Accessed January 9, 2017. http://www.wvgazettemail.com/gazette-columns/20161231/tyler-cowen-us-economic-problems-also-partly-cultural

[7] What are poverty thresholds and poverty guidelines? Institute for Research on Poverty. Accessed January 9, 2017. http://www.irp.wisc.edu/faqs/faq1.htm.

[8] Proctor, B. D., Semega, J. L. Kollar, M. A. Income and Poverty in the United States: 2015. United States Census Bureau Report P60–256. September 13, 2016. Accessed January 9, 2017. http://www.census.gov/library/publications/2016/demo/p60-256.html

[9] Topic 751 — Social Security and Medicare Withholding Rates. IRS. December 30, 2016. Accessed January 9, 2017. https://www.irs.gov/taxtopics/tc751.html.

[10]Rural Employment and Unemployment. United States Department of Agriculture Economic Research Service. November 17, 2016. Accessed January 9, 2017. https://www.ers.usda.gov/topics/rural-economy-population/employment-education/rural-employment-and-unemployment/

[11]See, for example, Haushofer, J. and Fehr, E. 2014. On the Psychology of Poverty. Science. 344, 862

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