The money that low income Americans get in the form of welfare benefits are, except for very specific circumstances, tax free.

To understand why it has been set up that way, let's consider the example of food stamps, which are now doled out in the form of Supplemental Nutrition Assistance Program (SNAP) benefits. Here, each month, the U.S. government loads the Electronic Benefit Transfer (EBT) debit cards that have been issued to low income-earning Americans who have qualified to have their regular incomes supplemented with SNAP benefits to cover a portion of their food expenses.

They may then go purchase food, drinks, and other groceries at any retailer that accepts EBT card transactions for the purchase of U.S. Department of Agriculture-approved eligible items, where they can spend the amount of benefits they have received as if it were like any other cash-backed bank debit card, but with the limitation that they cannot withdraw any part of their alloted benefits in the form of cash.

We see that their SNAP benefits are nearly the equivalent of additional cash income that can be spent, which effectively adds to the regular income of who receive the welfare benefits. So why doesn't the IRS exempt welfare benefits from being treated just like their other income on their tax returns?

We think the answer has to do with the combination of minimizing the cost to the government for providing the welfare benefits while also maximizing the benefits to the welfare recipient. By making the welfare benefits they receive tax-free, the government technically achieves both these results, where if that money was subject to income taxes, the federal government would have to increase the amount of taxpayer money that it pays out in welfare benefits to compensate, unless it were willing to cut the real after-tax amount of the benefits for those whose low incomes make them eligible to receive food stamps.

In the case of food stamps/SNAP benefits, the government takes that principle a step further and also exempts the value of benefits received from the program from state and local income taxes, and also from sales taxes.

Taking this action helps maximize the value of the welfare benefits for their recipients, which would otherwise be diminished if they were allowed to be subjected to these kinds of taxes, defeating the purpose of providing the tax-free welfare benefits in the first place.

There are multiple downsides to this practice, with the first being that administering it imposes higher regulatory compliance costs on businesses, such as those that accept the EBT card for SNAP benefit recipients, which have to apply a whole separate set of rules at their checkout counters based only on how their customer chooses to pay for what they buy. Some items are eligible and may be paid for with SNAP benefits, some are not, so sales taxes that would apply to an entire purchase for a non-EBT purchase now has to be individually calculated.

Beyond that, the practice of making welfare benefits tax free has the more significant downside in that it doesn't take into account all of the other kinds of welfare assistance that low-income Americans enrolled in SNAP might also receive, which could boost their effective after-welfare incomes near that of those who toil in higher paying jobs but don't receive similar levels of welfare. If the purpose of government is to achieve fairness, that would be an exceptionally unfair result, because one American had to earn it, where the welfare recipient did not.

Exempting the value of such benefits from taxation creates other undesirable outcomes, as recently noted by the Congressional Budget Office.

As income rises, phasing out a benefit (such as SNAP) increases the marginal tax rate and reduces the incentive to work. SNAP also effectively increases the after-tax income of its recipients—even as the benefit phases out—further discouraging work.

We wonder if the right incentive signal might be sent to those affected by welfare's disincentives if the value of those welfare benefits were taxed just like the rest of their incomes. In practice, you would have to increase the amount of the benefits to offset the negative effect of taxes, so that you wouldn't be diminishing the benefit of having the welfare support for those who need it, but that increased cost would be netted out in the wash, where the excess money would be coming back into the government.

For those receiving benefits, who wish to minimize the income taxes that would come along with their welfare-boosted incomes, it may be desirable to provide these individuals with the ability to customize the type and value of welfare benefits they receive, where their annual tax bill might be used to help them determine which benefits they value most in that exercise. Today, that kind of information coordination is almost completely absent among the U.S. government's welfare programs, which leads to large inefficiencies in how U.S. taxpayer money is spent for its full array of assistance programs.

Meanwhile, businesses would gain by having their regulatory compliance costs reduced, while state and local governments would benefit from being able to apply their taxes across a wider base, which would allow them to lower their tax rates to collect the same amount of revenue - the latter of which would be a benefit to consumers.

At the very least, it would also address the misperception that many who use tax return data to measure the well-being of Americans have as a result of the way that welfare income is exempted from taxes, where they think that those who have incomes that fall below the poverty level are living in poverty, even after they've benefited from all of the U.S.' social welfare programs.