Last week, national media reported on the story of a formerly homeless New Jersey man whose honesty, after finding and turning in $850 he found on the street, turned him into a local celebrity but cost him his welfare and Medicaid benefits.

James Brady was unemployed and living in a shelter in Hackensack at the time he found the unmarked envelope, but he didn't think twice before giving it to the police, reasoning that the money might belong to someone even worse off. Six months passed and no one came to claim it, so the police returned the cash to Brady. The local headline that day read “Ex-homeless man’s selfless act pays off.”

Unfortunately, all of the attention caught the eye of Hackensack Human Services director Agatha Toomey, who proceeded to cut Brady’s General Assistance and Medicaid benefits for failing to report the reward as new income. Media around the country immediately seized on the story as an object lesson in the casual cruelty of bureaucratic indifference.

Still, the saddest part of the story isn't Toomey’s cold-heartedness, or even the two months Brady will have no health insurance coverage (he sees a therapist and takes medication regularly for the depression he has had since September 11th, when he was supposed to be at the World Trade Center for a business event). It’s the fact that Brady’s dilemma is so commonplace.

Public policy and the poverty trap

Every day, millions of low-income Americans live in fear of losing public assistance entirely if they earn any extra income, save too much money, or buy a car to get to a new job.

The way that asset tests are designed, even one additional dollar in income could be enough to disqualify a family from receiving benefits worth thousands. That isn't a problem when benefits are phased out slowly, as with the Earned Income Tax Credit. But with many other programs—TANF (welfare), SNAP (food stamps) and Medicaid, to name a few—beneficiaries face a stark choice: continually spend down their savings or become suddenly ineligible.

Means-testing makes sense in theory. Public assistance programs are designed to provide benefits only to people with too few resources to avoid destitution. To determine whether an applicant is eligible, government agencies consider both income and assets, including anything that can be converted into cash, like stocks, bonds and bank accounts. In some cases, the list even includes cars, retirement accounts and college savings plans.

There is no doubt that denying benefits based on these criteria helps the government to save money. The problem from a public policy standpoint is that asset-testing also creates a powerful incentive for families not to save money.

In general, taxes increase progressively with income. But benefits also disappear as income rises, acting as a secondary tax on each additional dollar. The result, according to the nonpartisan Congressional Budget Office, is an effective marginal tax rate on income as high as 95 percent for some low-income people. This is the very definition of a poverty trap.

The future of asset-testing

Today, states enjoy a wide range of flexibility in how they determine eligibility for public assistance programs like TANF, Medicaid and the Children’s Health Insurance Program (CHIP). Six states have already eliminated asset tests for TANF, and many more have decided to increase their limits and exclude various asset classes, such as retirement and college savings accounts. And, thanks to the Affordable Care Act, all states must eliminate asset tests for Medicaid by 2014.

Food stamps are a different story. Currently, a policy called “categorical eligibility” allows states to bypass the federal asset limit for SNAP, which was set at $2,000 in 1986 and has never been adjusted for inflation. But instead of raising the federal asset limit (which should be worth $4,250 in today’s dollar), Republicans in Congress want to remove the “categorical eligibility” option entirely.

Applicants would once again have to provide detailed financial records to prove how poor they are—a requirement that, when instituted recently in the state of Pennsylvania, overloaded SNAP case officers and resulted in tens of thousands of otherwise-eligible families being denied benefits for lack of paperwork.

For conservatives who aim to dismantle the welfare state by breaking it first, Pennsylvania couldn't be a better outcome. But House Republicans would go even further: According to the Congressional Budget Office, their “Nutrition Reform and Work Opportunity Act” would cut $40 billion from SNAP, denying benefits to an average of nearly 3 million people a year for the next decade. Of that number, 1.8 million would be denied for having more than $2,000 in savings.

How to end the poverty trap

A better idea would be to eliminate asset-testing for food stamps and other programs entirely. Or, at the very least, to intelligently raise asset limits to a level that encourages savings.

Personal finance experts suggest that everyone have an emergency savings account with enough money to cover up to six months of living expenses—about $6,000 for a family of four living on the poverty line. Today’s asset limits require families to live in a state of perpetual economic instability, without the savings they need to cope with unexpected medical costs or periods of unemployment. They deny individuals the opportunity to become self-sufficient through investments in higher education or job training.

People like James Brady shouldn't have their benefits cut for collecting an $850 reward; they should get a tax credit for putting that money in a high-interest savings account. That we should bend over backwards to provide tax-advantaged accounts for high-income households to save, and then turn around and punish the poor for trying to do the same is more than counterproductive—it’s unconscionable.