Chapter 17 Income Distribution and Welfare Programs Jonathan Gruber Public Finance and Public Policy...

Chapter 17Income Distribution

and Welfare Programs

Jonathan GruberPublic Finance and Public Policy

Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

The moral hazard costs of welfare policyMoral hazard effects of a means-tested

transfer system Actual welfare benefits are related to

program parameters through the following equation:

Where B stands for actual benefits received, G is a benefit guarantee level, Τ is the benefit reduction rate, w is the hourly wage rate, and h is hours worked.

B G earn ings G wh


transfer system Setting actual benefits equal to zero

results in the “break-even formula” – the income level where welfare eligibility ends:

Thus, with a guarantee of $300 and tax rate of 75%, earnings of $400 reduces the welfare benefit to zero and removes the person from welfare.

B earn ingsG

0


transfer system In principle, setting G equal to the

poverty line (with, say, =1.00) would eliminate poverty.

The Current Population Survey suggests that such a policy would cost $98 billion, a concept known as the poverty gap.

Yet such an exercise does not account for the moral hazard effects of such a policy.


transfer system Figure 3Figure 3 considers the individual’s

choice of leisure and consumption with such a grant and tax rate.

There are dramatic work disincentives, especially for those mechanically eligible for welfare who earn less than the grant, G.

2,000 Hours of leisureper year

$ of consumptionper year

25,000

G = 9,000

A

B

C

Z

D

X

Y

5,000

20,000

1,6001,200400

10,000

slope = -wage = -12.50

1,280

Figure 3This is the budget constraint before welfare is introduced.

Individuals make different choices based on preferences.

Welfare is introduced with a $9,000 guarantee and a

BRR of 100%.

Some will be “mechanically” eligible and reduce hours of work.

Others are initially ineligible, but reduce their work effort, too.


transfer system Thus, eliminating poverty is potentially

much more expensive – perhaps three times as much: Those who are mechanically eligible for

welfare stop working completely, costing the government more money.

Some who are initially ineligible change their behavior by cutting back on work and getting onto welfare. By doing so, they give up some consumption, but get much more leisure.

The moral hazard costs of welfare policy

Lowering the benefit reduction rate A natural solution to the moral hazard

problem here (the reduction in labor supply) is to lower the benefit reduction rate.

This is illustrated in Figure 4Figure 4.



25,000

G = 9,000

A

B2

C

Z1

D

X1

Y1

slope = -net wage = -6.25

560

Y2

X2

B1


18,000 Z2

1,280

Figure 4

Lowering the BRR changes the

budget constraint.

Hours of work fall for person X.

Hours also fall for person Y.

And person Z becomes eligible.


Lowering the benefit reduction rate Although such a policy ameliorates the

work disincentives relative to higher tax rates for some people, it potentially exacerbates the work disincentives for others.

This is because the breakeven level to qualify for welfare goes up when the tax rate is lowered.

The net impact depends on the relative sizes and preferences of the different consumers.


The “iron triangle” of redistributive programs The iron triangle means that there is no

way to change either the benefit reduction rate or benefit guarantee to simultaneously encourage work, redistribute more income, and lower costs. If the tax rate is lowered, work could be

discouraged for some and costs could go up.

If the guarantee is lowered, work increases and costs fall, but redistribution falls.

REDUCING THE MORAL HAZARD OF WELFARE

Are there other policy instruments that can overcome these moral hazard problems? Moving to categorical welfare payments Using ordeal mechanisms Increasing outside options

Reducing the moral hazard of welfare

Moving to categorical welfare payments Moral hazard occurs because the

benefits are not well targeted – the government cannot observe an individual’s earnings capacity.

If the government could observe true earnings ability, it could simply give payments to those with low earnings ability.


Moving to categorical welfare payments Instead, the government observes

earnings outcomes. Outcomes are related to ability, but not perfectly. A person may be poor either because: He or she is high ability but lazy He or she is low ability and working hard

By targeting benefits to actual earnings, the government creates incentives for high ability people to be lazy.


Moving to categorical welfare payments There are some characteristics that are

easy to verify, hard to change, and related to low earnings. For example, being blind limits a

person’s job opportunities and individuals are unlikely to change their behavior to qualify.

This type of targeting – categorical welfare payments – can overcome the iron triangle.


Moving to categorical welfare payments What characteristics make a good

targeting mechanism? Characteristics that are unchangeable. Characteristics that target those with

low earnings capacity. In reality, welfare programs target

characteristics like blindness, age, disability, and single motherhood.


Moving to categorical welfare payments The last of these – single motherhood – seems

on the surface to meet these two criteria. The second criterion, low earnings capacity, is

clear: poverty rates for single parent families exceed 33%.

The first criterion – whether single motherhood is unchangeable – is more debatable, however.

Although theoretically women might become single mothers to qualify, in practice this does not seem to be very common.

Figure 5Figure 5 shows the time-series correlations.

Figure 5

Single motherhood has increased over time.

While benefits have fallen.


Moving to categorical welfare payments Although single motherhood and

welfare generosity rose together during the 1960s, welfare benefits fell thereafter while single motherhood continued to rise.

This appears true for within-state comparisons over time.

The consensus from existing research is that this effect is, at most, very small.


Moving to categorical welfare payments Despite the view of the existing academic

studies, the possible negative effects of welfare on formation of stable families remains a major source of opposition.

This opposition affected the targeting in the TANF program – which, in theory, removed the distinction between single parent families and other types. The potential moral hazard from such a

policy must be weighed against the costs of expanding eligibility to a larger set of richer families.


Using “ordeal mechanisms” An alternative approach is to try get

individuals to reveal themselves as less able through ordeal mechanisms.

Ordeal mechanisms are features of welfare programs that make them unattractive, leading to self-selection of only the most needy recipients.


Using “ordeal mechanisms” Consider two types of individuals –

hard-working but low-ability individuals, and lazy but high-ability individuals.

Although some characteristics, like education, are correlated with ability but only imperfectly.

If the system was set up such that high-ability, lazy individuals find the system unattractive, they self-select out of welfare.


Using “ordeal mechanisms” Work or training requirements of TANF are

an example of such a mechanism – they impose a cost on lazy individuals who are just using welfare as a means of increasing their leisure.

The provision of in-kind benefits rather than cash is another example. If the government gives away cash, then individuals who are not needy will pretend to be needy to qualify. If the government offers, instead, a somewhat run-down public housing project, those with high ability may not be interested in taking up the benefit.


Using “ordeal mechanisms” The efficiency problem is that non-needy

individuals might masquerade as needy in order to qualify for benefits.

If the government provides a benefit that is not attractive to the non-needy, they won’t pursue this masquerade and targeting will be more efficient.

The paradox of ordeal mechanisms is therefore that apparently making the less able worse off actually makes them better off, because the government can make a fixed budget go further.

An example ofAn example ofordeal mechanismsordeal mechanisms

Ordeal mechanisms suggest a rationale for “stigmatizing” welfare programs. For example: Food stamps that are redeemed in

public at a supermarket. Waiting in lines at public welfare

offices.

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Consider the following “soup kitchen” example. Imagine that there are two types, low (l) and high (h) ability, and they enjoy soup (S) but dislike waiting in line for it (W).

The low ability person’s utility function is:U S WL 240

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The high ability person’s utility function is:

Thus the high ability person gets less utility from each serving of soup, and more disutility from waiting in line.

U S WH 120 2

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Further, imagine that the SWF is utilitarian, and that the government has 2 bowls of soup to allocate.

If the waiting time was W=0, both would want the soup, and if it were divided evenly, societal welfare would be:U UL H 240 120 360

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If the waiting time was such that W=61, then the high ability person would not wait in line for 1 bowl of soup, but the low ability person would.

Thus, both bowls of soup go to the low ability person, and societal welfare equals: U UL H 240 240 61 0 419

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Overall, social welfare has risen because those masquerading stop trying to collect the soup.

Making the low-ability person wait in line raise both his utility and social welfare.

This occurs because the gains from efficient targeting outweigh the costs of the ordeal mechanism in this case.

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Increasing outside options The third approach to reducing moral

hazard is to increase the outside options available so that it is no longer as attractive to be on welfare.

Consider Figure 6Figure 6, which raises wage rates.



25,000

G = 9,000

A

B

C

D

Y1

1,200

10,000


35,000 E


F

Y212,250

1,300 1,486Figure 6

Higher wages rotate the budget

constraint outward.

And reduce the “breakeven” level

for eligibility.

Individuals will adjust their hours. Person Y no longer goes onto welfare.


Increasing outside options There are five different approaches the

government can take to increase outside opportunities for welfare recipients: Training Labor market subsidies Child care Child support Removing welfare lock


Increasing outside options The traditional approach to increasing

outside opportunities is training welfare recipients. Most recipients have low skills.

Empirical evidence suggests training programs lead to modest declines in welfare receipts and increase earnings. Yet they cannot induce sizable reductions in the welfare rolls.


Increasing outside options Another approach is to directly

subsidize wages. One fairly expensive, broad approach is

the Earned Income Tax Credit. An alternative is targeted wage

subsidies to those on welfare. This runs into the problem that it does not help those who are reluctant to go on welfare, and could also have “entry” effects for those who did not intend to go on welfare.


Increasing outside options A third approach is to subsidize

childcare costs. This raises the net wage in the previous

figures. Regulation of quality of childcare

providers usually goes hand-in-hand with subsidies, however. This could push individuals into unregulated forms of childcare, which may be detrimental to children.


Increasing outside options A fourth approach is fully enforcing child

support obligations of absent fathers. Child support is a court-ordered payment

from an absent parent to support the upbringing of their children.

Only half of court-ordered payments are actually made. As a result, women are unable to leave welfare

because they cannot finance consumption with their earnings alone.

Child support rules have become much more stringent over time.


Increasing outside options The key problem is that many of these

non-paying fathers are poor as well, so there is not much money that can be collected.

In addition, the welfare system essentially taxes these payments at 100%, creating a disincentive for women on welfare to help track down deadbeat dads.


Increasing outside options Finally, cash welfare is often linked

with other programs, most prominently, Medicaid health insurance.

Until the mid-1980s, Medicaid was restricted to those on AFDC cash welfare. Leaving welfare entailed the entire loss of the health insurance.

Figure 7Figure 7 shows what the disincentive looked like.



25,000

slope = -net wage = -6.25

560

9,000

slope = -wage = -12.50 HI = $3,000

Cash = $9,000

slope = -net wage = -6.2518,000

21,000

A

C

B

E

F

D

Figure 7

Medicaid is offered on an “all-or-

nothing” basis.

This creates a “notch” in the

budget constraint.


Increasing outside options The discontinuous loss of Medicaid is

known as the Medicaid “notch” – where the marginal tax rate on earnings is far in excess of 100%.

Uncoupling health insurance from cash welfare could therefore lead to exits from cash welfare.

Empirical evidence is mixed on the actual effects.

WELFARE REFORMChanges due to welfare

reform The 1996 legislation, PRWORA, made

many changes to the welfare system. These include: Block grants to states rather than open

ended entitlements. Greater freedom for states to

experiment with program rules. Time limited benefits. Work requirements. New efforts to limit unwed motherhood.

Welfare reformEffects of the 1996 welfare

reform As illustrated earlier, welfare caseloads

fell dramatically: On a national basis, caseloads fell more

than 50%. Some states experienced reductions of

more than 80%. Empirical evidence suggests one-third

of the decline was from welfare reform, but other factors, like the growing economy, also played an important role.


reform Welfare reform was a windfall to the

states, because their block grant was based on welfare expenditure in 1994, when caseloads were very high.

Some states used the windfall to subsidize pro-work policies, like subsidized childcare.


reform A key question about welfare reform is

how it affected the income and well being of single mothers.

Most single mothers have not seen a drop in their consumption – there was a large increase in labor supply at the same time that caseloads were declining.

Some subgroups, mainly low skilled single mothers, have suffered a decline, however.


reform Was welfare reform a success?

They have reduced the welfare rolls without lowering incomes of single mothers.

Yet, success in the long run also depends on: The distribution of income, not just the

average. The reduction in utility from reduced leisure. Whether the block grants will work well

during recessions. The long run effects on children in these

families.

Chapter 17 Income Distribution and Welfare Programs Jonathan Gruber Public Finance and Public Policy...

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