Transfer Payments: Welfare and Social Security Chapter 34

Introduction This chapter focuses on how income transfer programs alter work incentives and behavior. Central questions include: What are the goals of major income transfer programs? How are transfer benefits computed? How do transfer payments alter market behavior?

Major Transfer Programs Roughly 50 cents out of every dollar is devoted to transfer payments. Transfer payments – Payment to individuals for which no current goods or services are exchanges; like Social Security benefits.

Cash vs. In-Kind Benefits Income transfer doesn’t always entail cash payments. In-kind transfers are direct transfers of goods and services rather than cash. Cash transfers are income transfers that entail direct cash payments to recipients.

Cash vs. In-Kind Benefits Examples of in-kind transfers include food stamps, Medicaid benefits, and housing subsidies. Examples of cash transfers include Social Security, welfare, and unemployment benefits.

Cash vs. In-Kind Benefits In-kind benefits ensure the transfer is used as intended. For example, food stamps are given instead of cash to assure that recipients purchase only food.

Cash vs. In-Kind Benefits Target efficiency is the percentage of income transfers that go to the intended recipients and purposes. The target efficiency of a transfer program tells us how well the transfers attain their intended purpose.

Income Transfer Program Social Security 44% TANF 2% SSI 3% EITC 3% Food stamps 3% Unemployment insurance 3% Housing aid 3% Medicare 23% Medicaid 12% Other 4%

Social Insurance vs. Welfare Not all the $900 billion of income transfers goes to the poor. A lot of student loans go to middle-class college students. Disaster relief helps rebuild both mansions and trailer parks.

Social Insurance vs. Welfare Medicaid is an in-kind welfare program. Welfare programs – Means-tested income transfer programs, examples include welfare and food stamps.

Social Insurance vs. Welfare Social Security and Medicare aren’t welfare programs because recipients don’t have to be poor. To get Social Security or Medicare benefits, you just have to be old enough, and have paid into the program while you worked.

Social Insurance vs. Welfare Social insurance programs are event-conditioned income transfers intended to reduce the costs of specific problems. Examples include Social Security and unemployment insurance.

Social Insurance vs. Welfare Most income transfers are for social insurance programs, not welfare.

Social Insurance vs. Welfare Food Stamps TANF SSI Housing Aid Child Nutrition Medicaid SOCIAL INSURANCE Social Security Medicare Unemployment Insurance

Transfer Goals In general, all transfer programs aim to alter the distribution of income in some way.

Market Failure The need for government-provided transfers implies that there has been a failure of the market to distribute income equitably. Market failure – An imperfection in the market mechanism that prevents optimal outcomes.

Market Failure Reducing poverty is the explicit goal of virtually all welfare programs and is accomplished through transfer payments.

WHAT to Produce Transfer payments also change the mix of output. Food stamps increase food consumption. Housing subsidies increase the demand for housing. Student loans increase college enrollments.

Unintended Consequences Income transfer programs may change market behavior in unintended ways.

Reduced Output Transfer payments may dull work incentives, reducing labor supply and total output. Labor supply – The willingness and ability to work specific amounts of time at alternative wage rates in a given time period, ceteris paribus.

Reduced Output Attempts to redistribute income may reduce total income – the economic pie shrinks when we try to reslice it.

Reduced Labor Supply and Output Output of Goods (units per year) Output of Services (units per year) Quantity of Labor (hours per year) Wage Rate (dollars per hour) Production possibilities . . . S2 Labor supply with transfer programs S1 Labor supply before transfer programs . . . before transfer programs . . . with transfer programs

Undesirable Behavior People may also change their nonwork behavior. Welfare benefits encourage recipients to have more children. Medicare encourage recipients to overuse health care services. Unemployment benefits encourage recipients to stay unemployed longer.

Welfare Programs The largest federal cash welfare program is called Temporary Aid to Needy Families (TANF). The TANF program was created by congressional welfare reforms in 1996 and replaced an earlier program (AFDC)

Benefit Determination The first task of the TANF program is to identify potential recipients.

Benefit Determination A four-person family with less than $17,500 of income in 2001 would have been considered poor.

Benefit Determination A family with $15,000 income in 2001, would have a poverty gap of $2,900. The poverty gap is the shortfall between actual income and the poverty threshold.

The Work Incentive Problem We could just give people a check for the amount of their poverty gap. No one would be poor.

The Work Incentive Problem This might encourage people who are not poor to become poor.

The Work Incentive Problem By quitting their jobs, declaring themselves poor, and accepting a guaranteed income transfer, they would gain much more leisure at little financial or psychological cost.

The Work Incentive Problem Families that are already poor have reduced incentive to work harder to get out of poverty with transfer programs in place.

The Work Incentive Problem This occurs because the programs are generally set up to reduce benefits as earned income increases.

Marginal Tax Rates When welfare benefits are set equal to the poverty gap, every additional dollar of wages reduces welfare benefits by the same amount. This amounts to a 100 percent marginal tax rate.

Marginal Tax Rates By guaranteeing a poverty-level income, we destroy the economic incentive of low-income workers to support themselves.

Marginal Tax Rates This creates a moral hazard for welfare recipients. Moral hazard – An incentive to engage in undesirable behavior.

Less Compassion To reduce this moral hazard, Congress and the states set a much lower ceiling on welfare benefits. Rather than closing the poverty gap, states set a maximum benefit far below the poverty line.

Less Compassion The following formula for welfare benefits resulted.

Less Compassion In 2001, the typical state set a maximum benefit of about $8000 for a family of four. As a result, a family totally dependent on welfare is unquestionably poor.

More Incentives Another change has been made in the benefit formula to encourage welfare recipients to lift their own incomes above the poverty line

More Incentives The implicit marginal tax rate was cut from 100 to 67 percent. So we now have a new benefit formula.

More Incentives Now welfare recipients can increase their income above the poverty level by losing only a portion of their welfare payment.

Work (Dis)Incentives Hours Worked (per year) Income Total income at 100% rate Welfare benefits at 67% rate Welfare benefits at 100% rate A B G C Wages at $8/hour 2000 1500 1000 500 $16000 12000 8000 4000 Total income at 67% rate

Incentives vs. Costs Although this new benefit calculation is an improvement, it stills offers a 67 percent marginal tax rate.

Incentives vs. Costs Why not improve the plan even farther? If we don’t impose a marginal tax rate at some point, everyone will be eligible for welfare benefits.

Incentives vs. Costs We must recognize a basic dilemma: Low marginal tax rates encourage more work effort buy make more people eligible for welfare. High marginal tax rates discourage work effort buy make fewer people eligible for welfare.

Incentives vs. Costs The breakeven level of income summarizes the conflict between work incentives and the desire to limit welfare costs and eligibility.

Incentives vs. Costs The breakeven level of income is the income level at which welfare eligibility ceases.

Incentives vs. Costs Low marginal tax rates encourage work but make it hard to get completely off welfare.

Incentives vs. Costs There is a basic conflict between work incentives (low marginal tax rates) and welfare containment (smaller welfare rolls and outlays).

Tax Elasticity of Labor Supply The trade-off between more welfare and less work depend on how responsive people are to marginal tax rates.

Tax Elasticity of Labor Supply The tax elasticity of labor supply is the percentage change in quantity of labor supplied by the percentage change in tax rates.

Tax Elasticity of Labor Supply If the tax elasticity of labor supply were zero, it wouldn’t matter how high the marginal tax rate was. People would work for nothing.

Tax Elasticity of Labor Supply In reality, the tax elasticity of labor supply is more in the range of 0.2 to 0.4, so the marginal tax rates do affect work effort.

Time Limits The government requires TANF recipients must engage in some sort of employment-related activity within two years of receiving benefits. There is also a five-year lifetime limit on welfare eligibility.

Social Security The Social Security program faces the same conflicts among compassion, incentives, and costs.

Program Features The Social Security program is a mix of three separate income transfers.

Social Security Finances Where Tax Revenue Comes From 7.65% paid by workers 7.65% paid by employers Where Transfer Payments Go Annual Retirement Benefit Payroll taxes Retirement benefits Survivor benefits Disability benefits Minimum Median Maximum $270 billion $77 billion $80 $12,000 $20,000 $54 billion

Retirement Age People born before 1940 can choose early retirement at age 62 – 64 and normal retirement at age 65-67. Those who choose early retirement do so with reduced benefits.

Retirement Age The age threshold for “normal” retirement is increasing each year. By the year 2022, the age threshold for normal retirement will be age 67.

Progressive Benefits Retirement benefits are based on an individual’s wages. High-wage workers receive larger benefit checks than low-wage workers.

Progressive Benefits The Social Security benefits formula is progressive because the ratio of benefits to prior wages declines as wages increase.

Progressive Benefits A declining wage replacement rate ensures that low-wage workers receive proportionately greater benefits. The wage replacement rate is the percentage of base wages paid out in benefits.

The Earnings Test The government imposes an “earnings test” to determine how much retirement benefits an older person can collect while still working.

The Work Disincentive In 2001, the wage “ceiling” for workers 62 to 64 was $10,680. A person could earn as much as $10,680 and still get maximum retirement benefits.

The Work Disincentive Earning over $10,680 results in a 50 cent reduction in benefits for each dollar earned. This fifty percent marginal tax rate creates a large disincentive for Social Security recipients to work.

Social Security Work Test Hours Worked (per year) Dollar Amounts (per year) A C D 2000 1500 1000 500 $40,000 $30,000 $20,000 $10,000 Social Security benefits Wages at $20/hour Total income

Declining Labor Supply The labor force participation rate for the over-65 has declined dramatically in the U.S. since the 1950s. Labor-force participation rate - A measure of the percentage of the population that is either employed or actively seeking a job.

Declining Labor-Force Participation Rate (percent of men over age 65) 46 27 33 19 16.4 16.7 50 40 30 20 10 1950 1960 1970 1980 1990 2000

Compassion, Incentives, and Cost The primary economic cost of the Social Security program isn’t the benefits it pays, but the reduction in total output that occurs when workers retire early.

Compassion, Incentives, and Cost The economic cost of Social Security is increased further by a labor supply reduction among younger workers.

Compassion, Incentives, and Cost As the behavior of both older and younger workers changes, the economic pie shrinks as we try to redistribute it from younger to older workers.

Trade-Offs Like any other program, the social security program faces trade-offs between work incentive, budgetary costs and equity

Privatize Social Security? Private retirement programs are advanced funded while Social Security is a pay-as-you-go program.

Privatize Social Security? Many people believe the Social Security system should be privatized by permitting workers to establish their own retirement plans.

Privatize Social Security? Instead of paying payroll taxes to fund someone else’s benefits, you’d make a contribution to your own pension fund.

Privatize Social Security? Although on the surface this seems attractive, it is not without controversy.

Privatize Social Security? The primary goal of Social Security is to fend off poverty among the aged.

Privatize Social Security? It transfers income from workers to retirees and redistributing income from high-wage workers to low-wage workers in retirement.

Privatize Social Security? In these ways, the program changes market outcomes.

Privatize Social Security? By contrast, a privatized system would let the market alone determine FOR WHOM goods are produced.

Privatize Social Security? Low-income workers and other people who saved little while working would end up poor in their “golden years.”

Privatize Social Security? Even in a privatized system, some high earners and savers might end up poor if their investments turned sour.

Transfer Payments: Welfare and Social Security End of Chapter 34