More on income distribution Today: Family income distribution Should we redistribute income? Why? Some government programs

Reminder on Test 2 Test 2 Monday 65 minutes Restrictions on calculators are the same as for Test 1

Income distribution How is income distributed? Is there such a thing as “too much” income inequality? Why should there be redistribution? In-kind versus cash transfers When income is redistributed, should recipients be forced to consume a minimum amount of certain goods? What are the problems of redistribution?

Mean income table (families) Quintile 1980 1990 2000 Bottom 20 percent $12,756 $12,625 $14,232 Second 20 percent $27,769 $29,448 $32,268 Middle 20 percent $41,950 $45,352 $50,925 Fourth 20 percent $58,200 $65,222 $74,918 Top 20 percent $97,991 $121,212 $155,527 Top 5 percent $139,302 $190,187 $272,349 Source: “Principles of Microeconomics” 3rd edition, by Frank and Bernanke Real income growth, 1980-2000 Bottom 20% has been flat Top 20% has seen huge growth (59%)

What is “middle class?” This depends on who you ask Common answer Lower middle class is usually about $40,000-$70,000 Mostly those in the middle 20% of incomes Upper middle class is usually about $75,000-$150,000 Many people in the fourth and top 20% ranges

The gap between rich and poor widens The rich are getting richer, but the poor are not getting poorer Recent Census figures show that family incomes in the bottom 60% have stayed about the same since 2000 Working and middle class incomes have seen moderate real growth in income 16-29% growth for the categories in the middle 60% Some of this is due to more middle-class families having two incomes

Problems with annual income figures Ignores number of workers in a household General trend from one earner to two Expenses, such as child care, could be higher within two-worker households In-kind transfers ignored Taxes change over time Disposable income changes over time (given the same income) Income changes over time If a rich person earns no income in a calendar year, should she be considered “poor?”

“Too much” income inequality? Some people would argue no “When economic incentives to make a good living go away, the economic pie becomes smaller” Think about communist systems “People that have a good work ethic and work hard should make more money” “There are plenty of opportunities for anybody born today in the US to become successful” Free K-12 education; subsidized colleges and universities

Arguments for less income inequality “Marginal utility of income is lower for somebody with high incomes” “Each person has a right to a minimum standard of living” “Social unrest may occur unless each person is above the poverty line”

Other problems with income inequality Those that are relatively poor may feel inferior This problem may perpetuate to their children Jealousy towards other people Envy towards other people’s accomplishments

More on fairness There are different views of fairness Additive social welfare function “Veil of ignorance” Social welfare function should be minimum utility of all people in a society Commodity egalitarianism

Different views of fairness Some people believe that utility, not income, should be maximized within a population Additive social welfare function W = U1 + U2 + … + Un

Implications for additive utilities This is the net gain to society Paul gains this much utility Paul’s marginal utility Peter’s marginal utility e f Peter loses this much utility d c MUPeter Take ab from Peter and give to Paul Social welfare maximized MUPaul Paul’s income Peter’s income 0’ a b I* Paul’s income Peter’s income

Different views of fairness Others believe that social welfare should be the minimum of the utilities of each person in society “Veil of ignorance” argument developed by John Rawls Conceals knowledge and talents from people Risk averse people will want to have income equality under these conditions No inferiority, jealousy or envy based on income

Problem The “economic pie” will shrink with Rawls’ ideas If income was guaranteed to be equal to everyone, nobody will have an economic incentive to gain human capital Smaller “economic pie” Less human capital People work less

Optimal amount of income inequality? Impossible to answer Different people have different opinions about effectiveness of realistic ways to redistribute income

Different views of fairness Commodity egalitarianism Some things should be made available to everyone without restrictions Right to vote (if 18 or older) Basic education “Needed” items such as food, shelter, and clothing Basic medical care Recall issues presented in Chapters 9 and 10

Some other factors Income redistribution does not directly take into account other factors Number of hours worked If our goal is to maximize utility from income, why not reduce leisure? Not necessarily, since additional leisure likely increases utility Income depends on number of hours worked Does relative income matter? Does someone get a decrease in utility when his income remains the same and someone else’s increase?

In-kind versus money transfers With some views, such as commodity egalitarianism, in-kind transfers have more appeal than monetary ones How does this affect individual utility?

In-kind Transfers H Other goods per month 420 E3 340 A F U 300 E1 260 B D 20 60 150 210 Pounds of cheese per month

In-kind Transfers H Other goods per month 420 A F 300 E5 168 E4 136 B 82 126 150 210 Pounds of cheese per month

If income redistribution is good… …then how do we move money from one person to another? Welfare payments We will spend most of our time on this The earned-income tax credit Negative income tax Minimum wage Public employment of the unemployed

Some methods of income redistribution Welfare payments Little economic incentive to get off of welfare without time limits Many types of programs TANF Supplemental Security Income Medicaid Unemployment insurance

TANF Temporary Assistance for Needy Families Federal government provides block grants to states for welfare spending Over 80% of recipients in every state must be on TANF for five years or less States face penalties if a substantial percentage of recipients are not working or in work preparation programs

TANF TANF replaced Aid to Families with Dependent Children (AFDC) Under AFDC, some argued that many women on AFDC had children out of wedlock to continue get benefits and not have to work If the mother had to work once the child reached kindergarten, then there would be an economic incentive to have another child

TANF and benefit reduction rates TANF benefits are reduced when income reaches a certain level Example: In California, recipients can earn up to $225 per month before benefits are reduced at a rate of 50% of money earned How do people respond to these incentives in the short run?

Work incentives The Basic Trade-offs B = G – tE The Basic Trade-offs B = G – tE B = 0 if E = G/t G – basic grant if not working t – rate at which grant reduced when recipient earns money B – benefit received the higher G, the higher t higher G or lower t leads to a higher breakeven E which raises the costs of the system and includes more people

Analysis of work incentives D |Slope| = w Income per month c Time Endowment b 2w w* a T Hours of leisure per month

Analysis of work incentives D |Slope| = w Income per month E1 G iii ii Income Leisure Work i F T Hours of leisure per month

Analysis of work incentives In this example, someone can get $100 in TANF benefits if not working Between point Q and point S, an implicit tax rate of 25% is imposed Note that there are some incentives to work while still receiving benefits D |Slope| = w Income per month (= earnings + transfers) |Slope| = 3/4w S G Hours after TANF Hours before TANF Q $100 V F K T Hours of leisure per month

Analysis of work incentives In this case, a 100% implicit tax rate is imposed after a benefit of $338 is received D Budget constraint with t = 100% 0 hours of work selected P1 Income per month (= earnings + transfers) P S R G $338 F T Hours of leisure per month

Analysis of work incentives This person is indifferent between working and receiving benefits D E2 Income per month (= earnings + transfers) R P G Hours worked (if working) M T Hours of leisure per month

Analysis of work incentives This person prefers working to receiving benefits D E2 Income per month (= earnings + transfers) R P G Hours worked M T Hours of leisure per month

Supplemental Security Income (SSI) Federal program that provides benefits for the aged, blind, and disabled with little or no assets In 2003, average benefit was $342 SSI recipients can earn up to $65 per month without loss in benefits After $65 is earned, additional earnings have a 50% implicit tax rate

Medicaid Medicaid affects incentives to work Under old incentive structures, people often lost eligibility once they earned enough money to get off of welfare This created a “Medicaid notch” For main details about Medicaid, see Chapter 10

The Medicaid notch M Income per year D R S Z N $1,000 X T X T Hours of leisure per year

Solving the Medicaid notch problem In recent years, families that earn enough to leave welfare can often stay on Medicaid 12 month coverage after leaving TANF Low-income children and pregnant women

Unemployment insurance (UI) States provides insurance for unemployment due to adverse selection and moral hazard reasons Benefits Average weekly benefit in 2005: $266 Maximum length of benefits in most states: 26 weeks Typically financed by a payroll tax on employers Empirical studies find that increasing benefits increases the duration of unemployment

EITC The earned income tax credit A success story for the working poor Provides credits to workers within low incomes Essentially a negative income tax for some levels of income

EITC How it worked in 2006 for a family with 2 or more kids 40% credit for first $11,340 earned No additional credit for next $5,470 earned Phased out at a 21.06% rate after $16,810 is earned, until the credit is gone at $38,348 earned

The earned income tax credit

What has the EITC done? Households with nobody working Encourages one person to work Households with one person working Additional work not encouraged once a family with 2+ kids earns $11,340 Does not encourage additional hours of work of the person already working Does not encourage a second worker in the household to work

Other ideas Negative income tax Minimum wage Supply a lump sum to everyone, then tax income more heavily Problem: Incentive to work for pay diminishes Some people will stop working and will pay no taxes Minimum wage Problem: Increased unemployment

What about public employment? Public employment of the unemployed To be successful… Needs to have enough incentives for unemployed people to want to work Needs to have incentives low enough for employed people to stay in their old job

Future of social insurance? Academics are starting to study alternate ideas to help the poor Providing benefits to those most in need, rather than those that are already “in the system” “One-stop shopping” for help Faith-based support Government provides cash to the faith-based organization, and the organization provides the service

Overview Figure 13.10: Estimated effective marginal tax rates for a one-parent, two-child household residing in Wisconsin (2000) Source: Holt [2005, Part D, Figure 1].

Summary: Welfare programs for the poor Many programs exist to support poor people Some programs give little economic incentive to work Exception: Earned income tax credit

Recall Timothy Timothy is currently working 1,500 hours per year Hourly wage is $10 He also receives government health care, valued at $3,000 per year Timothy could work a second job for 700 hours per year Hourly wage is $8 With the second job, Timothy would make too much money for government health care

Now we add value to leisure New problem Tabitha has 24 hours per day Each hour can be used only for labor (L) or leisure (l) Tabitha’s wage is $10 per hour worked She receives $5 in Medicaid benefits per day if she earns no more than $60 M denotes the daily earnings plus Medicaid benefits, if any Tabitha has the following utility function U(M, l) = 2(M½) + l

Tabitha’s problem Two cases No Medicaid benefits Work 6 hours or less and receive Medicaid benefits

No Medicaid benefits Maximize 2(M½) + l subject to (M/10) + l = 24 Same as Maximize 2(M½) + l subject to l = 24 – (M/10) Same as Maximize 2(M½) + 24 – (M/10) FOC set equal to 0: 1/M½ – 1/10 = 0 M = 100 10 hours worked, 14 hours of leisure

What is Tabitha’s utility w/o Medicaid? 10 hours worked, 14 hours of leisure U(100, 14) = 2(100½) + 14 = 34

What about if she works less? Notice that this problem is almost the same Maximize 2(M½) + l subject to (M/10) + l = 24.5 The Medicaid benefit acts like 0.5 hour of work benefits Using the same steps as previously, M = 100 We can’t work that much to get the benefit, so the closest we can get is by working 6 hours Total M is 65 ($60 in wages, $5 in Medicaid benefits)

What is Tabitha’s utility with Medicaid? 6 hours worked, 18 hours of leisure U(65, 18) = 2(65½) + 18 = 34.12

What should Tabitha do? If she works 10 hours (no Medicaid benefit)… If she works 6 hours (with a Medicaid benefit)… U(65, 18) = 2(65½) + 18 = 34.12 Tabitha should work 6 hours and accept the Medicaid benefit $5

How do we solve poverty?