1. Public Finance (MPA405) Dr. Khurrum S. Mughal

2. Lecture 18: Government Subsidies and Income Support for the Poor Public Finance

3. Subsidizing Food Food Stamps are the subsidy that allows the recipient a particular allotment of vouchers to buy food but the recipient may supplement the subsidy with their cash. It is illegal to sell the food stamps though it may be in the recipients interests for them to do so. Two different Cases

4. The Impact of an In-Kind Transfer: Food Stamps Person initially at E1 Can use subsidy for food only so BC is not attainable Cash grant could enable her to attain that point Total food consumption is grant plus her own spending Grant frees some of her income for consumption of other goods Expenditure on Other Goods per Month (Dollars) 0QFQF A B I A U2U2 U1U1 A' M2M2 M1M1 Q F1 Q F2 Food per Month C F E2E2 E1E1

5. The Impact of an In-Kind Transfer: Food Stamps 0 B B I A U2U2 U1U1 A' M1M1 QF1QF1 L U3U3 QFQF Food per Month Q* 1 QF2QF2 E2E2 E1E1 C Person initially at E1 Can use subsidy for food only so BC is not attainable Moves to pint C on U2 Cash grant could enable her to attain that point E2 at U3

6. Implication Given that on average recipients would spend more per person than the grant So the subsidy can be treated as substitute of cash grant Only a situation where the subsidized amount is low enough

7. International Food Subsidies Several nations use a price-reducing subsidy to make food more affordable. –Programs that reduce the price of food benefit higher-income people as well. Some nations only subsidize food that is typically consumed by the poor. Some nations distribute food directly.

8. The Impact of Government Assistance Programs on Incentive to Work Grant ensures minimum level of income independent of work Larger the grant size, greater is the disincentive to work –Because of income effect that makes work unfavorable Transfers could cause people to work more or less depending on whether leisure is a normal good.

9. The Impact of Government Assistance Programs on Incentive to Work Economic Analysis can be conducted by using indifference curve with leisure and work for pay. Leisure is engaging in any activity other than work for pay Maximum leisure per day is 24 Hrs

10. The Impact of Government Assistance Programs on Incentive to Work Budget Line: Person’s opportunity for giving up leisure for work Nonwage income is Zero – I = w(24-L) –Where I is income per day and L is leisure per day

11. The Income Effect of a Transfer Income per Day Leisure Hours per Day 0L1L1 24 F C A L2L2 D U3U3 U2U2 U1U1 E1E1 E2E2 E3E3 G Transfer Payment

12. Implication Increase in transfer payments induces individual to increase leisure hours and reduce wok per day.

13. The Impact of Government Assistance Programs on Incentive to Work Another work disincentive –The way benefits are reduced as individual earns more income A subsidy of BD shifts the budget line up –From the point he will be paid Point C in figure

14. A Transfer that Declines with Earned Income Subsidy shifts Budget Line up to CD and decreases its slope with more leisure Meaning: Reduce the person’s real wage as he works less than 24-L* Move from E1 to E2 after subsidy Substitution as well as income effect Work increases work income but reduces transfer income – An incentive to substitute Decreases the opportunity cost of leisure Low level of subsidies are desirable L*24L2L2 L1L1 Maximum Daily Transfer Leisure Hours per Day Income per Day U2U2 U1U1 A D B C E1E1 E2E2

15. Empirical Evidence A 10% increase in welfare payments to individuals decreases work effort by 2%. –Even if welfare benefits are reduced substantially –Or rate at which they are phased out with earnings is reduced –The increase in work would be insufficient to reduce poverty

16. A Negative Income Tax A Negative Income Tax is a system where there is no status test but there is an income guarantee and a take-back rate. A minimum income guarantee for everyone People below the floor will receive subsidies, while above that people will pay taxes Floor would vary with household size

17. A Negative Income Tax T = I G – t N I E Where I G = Income guarantee t N = take back rate I E = earned income T = Transfer

18. Break-Even Income 0 = I G – t N I B I B = I G /t N

19. Negative Income Tax Earned Income I E Transfer T = I G – t N I E Disposable Income I D 05,000 1,0005,000 – (.5 × 1000) = 4,5005,500 2,0005,000 – (.5 × 2000) = 4,0006,000 3,0005,000 – (.5 × 3000) = 3,5006,500 4,0005,000 – (.5 × 4000) = 3,0007,000 5,0005,000 – (.5 × 5000) = 2,5007,500 6,0005,000 – (.5 × 6000) = 2,0008,000 7,0005,000 – (.5 × 7000) = 1,5008,500 8,0005,000 – (.5 × 8000) = 1,0009,000 5,000 – (.5 × 9000) = 5009,500 10,0005,000 – (.5 × 10000) = 010,000

20. A Negative Income Tax Implication: – A very expensive program if I G is set at a reasonable level. – Assuming I G equal to $20, 000 per year for a family of four and t N = 50% – All families of four with income less than $40,000 will be eligible, specially in absence of status test – If t N is set lower to improve work incentive like 20% then the break-even income level would rise to $100,000 per year – Tax rates and prices of other Govt services would have to increase a lot to finance such activity

21. A Negative Income Tax Plan IGIG IBIB Annual Disposable Income (I D ) 45º Transfers Taxes Annual Earned Income

22. Wage Rate Subsidies Wage Rate Subsidies are government additions to wages designed to increase the pay of the working poor.

23. Wage Rate Subsidies Wage PaidSubsidy per Hour Total Wage Received $2.00$1.50$3.50 $2.50$1.25$3.75 $3.00$1.00$4.00 $3.50$0.75$4.25 $4.00$0.50$4.50 $0.25$4.75 $5.00$0.00$5.00