Chapter 17 Income Distribution and Welfare Programs

Chapter 17 Income Distribution and Welfare Programs
Jonathan Gruber Public Finance and Public Policy Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

Introduction The welfare reform law, known as the Personal Responsibility and Work Opportunity Reconciliation Act (“PRWORA”) was signed into law in 1996. It dramatically changed the delivery of welfare in the United States.

Introduction Instead of receiving matching grants, state governments now received lump-sum block grants. With this flat payment, states were given broad latitude to redesign their welfare system. In addition, work requirements and time limits were imposed on welfare recipients. The welfare caseloads declined dramatically, as shown in Figure 1.

Figure 1 With welfare reform and Temporary Assistance to Needy Families (TANF), the caseloads fell dramatically. The number of people on Aid to Families with Dependent Children (AFDC) skyrocketed during the 1960s.

Introduction Government spending on cash welfare is relatively modest – 1.7% of the federal budget. Yet the programs generate controversy because it is thought, by some, that welfare is responsible for many social ills. “The welfare system’s greatest cost is the human cost to the poor. In the name of ‘compassion’ we have funded a system that is cruel and destroys families.” – Newt Gingrich.

Introduction Why is the government involved in redistributing income?
The socially efficient outcome of a nation’s economy does not necessarily maximize a nation’s social welfare function. Utilitarian, Rawlsian SWF lead to redistribution The private sector is unlikely to provide such redistribution, because of the free-rider problem from redistributing. The government may be able to solve this problem by taxing its citizens and providing public redistribution.

Introduction This lesson begins with some facts on the income distribution. It then discusses means of redistributing income. Finally, it reviews evidence from PRWORA.

FACTS ON INCOME DISTRIBUTION IN THE UNITED STATES Relative income inequality
We can think about the distribution of income in either a relative sense or an absolute sense. Relative income inequality is the amount the poor have relative to the rich. This is illustrated in Table 1 for the United States, over time.

Share of Aggregate Income Received by Quintile of Household (%)
Table 1 Share of Aggregate Income Received by Quintile of Household (%) Income Quintile 1967 1970 1975 1980 1985 1990 1995 2000 Lowest 4.0 4.1 4.4 4.3 3.9 3.7 3.6 Second 10.8 10.5 10.3 9.7 9.6 9.1 8.9 Third 17.3 17.4 17.1 16.9 16.3 15.9 15.2 14.8 Fourth 24.2 24.5 24.8 24.9 24.6 24.0 23.3 23.0 Highest 43.8 43.3 43.2 43.7 45.3 46.6 48.7 49.8 The share of income that the poorest one-fifth receives has fallen over time. The share of income that the richest one-fifth receives has increased over time.

Facts on income distribution in the United States Relative income inequality
As a benchmark, a society with no income inequality would have a 20% share of income for each quintile. From the late 1960s to 1970s, income inequality fell. From 1980 onward, it rose. Relative income inequality is much higher in the U.S. than other countries, as illustrated in Table 2.

Share of Aggregate Income Received
Table 2 Share of Aggregate Income Received by Quintile of Household for OECD Nations Country (year) Income Quintile First Second Third Fourth Fifth Austria (1995) 7.0 13.2 17.9 24.0 37.9 Belgium (1996) 8.3 14.1 17.7 22.7 37.3 Canada (1997) 7.3 12.9 17.4 23.1 39.3 Czech Republic (1996) 10.3 14.5 21.7 35.9 Portugal (1997) 5.8 11.0 15.5 21.9 45.9 Slovak Republic (1996) 8.8 14.9 18.7 22.8 34.8 Sweden (1995) 9.1 18.4 23.4 34.5 Turkey (2000) 6.1 10.6 21.8 46.7 United Kingdom (1995) 11.7 16.3 43.2 Unweighted average 7.6 12.7 16.9 22.5 40.3 United States (2002) 3.5 14.8 23.3 49.7 The poorest one-fifth in the U.S. receive a smaller share of income than in the typical OECD country. While the richest one-fifth receive considerably more.

Facts on income distribution in the United States Relative income inequality
The poorest fifth of households in the U.S. receive less than half the share of income of the poorest fifth in a typical industrialized nation. The bottom three quintiles in the U.S. all receive a smaller share.

Facts on income distribution in the United States Absolute deprivation and poverty rates
Of course, the United States is also a much richer country, in an absolute sense, than the comparison countries. Absolute deprivation is the amount of income the poor have relative to some measure of “minimally acceptable” income.

The poverty line is the federal government’s standard for measuring absolute deprivation. The poverty line was developed in 1964 by Molly Orshansky, an employee of the Social Security Administration. She started with nutritional standards for a minimally acceptable diet, and applied average national food costs to price out the cost of buying this bundle. Then, using the fact that the average family spent about one-third of their after-tax income on food, she multiplied the food bundle by 3. That is how the poverty line came to be. It has been updated for inflation for the last 40 years.

The poverty thresholds for 2004 are shown in Table 3. They increase with family size, but reflect the economies of scale in home production.

Poverty Lines by Family Size (2004)
Table 3 The poverty line increases with family size, but not proportionally. This reflects “economies of scale” in household production. Poverty Lines by Family Size (2004) Size of Family Unit Poverty Line 1 $9,310 2 12,490 3 15,670 4 18,850 5 22,030 6 25,210 7 28,390 8 31,570 Each additional person 3,140

The poverty rate (the fraction of households with incomes under the poverty line) has been tracked for many decades. In the 1960s, poverty rates fell for all groups. The trends diverged, especially for children, from 1970 to 1995. The late 1990s witnessed improvements for all groups. See Figure 2.

Figure 2 Poverty rates have fallen dramatically for the elderly, due to Social Security. Unfortunately, poverty rates for children under 18 are relatively high.

Problems in poverty line measurement
Application Although the poverty line is a mainstay in U.S. public policy, there are numerous criticisms: Bundle has changed. Share of budget spent on food has changed, and multiplying by 3 is no longer appropriate. Cost of living differences are ignored.

Problems in poverty line measurement
Application More criticisms: Income definition incomplete. Uses cash income only. Ignores non-cash transfers like Medicaid, food stamps, and public housing. Ignores job related expenses like childcare. Ignores taxes. Nonetheless, difficult to change poverty definition. For example, difficult to value in-kind benefits and changes could run into political problems.

Facts on income distribution in the United States What matters – absolute or relative deprivation?
Should the government be concerned about absolute or relative deprivation? Intuitively, once the poor can reach an acceptable level of consumption, why should the incomes of the rich matter? One counterargument is that the “minimal standard” of living is, in reality, a relative comparison. In addition, some evidence suggests that the level of inequality is negatively related to measures of well being.

WELFARE POLICY IN THE UNITED STATES
There are several characteristics of welfare programs that are important to understand. Categorical versus means-tested programs Cash versus in-kind programs

Categorical welfare means welfare programs are restricted by some demographic characteristic. Single motherhood or disability are examples. Means-tested welfare are welfare programs that are restricted only by income and asset levels. For example, programs that restrict eligibility to those under 100% of the poverty line.

Cash welfare are welfare programs that provide cash benefits to recipients. In-kind welfare are welfare programs that deliver goods rather than cash to recipients. Medical care, food, and housing are all examples.

Welfare policy in the United States Cash welfare programs
The two major cash welfare programs are Temporary Assistance to Needy Families (TANF) and Supplemental Security Income (SSI). A third program, administered through the tax code, is the Earned Income Tax Credit (EITC).

Aid to Families with Dependent Children (AFDC) was begun in 1935 to support widows and orphans. As family structure changed, the program focused largely on mothers who were either divorced or never-married. In 1996, TANF replaced AFDC. Expenditure on TANF, $25.5 billion, is about ten times smaller than that on Medicare, and almost twenty times smaller than that on Social Security.

The benefit guarantee is the cash welfare benefit for individuals with no other income. This varies across states, from $170 per month in Mississippi to $923 per month in Alaska. Payments too low to move a family out of poverty.

The actual benefit is reduced as income increases. The benefit reduction rate is the rate at which benefits are reduced per dollar of other income earned. This is essentially a tax rate on earnings. The tax rate tends to be very high, in the neighborhood of %.

The federal government provides block grants to states to finance the program. The federal government also imposes: Time limits: Lifetime limit of 60 months on welfare Work requirements: Individuals must work after receiving, at most, 24 months of TANF benefits. Federal government requires that half of state’s TANF caseload must be working at any point in time (but there are some loopholes).

SSI provides welfare to the aged, blind, and disabled. Expenditure was $31.6 billion in 2002. It essentially fills in some of the holes created by Social Security and Disability Insurance, by allowing those who have insufficient work experience to smooth consumption. Both adults and children can qualify. Most of the growth in SSI has been because of the disabled population, especially disabled children.

Welfare policy in the United States In-kind programs
There are also numerous programs that provide in-kind assistance, including: Food Stamps Medicaid Public Housing Projects/Section 8 vouchers Nutritional programs

Food stamps is a nationally uniform program that allows for the purchase of food items by the poor. Expenditure was $24.1 billion in 2002. Eligibility is considerably broader than TANF, yet some are ineligible: Able-bodied adults are required to work. Many noncitizens are ineligible.

Medicaid is by far the largest categorical welfare program, with expenditure of $250 billion in 2003 – about 10 times that of TANF. Many of the incentive effects were discussed in earlier lessons.

Public housing consists of two separate programs: projects and vouchers. Public housing projects are typically large apartment buildings provided directly by the government. Section 8 vouchers can be used by individuals to subsidizes private market rentals from participating landlords. Income limits and subsidies vary locally. Total expenditure was $32 billion in 2002.

Nutritional programs include: WIC (Women, Infants, and Children): Provides funds for nutritious food purchases specifically intended to improve fetal development and infant health. National School Lunch and Breakfast Programs: Provide free or reduced-price meals. Expenditure is roughly $4.4 billion for WIC, and $8.4 billion for school meals.

THE MORAL HAZARD COSTS OF WELFARE POLICY
Prominent economist Authur Okun once compared the process of income redistribution to a “leaky bucket”: we are carrying money from the rich to the poor, but some money leaks out along the way. Redistribution comes with potentially large moral hazard costs. The social welfare function quantifies the efficiency-equity tradeoff between less redistribution and more social efficiency, and more redistribution and less social efficiency.

THE MORAL HAZARD COSTS OF WELFARE POLICY
The “leakage” from transfers comes from: Administrative costs. Taxation on higher income individuals may affect their labor supply and savings. And most importantly, by insuring against being poor, the programs create an incentive for individuals to become poor in order to qualify for the transfers.

The moral hazard costs of welfare policy Moral 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.

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.

In principle, setting G equal to the poverty line (with, say, J=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.

Figure 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.

This is the budget constraint before welfare is introduced.
Figure 3 This is the budget constraint before welfare is introduced. Individuals make different choices based on preferences. $ of consumption per year A 25,000 20,000 Welfare is introduced with a $9,000 guarantee and a BRR of 100%. Z slope = -wage = Y 10,000 G = 9,000 B D Others are initially ineligible, but reduce their work effort, too. 5,000 X Some will be “mechanically” eligible and reduce hours of work. C Hours of leisure per year 400 1,200 1,280 1,600 2,000

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 4.

Lowering the BRR changes the budget constraint.
Figure 4 $ of consumption per year A 25,000 Z1 18,000 Z2 Lowering the BRR changes the budget constraint. And person Z becomes eligible. B2 Y2 slope = -wage = slope = -net wage = -6.25 X2 Y1 G = 9,000 B1 D Hours also fall for person Y. X1 Hours of work fall for person X. C Hours of leisure per year 560 1,280 2,000

The moral hazard costs of welfare policy 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 moral hazard costs of welfare policy 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.

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.

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.

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.

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 5 shows the time-series correlations.

While benefits have fallen.
Figure 5 While benefits have fallen. Single motherhood has increased over time.

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.

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.

Reducing the moral hazard of welfare 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.

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.

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.

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 of ordeal mechanisms
Application 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.

Application 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:

Application 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.

Application 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:

Application 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:

Application 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.

Reducing the moral hazard of welfare 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 6, which raises wage rates.

And reduce the “breakeven” level for eligibility.
$ of consumption per year E 35,000 A slope = -wage = 25,000 slope = -wage = And reduce the “breakeven” level for eligibility. Y2 12,250 Y1 10,000 F G = 9,000 Higher wages rotate the budget constraint outward. B D Individuals will adjust their hours. Person Y no longer goes onto welfare. C Hours of leisure per year Figure 6 1,200 1,300 1,486 2,000

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

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.

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.

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.

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.

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.

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 7 shows what the disincentive looked like.

Medicaid is offered on an “all-or-nothing” basis.
Figure 7 $ of consumption per year A 25,000 E 21,000 Medicaid is offered on an “all-or-nothing” basis. This creates a “notch” in the budget constraint. 18,000 slope = -net wage = -6.25 B slope = -net wage = -6.25 F slope = -wage = HI = $3,000 D 9,000 Cash = $9,000 C Hours of leisure per year 560 2,000

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 REFORM Changes 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 reform Effects 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.

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.

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.

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.

Recap of Income Distribution and Welfare Programs
Facts on income distribution in the U.S. Welfare policy in the U.S. The moral hazard costs of welfare policy Reducing moral hazard of welfare Welfare reform

Chapter 17 Income Distribution and Welfare Programs

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