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

2. Lecture 16: Government Subsidies and Income Support for the Poor Public Finance

3. Economic Analysis of the Effects of Government Transfers Effect on Resource allocation Consumer may consume where MSB is less that MSC Loss of willingness to work if after work income is less Analysis highlights the equity- efficiency trade-off

4. Price Distorting Subsidies Price Distorting Subsidies lower the price of the particular good relative to others for eligible people.

5. Price Distorting Subsidies Example of Housing subsidy – Hiring apartment at below the market rent – Govt pays the difference Subsidized Mortgage loans

6. A Price Distorting Subsidy Expenditure on Other Goods per Month (Dollars) Housing Services per Month 0 L'H1H1 H2H2 H3H3 N3N3 N1N1 N2N2 S I B A L E1E1 E3E3 U2U2 U3U3 U1U1 E2E2 Subsidy

7. Price Distorting Subsidies Implications: – Induces to purchase a larger amount of housing that he/she would normally do – Higher level of utility in presence of cash grant equal to the subsidy – Spending on other goods can also be increased – Dead weight loss Difference between E2 and E3

8. Price Distorting Subsidies and Market Effects Example of Housing Market Operates on constant cost Long run supply curve is perfectly elastic Government agrees to pay half the rent

9. Excess Burden of a Subsidy: Market Effects BE Q1Q1 F A E’ S’ D = MSB 400 200 Number of Apartments Rented Q2Q2 0 C Rent (Dollars per Month) S = MSC Excess Burden of Subsidy

10. Dead Weight Loss or Excess Burden Dead Weight Loss (sometimes called Excess Burden ) is the measure of the dollar value of the distortion that exceeds the amount transferred to the recipient.

11. Implications Induces low-income people to increase their consumption – increased demand More resources are allocated for building more houses –But value exceeds the benefits Important to compare costs to tax payers and the benefits accruing to low income tenants

12. Implications Cost of Subsidy to tax payers –$200 multiplied by increase in apartments rented after subsidy Area BAE`C

13. Excess Burden of a Subsidy: Market Effects BE Q1Q1 F A E’ S’ D = MSB 400 200 Number of Apartments Rented Q2Q2 0 C Rent (Dollars per Month) S = MSC Excess Burden of Subsidy

14. Implications Benefits to Low Income Tenants –Those who would rent one bedroom apartment even without the subsidy. $200 multiplied by Q1 (Area BEFC) –Those who would rent after the subsidy. Net benefit would be the difference between MB they assign to housing and $200 (Area EE`F)

15. Excess Burden of a Subsidy: Market Effects BE Q1Q1 F A E’ S’ D = MSB 400 200 Number of Apartments Rented Q2Q2 0 C Rent (Dollars per Month) S = MSC Excess Burden of Subsidy

16. Implications Total Benefit: Area BEFC + EE`F Total Cost: Area BAE`C So the cost is greater than the benefit and there is excess burden

17. Price Distorting Subsidies that Lowers the Price to Zero Medicaid – Largest program of assistance to Poor in USA Reduced the cost of medical services to “zero” Assuming annual quantity of medical care consumed can be measured by number of hospital visits Supplied by perfectly competitive industry MSC doesn’t increase when more is made available

18. Full Subsidization of Medical Services Medical Office Visits per Year 0 Q* E1E1 QGQG 25 = P* E2E2 MB L B A Price (Dollars per Month) Excess Burden

19. Implications Increase in Consumer Surplus Part of increase is already what would have been acquired anyway Excess burden is the due to subsidy in kind Medicaid recipients would be better off with cash subsidy

20. Additional Effects of Subsidies: The Case of Increasing Costs Medicaid not only costs taxpayers money to pay for the program, it also increases the amount they pay for medical services by increasing demand for those services.

21. The Impact of The Medicaid Program on Price: The Case of Increasing Cost Price (Dollars) Medical Office Visits per Year 0 QIQI O Q' E1E1 QLQL 140 Q2Q2 QGQG QOQO E2E2 100 S = MSC DODO D M = MSB DLDL D' M

22. Implications Increase in Prices of Medical Services Tax payers finance the program Tax payers face the higher medical service prices for themselves Overall decrease in real incomes of tax payers Losses in efficiency as well as changes in income distribution

23. Subsidizing Housing Providing an Apartment: This subsidy allocates a standard apartment to an eligible recipient. With this type of subsidy the recipient cannot supplement the subsidy with their cash. It is a “take it or leave it” option. Housing Vouchers: This subsidy allows the recipient a particular allotment of vouchers to rent housing but the recipient may supplement the subsidy with their cash. Cash: This subsidy is not restricted to spending on housing.

24. Public Housing Government constructed low cost housing for low income families Rented at well below market rates Public Housing are expected to increase recipient's housing consumption Might reduce housing consumption due to lack of freedom of choice Suppose Government offers housing at $30 per room where the rent for 3 bedroom apartment is 90 $ – The same goes for rent in the market for $300

25. Eligibility for Public Housing and the Effect on Housing Consumption Expenditure on Other Goods per Month (Dollars) Housing per Month (Number of Rooms Rented) 0 800 = I M H 400= F J BA 210 4 E1E1 U1U1 U2U2 U3U3 I'I' 132567 90 G E2E2

26. Refusing a Public-Housing Subsidy Expenditure on Other Goods per Month (Dollars) Housing per Month (Number of Rooms Rented) 0 U3U3 E1E1 U2U2 I M G J A 1234567

27. 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.

28. The Impact of an In-Kind Transfer: Food Stamps 0 B B I A U2U2 U1U1 A' M1M1 QF1QF1 L U3U3 QFQF 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 Q* 1 F QF2QF2 E1E1 E1E1 C E2E2 E1E1

29. The Impact of Government Assistance Programs on Work Transfers could cause people to work more or less depending on whether leisure is a normal good.

30. 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.

31. 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

32. A Transfer that Declines with Earned Income e.g. T=$300-.7I E L*24L2L2 L1L1 Maximum Daily Transfer Leisure Hours per Day Income per Day U2U2 U1U1 A D B C E1E1 E2E2

33. Empirical Evidence A 10% increase in welfare payments to individuals decreases work effort by 2%.

34. 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. T = I G – t N I E Where I G = Income guarantee t N = take back rate I E = earned income T = Transfer

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

36. 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

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

38. 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