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Incentives and the Welfare State James Mirrlees University of Melbourne and Chinese University of Hong Kong Trevor Swan Lecture ANU 13 March 2008.

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Presentation on theme: "Incentives and the Welfare State James Mirrlees University of Melbourne and Chinese University of Hong Kong Trevor Swan Lecture ANU 13 March 2008."— Presentation transcript:

1 Incentives and the Welfare State James Mirrlees University of Melbourne and Chinese University of Hong Kong Trevor Swan Lecture ANU 13 March 2008

2 The welfare state as a tax schedule The welfare state provides unemployment and disability insurance, school education, health care, some pension, for (almost) everyone. It may provide basic income, low-cost housing, subsidised food, transportation, etc. for people with low incomes. Real income is higher than earned and capital income when low, though less at higher income.

3 UK as an example Income tax and national insurance: at an increasing rate, starting at incomes well below median income. Working tax credit, for lower-income workers, depending on family size. Substantial commodity taxes, averaging maybe 14% (ignored in following figures) Health care and school education of value at least 15% of median income (also not in the graph).

4 0 5K 10K 15K 20K 25K 30K 35K 40K Annual Gross Earnings (1 earner, 2 children) UK Budget Constraint, 2006 30K 20K 10K 0 Disposable income from: Mike Brewer, Emmanuel Saez, and Andrew Shephard

5 Marginal tax rates and incentives The marginal tax rate at low incomes is 100%. For most, it is over 70% Economists believe that creates poor work incentives. Someone with low earning ability would be expected not to work at all. Someone with moderate earning ability would settle for a job with productivity around £10,000 per year.

6 Impact on GDP The orthodox claim is that countries that give large welfare benefits independent of income, and that redistribute income strongly from rich to poor will have a lower GDP, since people will work less and produce less. Prescott has argued that is why Americans work more than Europeans, and have a higher average income.

7 Charging for services Another implication drawn is that people should pay for medical care, and for education. Because then extra income is more valuable… improving work incentives. A change in the system that would increase work incentives would, however, reduce the real (after tax and subsidy) income of people with the least earning capacity.

8 Qualitative and quantitative arguments In principle, –More pay for more work encourages work. –And having less encourages work. Are these quantitatively large effects? If that UK budget constraint did reduce most people’s annual earnings to £10,000, it would be a large effect. It has not yet done so. Why? A wrong assumption (I claim).

9 Is working all bad? Standard assumption: work is painful. But: – People like to be doing something (maybe vicariously, and not all the time). Natural selection must have made us that way. –People like to be useful. –Studies show that unemployment makes people more unhappy than lower income. –Statistical estimates of labour preferences yield U-shaped indifference curves. –People rarely work for very short periods.

10 I do not claim that more work is always better: we want leisure too. And maybe some kinds of work are unpleasant even for an hour or two. And some people may not be able to do work that is both enjoyable and useful. And there are people who seem not to like working at all, at least when old, or young. But, as a simplified model of the world, we should assume that (most) people prefer working up to a point.

11 Optimal budget constraints We imagine an economy in which people choose how much to work, expecting particular (lifetime) consumption for each possible (lifetime) work plan. The total consumption available is what can be produced from the total amount of work they do. How can we maximize their total utility?

12 How the model works The answer depends on the way we measure people’s utility. But not as much as you might think. It also depends on the distribution of working skills in the population: how many can do unskilled, skilled, and professional jobs, for example. I assume that a household’s consumption cannot fall when earnings increase.

13 Results I find that there is a range of incomes, from zero to some positive level, for which the marginal tax rate should be 100% (as for many in the UK). This holds provided the distribution of skills within the population is realistic. It holds whether preference for redistribution is strong or weak.

14 Proof It is harder to prove than you might think. Essentially: –(1) The least skilled people are going to do some work even if not rewarded for it. –(2) Introducing net pay for work increases work done, and therefore GDP, but only proportionately, so not very much. –(3) And it forces a reduction in minimum net income, so not worth it (unless very few at the bottom).

15 Provisos The conclusion is too extreme. The labour market does not work well for jobs with wage rates in the 100%-marginal-tax range. So the marginal tax rate should be less than 100%. Then employers can attract workers by increasing the wages for low- wage jobs.

16 Implementation Can use means-tested welfare benefits, or employment subsidies. With employment subsidies, employers might report lower wage rates than they pay. In reality, e.g. because of minimum wages, they pay too much. I presume unemployment is the result. Not a minimum-wage proposal: more a minimum-take-home-pay proposal.

17 Unemployment The model used implies that people are unemployed only if they are unable to get jobs, e.g. because of wage-stickiness or efficiency wages. It does not tell us how high the income of the unemployed should be. An alternative view: Emmanuel Saez assumes there is substantial disutility from having a job, and deduces the m.t.r at zero income should not be high.


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