Transfer Payments
Major Transfer Programs
  • Cash vs. In-Kind Benefits
    1. Income transfer doesn’t always entail cash payments.
    2. In-Kind benefits, rather than cash, are intended to promote specific objectives such as.  For example, food stamps are offered in place of cash to assure that recipients purchase only food with the transfer payment.
    3. The target efficiency of a transfer program refers to how well the transfers attain their intended purpose.
  • Social Insurance vs. Welfare
    1. Not all the $900 billion of income transfers goes to the poor
    2. A lot of student loans go to middle-class college students.
    3. Disaster relief helps rebuild both mansions and trailer parks.
    4. Medicaid is an in-kind welfare program.
  • Transfer Goals
    1. Because there are so many income transfer programs, it’s hard to keep track of their many purposes.  In general, most transfer programs aim to alter market outcomes.
    2. For WHOM to Produce
      • The most obvious goal of transfer programs is to alter the distribution of income.
      • Reducing poverty is the explicit goal of virtually all welfare programs and is accomplished through transfer payments.
    3. WHAT to Produce
      • Transfer payments also seek to change the mix of output.
      • Food stamps increase food consumption, housing subsidies increase the demand for housing, student loans increase college enrollments.
  • Unintended Consequences
    1. Reduced Output
      • The provision of transfer payments may dull work incentives.
      • If people reduce their labor supply in response to income transfers, total output will shrink.
      • Attempts to redistribute income may reduce total income 
    2. Undesirable Behavior
      • People may also change their nonwork behavior.
      • Until 1997, federal welfare benefits (Aid to Families with Dependent Children) were largely available only to one-parent families.
      • This created incentive for mothers to remain single and for teenagers to give birth and establish their own households.
Welfare Programs
  • The largest federal cash welfare program is called Temporary Aid to Needy Families (TANF).  The TANF program was created by congressional welfare reforms in 1996 and replaced an earlier program (AFDC)
  • Benefit Determination 
    • The first task of the TANF program is to identify potential recipients.
    • A four-person family with $12,000 of income in 1999 would have been considered poor.
    • Poverty Gap – The shortfall between actual income and the poverty threshold.
  • The Work Incentive Problem
    • We could just give people a check for the amount of their poverty gap.  No one would be poor.
    • This might encourage people who are not poor to become poor.  By quitting their jobs, declaring themselves poor, and accepting a guaranteed income transfer, they would gain much more leisure at little financial or psychological cost.
    • Families that are already poor have reduced incentive to work harder to get out of poverty with transfer programs in place.  This occurs because the programs are generally set up to reduce benefits as earned income increases.
  • Less Compassion
    • To reduce this moral hazard, Congress and the states changed the way benefits are computed.
    • They first set a much lower ceiling on welfare benefits.
    • States don’t offer to close the poverty gap, instead, they set a maximum benefit far below the poverty line.
  • More Incentives
    • To encourage welfare recipients to lift their own incomes above the poverty line, welfare departments made another change in the benefit formula.
    • The implicit marginal tax rate was cut from 100 to 67 percent.  So we now have a new benefit formula.
    • Now a welfare recipient can increase their income above the poverty level by losing only a portion of their welfare payment.
  • Incentives vs. Costs
    • Although this new benefit calculation is an improvement, it stills offers a 67 percent marginal tax rate.  Why not improve the plan even farther?
    • If we don’t impose a marginal tax rate at some point, everyone will be eligible for welfare benefits.
    • We must recognize a basic dilemma:
      • Low marginal tax rates encourage more work effort buy make more people eligible for welfare.  Low marginal tax rates encourage work but make it hard to get completely off welfare.
      • High marginal tax rates discourage work effort buy make fewer people eligible for welfare.
  • Tax Elasticity of Labor Supply
    • The trade-off between more welfare and less work depend on how responsive people are to marginal tax rates.
    • If the tax elasticity of labor supply were zero, it wouldn't matter how high the marginal tax rate was: People would work for nothing.
    • In reality, the tax elasticity of labor supply is more in the range of 0.2 to 0.4, so the marginal tax rates do affect work effort.
    • To sidestep this problem, the government simply requires welfare recipients to work rather than let them make an economic choice.
Social Security
  • The Social Security program faces the same conflicts among compassion, incentives, and costs.
  • Program Features
    • Retirement Age
      • People born before 1940 can choose early retirement at age 62 – 64 and normal retirement at age 65-67.  Those who choose early retirement do so with reduced benefits.
      • The age threshold for “normal” retirement is increasing each year.  By the year 2022, the age threshold for normal retirement will be age 67.
    • Progressive Benefits
      • Retirement benefits are based on an individuals wages.
      • Although high-wage workers receive larger benefit checks than low-wage workers, the ratio of benefits to prior wages isn’t constant.
      • The Social Security benefits formula is progressive because the ratio of benefits to prior wages declines as wages increase.
  • The Earnings Test
    • The government imposes an “earnings test” to determine how much retirement benefits an older person can collect while still working.
  • The Work Disincentive
    • In 1999, the wage “ceiling” for workers 62 to 64 was $9600.  As a result, a person could earn as much as $9600 and still get maximum retirement benefits.  Any income over $9600 will result in a fifty cent reduction in benefits for each dollar earned.
    • This fifty-percent marginal tax rate creates a large disincentive for Social Security recipients to work.
  • Declining Labor Supply
    • Not surprisingly, older people have exited the labor market in droves.
    • The labor force participation rates have declined dramatically in the U.S. since the 1950s.
  • Compassion, Incentives, and Cost
    • The primary economic cost of the Social Security program isn’t the benefits it pays, but the reduction in total output that occurs when workers retire early.
    • The economic cost of Social Security is increased further by a labor supply reduction among younger workers.
    • As the behavior of both older and younger workers changes, the economic pie shrinks as we try to redistribute it from younger to older workers.
    • Trade-Offs – Like any other program, the social security program faces trade-offs between work incentive, budgetary costs and equity
Privatize Social Security?
  • One major difference between private retirement programs and Social Security is that private retirement programs are advanced funded while Social Security is  a pay-as-you-go program.
  • Many people believe the Social Security system should be privatized by permitting workers to establish their own retirement plans.  Instead of paying payroll taxes to fund someone else’s benefits, you'd make a contribution to your own pension fund.
  • Although on the surface this seems attractive, it is not without controversy. 
  • The primary goal of Social Security is to fend off poverty among the aged. By transferring income from workers to retirees and redistributing income from high-wage workers to low-wage workers in retirement.  In these ways, the program changes market outcomes.
  • By contrast, a privatized system would let the market alone determine FOR WHOM goods are produced.  Low-income workers and other people who saved little while working would end up poor in their “golden years”.  Even in a privatized system, some high earners and savers might end up poor if their investments turned sour.

back to the  top of this page
back to the  Microeconomics Home Page
back to  Professor Fisher's Home Page

this page is maintained by Reed Fisher
last updated January 15, 2011