Education and Income Inequality

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13 Poverty, Inequality, and Income Redistribution Policies

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Learning Outcomes

After reading this chapter, you should be able to

• Describe the measurement of income distribution in the United States.

• Explain how poverty is defined and the characteristics of those most likely to be poor.

• Summarize the advantages and disadvantages of redistribution in kind versus in cash.

• Analyze the effects of discrimination on wage differences.

• Summarize the advantages and disadvantages of equality of opportunity versus equality of results strategies.

• Describe current government transfer programs and proposals for policy reform.

• Summarize the arguments for and against the redistribution of income through government policy.

278

Section 13.1 Personal Distribution of Income

Introduction C. K. is a real person in her 20s, a college graduate who has been supporting herself but not earning much income. After working for about 6 years, part time in college and full time after- ward, she was diagnosed with a chronic disease that makes it impossible to hold a regular, full-time job. She can work part time and would like to do so. What should the social safety net do for C. K., and what does it actually do? How much will it cost taxpayers? What incentive does C. K. have to continue working part time?

J. T. is a hypothetical person, a 20-year-old high school dropout and mother of two small chil- dren, ages 2 and 4. She has never been married and has no real work experience. She has no means of support for herself and her children. What should the social safety net do for J. T., and what does it actually do? How much will it cost taxpayers? What incentive does J. T. have to acquire skills and work at least part time?

This chapter is about the C. K.s and J. T.s of a market system. Some, like C. K., are unable to provide for themselves through no fault of their own. Others, like J. T., make choices that lead to a lack of income, in part because they know that there is a social safety net to provide some minimal level of income. J. T. is the image some people have in mind when they attack the social welfare system, not C. K. But both represent a challenge to policy makers to design a system that helps those in need—while preserving work incentives—at a cost society is will- ing to pay.

The problem of defining a basic adequate standard of living and ensuring it to all without destroying work incentives is a challenge to all economic systems. It is a particular challenge to those systems that rely primarily on markets to allocate resources and encourage pro- ductive activities. This chapter examines the actual distribution of income, the measures of income distribution and poverty, the effects of labor market discrimination, and the role of government in redistributing income.

13.1 Personal Distribution of Income No single topic in economics generates more controversy than income distribution and poli- cies for income redistribution. The market results in an unequal distribution of income. The government is a powerful tool for redistribution, although it does not always redistribute from the rich to the poor.

Economists are reluctant to propose schemes for the redistribution of income because value judgments are necessary to choose among alternative income distributions. However, many economists, philosophers, and politicians have developed normative standards for the distri- bution of income. Three widely used measures of how “fairly” income is distributed are need, equality, and productivity. The foundation of pure communism as stated by Karl Marx was “to each according to his needs, from each according to his abilities” (Marx & Engels, 1848). The principle of pure equality would provide the same income for everyone. The productivity standard is based on the marginal productivity theory of labor discussed in Chapter 12.

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Section 13.1 Personal Distribution of Income

In the United States productivity is the primary determinant of income. However, there is redistribution to the poorer members of society. Part of this redistribution is done privately through charitable giving, and part is done publicly through governmental programs at all levels of government. The ideal of equality is the basis for the use of high marginal tax rates and the provision of certain basic services to all, regardless of income. Social welfare pro- grams are usually based on some indicators of need.

Income distribution in a market economy is determined primarily by ownership of the factors of production and by the prices those factors can command. The previous chapter described income distribution among the factors of production. Another way to describe income dis- tribution is according to how income is divided, equally or unequally, among individuals or households. This measure is called the personal distribution of income.

Lorenz Curves A Lorenz curve is a graph showing the cumulative percentage of income received by a given percentage of households, whose incomes are arranged from lowest to highest. It is con- structed by cumulating the percentage of households on the horizontal axis and the percent- age of income on the vertical axis.

Figure 13.1 shows Lorenz curves for three societies. A perfectly egalitarian society would have the Lorenz curve labeled distribution A. If incomes were equally distributed, the lowest 10% of all households would receive 10% of total income, the highest 20% would receive 20% of total income, and so on.

Figure 13.1: Lorenz curves

A Lorenz curve shows the percentage of income received by all percentages of households. A perfectly equal distribution would be represented by Lorenz curve A. Curves B and C represent more unequal distributions of income.

Cumulative percentage

of income

100

10080604020 Cumulative percentage of households

Distribution A (perfect equality)

Distribution B

Distribution C

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Section 13.1 Personal Distribution of Income

When household incomes vary, the Lorenz curve diverges from the 45° line of perfect equal- ity. Distribution B in Figure 13.1 shows a less egalitarian society. The greater the distance between the 45° line and the Lorenz curve, the greater the inequality in the income distri- bution. In Figure 13.1 distribution C represents more inequality than distribution B. Lorenz curves for different countries can be used to compare levels of income inequality. Sweden’s Lorenz curve comes fairly close to the 45° line. Developing countries tend to have curves that are farthest from the 45° line.

Lorenz curves can also be used to show how income distribution changes over time. The data in Table 13.1 show income distribution before taxes and transfer payments by quintiles, each representing 20% of the population. Data for 1967, 1997, and 2015 are graphed as Lorenz curves in Figure 13.2. Both Table 13.1 and Figure 13.2 indicate that the distribution of pretax income in the United States has become less equal since 1997, after moving slowly toward greater equality since 1967 (actually since 1929).

Table 13.1: Distribution of income in the United States for select years, 1967–2015*

Year Lowest quintile

Second quintile

Third quintile

Fourth quintile

Fifth quintile

1967 4.0 10.8 17.3 24.2 43.6

1977 4.2 10.2 16.9 24.7 44.0

1987 3.8 9.6 16.1 24.3 46.2

1997 3.6 8.9 15.0 23.2 49.4

2000 3.6 8.9 14.8 23.0 49.8

2005 3.4 8.6 14.6 23.0 50.4

2010 3.3 8.5 14.6 23.4 50.2

2015 3.1 8.2 14.3 23.2 51.1

*Income in 2015 CPI-U-RS adjusted dollars.

From “Table A-2. Selected measures of household income dispersion: 1967–2015” in “Income and poverty in the United States: 2015,” by B. D. Proctor, J. L. Semega, and M. A. Kollar for United States Census Bureau, 2016, Retrieved from https://www.census. gov/content/dam/Census/library/publications/2016/demo/p60-256.pdf.

https://www.census.gov/content/dam/Census/library/publications/2016/demo/p60-256.pdf

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Section 13.1 Personal Distribution of Income

Gini Coefficients A quick measure of inequality is the area between the diagonal and the Lorenz curve. The ratio of this area to the whole triangle below the diagonal is called the Gini coefficient. The Gini coefficient takes on values between 0 and 1. If all people have equal income shares, the Lorenz curve will lie along the diagonal, and the Gini coefficient will be 0. If one person has all the income and everyone else has nothing, the Lorenz curve will lie along the horizontal axis and the right vertical axis, and the Gini coefficient will have a value of 1. The closer the Gini coef- ficient is to 1, the greater the degree of inequality.

The Gini coefficients for the United States tell the same story as Table 13.1. In 1979 the Gini coefficient was 0.346. Since 1980 the Gini coefficient was strictly increasing, up to 0.408 in 1997. Between 1990 and 2013, it hovered around 0.40 and then increased to 0.415 in 2016 (see Table 13.2).

Figure 13.2: Lorenz curves for the United States in 1967, 1997, and 2015

The distribution of pretax, pretransfer earnings became less equal after 1967.

Cumulative percentage

of income

100

10080

1967

604020 Cumulative percentage of households

Perfect income equality

1997

2015

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Section 13.1 Personal Distribution of Income

Table 13.2 shows the Gini coefficients for Canada, Sweden, Panama, and the United States for selected years from 1979 through 2016. As you can see, Panama had the largest degree of inequality of these four countries but is showing improvement, while Sweden had the small- est but has slightly worsened in the past decade.

Interpreting the Data Lorenz curves and Gini coefficients must be interpreted with caution for two reasons. First, Lorenz curves describe the relative distribution of income among households. A Lorenz curve might show the lowest 20% of households receiving only 5% of the income, but it doesn’t say if this amount of income is high or low in an absolute sense. This 5% could be enough income to make everyone in the lowest 20% well fed, well housed, and well clothed. A Lorenz curve only shows the degree of inequality. By itself, it does not measure either wealth or poverty.

Second, Lorenz curves show how income is distributed among households at a given time. If the households in the lowest 10% change over time, the Lorenz curve will give an incorrect picture of relative poverty. The typical household’s income changes in a predictable way over time. Income tends to be low when wage earners are young, increase as they reach middle age, and decline in their retirement years. This life-cycle pattern means that households will move around in the income distribution over time. Since the Lorenz curve shows an income distribution at a specific time, it may overstate income inequality over time.

One useful source of information on changes in income distribution over time is the Panel Study of Income Dynamics (PSID) prepared by the Institute for Social Research at the Uni- versity of Michigan. The PSID has followed income and employment histories of 5,000 U.S. families since 1968. These data show considerable mobility among income levels. For exam- ple, of those who were at the top of the income scale in 1996, the top 1/100 of 1%, only 25% remained in this group in 2005. The degree of mobility among income groups from 1996 to 2005 was unchanged from the prior decade (1987 through 1996). However, from 2009 to 2012, 57.1% of households remained in the same income quintile, while the remaining 42.9%

Table 13.2: Gini coefficients for selected industrial countries for select years, 1979–2016

1979 1997 2004 2013 2016

Canada 0.324* 0.316 0.337 0.34 —

Sweden — — 0.261 0.278 0.292**

Panama 0.487 0.582 0.549 0.515 0.504

United States 0.346 0.408 0.405 0.41 0.415

*Data is from 1981, closest available year. **Data is from 2015, closest available year.

From “GINI index (World Bank estimate),” by The World Bank, n.d., Retrieved from https://data.worldbank.org/indicator/ SI.POV.GINI?locations=US-CA-SE-PA. Licensed under CC-BY 4.0.

https://data.worldbank.org/indicator/SI.POV.GINI?locations=US-CA-SE-PA

https://creativecommons.org/licenses/by/4.0/

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Section 13.1 Personal Distribution of Income

of households experienced either an upward or downward movement across the income dis- tribution. Households with householders who had lower levels of education were more likely to remain in or move into a lower quintile than households whose householders had higher levels of education (DeNavas-Walt & Proctor, 2015).

Economics in Action: Global Expert Hans Rosling Explains Income Inequality

It’s easy to be pessimistic about everything economic, but it does pay to stand back, look at the big picture, and check that pessimism against the long-term data. Which is what Hans Rosling helps people do. He is a statistician, a man who specializes in data visualization and in tracking income disparities around the world. He briefed Evan Davis on the state of the world. Watch it here: https://www.bbc.com/news/av/business-30927354/davos-the-state- of-the-world-in-seven-snowballs.

Distribution of Income After Taxes and Transfers What people are interested in, of course, is not pretax income but how much is available to spend or save, measured by income after taxes and transfer payments. (Transfer payments also include in-kind transfers, such as subsidized housing and food stamps.) By this standard, the increase in inequality is even greater. In 1980 the Gini coefficient for income including taxes, cash transfers, and in-kind transfers was 0.347. In 1990 the Gini coefficient rose to 0.381—twice as much of an increase in inequality as was indicated by the pretax, pretransfer measure. By 2015 the Gini coefficient was 0.415 (World Bank, 2018b).

Why did the distribution of income, both before and after taxes and transfers, become more unequal in the United States in the 1980s than between 1990 and 2015? The change in pre- tax, pretransfer incomes goes back to the functional distribution of income. High interest rates throughout the 1980s benefited upper and upper middle income households, not the poor or lower middle income groups, who have few interest-earning assets. Changes in the structure of jobs also affected wage earners. The decline in high-paying factory jobs and rise in service employment reduced and continue to reduce earnings at the bottom of the scale. Wages in service industries (such as fast food) are often at the bottom end of the wage scale. The growth in two-income households was also an important factor. Households with two or more adult earners increased their income dramatically, but the decline in real weekly wages meant that single-earner households fell behind.

Lower top-bracket tax rates increase the after-tax incomes of higher income groups, while Social Security taxes hit the working poor harder, further eroding the income position of those near the bottom of the ladder. Tax and transfer programs still help narrow the income gap between the top and the bottom, but income inequality in the United States remains an issue today.

https://www.bbc.com/news/av/business-30927354/davos-the-state-of-the-world-in-seven-snowballs

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Section 13.2 Poverty in the United States

13.2 Poverty in the United States Income distribution is not just a relative concept. Data on starvation, malnutrition, homeless- ness, and disease show that poverty has an absolute meaning as well. Determining the level of income that marks the border between poverty and nonpoverty is difficult, because poverty is both absolute and relative. People who are relatively poor in one nation may be well off by the standards of another country or by the standards of the same nation at an earlier time.

Measuring Poverty The U.S. government first established an official definition of poverty in 1964. The definition was based on the cost of a minimally adequate diet. This figure was then multiplied by 3, since the typical household spent one third of family income on food. In 1964 the poverty income level for a family of four was $3,000 ($1,000 for food times 3) or below. The poverty threshold has been adjusted each year for inflation. In 2018 the official poverty income level was $12,140 or below for a single individual and $24,100 or below for a family of four (Q1Medicare.com, 2018).

The poverty rate is a rather crude measure of poverty or changes in poverty because this num- ber gives no indication of how poor people are. A person whose income is $1 below the thresh- old is counted as poor, and so is a person whose income is $3,000 below the threshold. If cash transfers bring the first person’s income up by $2, the poverty rate falls. If transfer payments raise the second person’s income by $2,000, the poverty rate is unchanged. However, even with these shortcomings, the poverty rate provides some indication of how much aggregate poverty exists and how it changes over time. Figure 13.3 shows the number of people living in poverty and the poverty rate from 1959 to 2015.

Figure 13.3: Number in poverty and poverty rate, 1959 to 2015

In 2015 there were 43.1 million people in poverty, 3.5 million less than in 2014. The official poverty rate in 2015 was 13.5%, down 1.2 percentage points from 14.8% in 2014.

Note: Data for 2013 and beyond reflect the implementation of redesigned income questions.

“Figure 4. Number in poverty and poverty rate: 1959 to 2015” from “Income and poverty in the United States: 2015,” by B. D. Proctor, J. L. Semega, and M. A. Kollar for United States Census Bureau, 2016, Retrieved from https://www.census.gov/content/dam/Census/library /publications/2016/demo/p60-256.pdf

25 Percent

Numbers in millions

Numbers in poverty

Poverty rate

Recession

43.1 million

13.5 percent

0 1959 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

https://www.census.gov/content/dam/Census/library/publications/2016/demo/p60-256.pdf

285

Section 13.2 Poverty in the United States

Who Are the Poor? In the United States, the poor come from all parts of the country and every age group. How- ever, poverty is more common in certain geographic, demographic, and racial groups. Geo- graphically, the poor tend to live in the rural south and in northern cities. Poverty is more common in rural areas than in cities. Table 13.3 points out other characteristics of people living below the poverty line in the United States. Almost 15% of the population fell below the poverty threshold in 2010. However, the poverty rate was above 31% for certain segments of the population. The poverty rate for non-Whites is higher than that for Whites. Age is also an important factor; children represent a large fraction of those below the poverty level. In fact, poverty is now a less serious problem for the elderly than for children under 18.

Table 13.3: Characteristics of the poor, 2015

Characteristic Percentage below poverty level

White (non-Hispanic) 9.1%

Black 24.1

Hispanic 21.4

Asian 11.4

Age under 18 years 19.7

Age 18 to 64 years 12.4

Age 65 years and older 8.8

No high school diploma, all races 26.3

High school graduate, all races 12.9

Some college (1 year or more), all races 9.6

Bachelor’s degree or higher, all races 4.5

From “Table 3. People in poverty by selected characteristics: 2014 and 2015” in “Income and poverty in the United States: 2015,” by by B. D. Proctor, J. L. Semega, and M. A. Kolllar for United States Census Bureau, 2016, Retrieved from https://www.census.gov /content/dam/Census/library/publications/2016/demo/p60-256.pdf.

Policy Focus: Income Redistribution: In Cash or In Kind?

Once a society decides to alter the market-determined distribution of income, the next question is how to carry it out. Should the method be cash payments or in-kind transfers of goods and services, such as housing, food, and health care?

Both private and public redistribution rely heavily on in-kind transfers of specific goods or services. In-kind transfers by private charities take place through soup kitchens, shelters for the homeless, and Meals on Wheels for shut-ins. The motive for such transfers is often not a desire to reduce income inequality but rather to ensure provision of basic needs such as food and shelter. Nobel laureate James Tobin describes people with this redistribution motive as specific egalitarians.

(continued)

https://www.census.gov/content/dam/Census/library/publications/2016/demo/p60-256.pdf

286

Section 13.2 Poverty in the United States

Discrimination and Market Forces Economic theory suggests that racial or sexual discrimination will not persist over time in a market system because it is costly to entrepreneurs. If employers discriminated, there would be large numbers of minority and female workers earning low salaries but having basically the same education and work skills as White male workers. A profit-motivated entrepreneur could hire these minority and female workers and produce goods and services more cheaply than other firms using the more expensive labor. As this activity spread, wages for the minor- ity and female workers would be bid up closer and closer to the level of White male workers. Thus, the profit motive would work to undermine discrimination.

Some economic historians argue that Jim Crow laws in the South in the late 19th and early 20th centuries were a response to the threat that market forces would undermine racial discrimination. Jim Crow laws put the force of law behind segregation and discrimination. These laws were eventually overridden by federal legislation. In South Africa, apartheid was needed to maintain a racially segregated system that economic forces would otherwise have undermined.

Policy Focus: Income Redistribution: In Cash or In Kind? (continued)

Economists, who tend to be general egalitarians, usually argue for giving cash instead of specific goods and services, because a cash transfer allows recipients more options and thus does more (per dollar) to increase the recipient’s well-being. The idea is that people can choose the goods and services that best fit their needs if they are given unrestricted income. Economists also prefer cash transfers because such programs are much less costly to administer.

Tobin argues that the majority of people are specific egalitarians who care about ill-clothed and ill-fed people, not inequality. The result of this widely held preference is that a large share of government benefits for the poor are in kind rather than in cash. The current dominance of in-kind transfer programs is based on politics rather than economics. For example, the 2018 U.S. federal budget contains $404 billion for Medicaid, $66 billion for food stamps, and $19 billion for rental assistance, which includes housing vouchers (U.S. Department of Health and Human Services, 2017b). These three programs comprise more than $489 billion in federal funds, bringing the ratio of in-kind assistance to cash aid at 5.6 to 1 (Glaeser, 2012).

Nobel laureate James Buchanan argues that a preference for in-kind rather than cash transfers simply means that voters are maximizing their own utility as donors rather than maximizing the utility of welfare recipients by allowing them freedom of choice. The donor/ voter’s motive for income redistribution may not be the welfare of the recipients but rather a desire to eliminate some perceived problem—homeless people on the streets, slum housing, or students who disrupt the learning process in public schools because of illness or hunger. Providing specific goods or services is a more direct way of accomplishing that goal.

287

Section 13.3 Income Redistribution

Discrimination begets poverty, and poverty begets little investment in human capital. Although discrimination is not the sole source of poverty, it does contribute. Government can help combat discrimination both with antidiscrimination laws and with equal treatment for government employees regardless of race or sex. These policies by themselves, however, are not enough to eliminate poverty. The government may also be called on to take policy actions that change the income distribution determined by the market.

13.3 Income Redistribution Income redistribution in the United States, and many other countries, has been carried out by both the pri- vate sector and the public sector. Many public goods or goods with some public benefits are produced at least partly in the private sector. Some roads, schools, outdoor concerts, and other goods and services gen- erate collective benefits but are privately produced. Income redistribution is another activity with public benefits produced at least in part by the private sec- tor through charitable organizations.

Private redistribution alone is not likely to achieve the desired level of income transfers. Individuals in a large group recognize that their contribution is too small to significantly affect total redistribution. Each person has an incentive to leave the respon- sibility to contribute to others. People who give because of personal satisfaction gained from the act of charity do not experience this incentive to shirk their responsibility. However, for some people, the motive for giving is seeing less poverty in the world. For this group, giving by others diminishes their need to give. If everyone followed this strategy, there would be no private redistribution. This kind of free riding explains why there is not enough private redistribution.

An important influence on the amount of private redistribution is the size of the group. In a relatively small, homogeneous group, there is likely to be relatively more private redistribu- tion. Think about the Mormon Church and Amish communities, for example, or small towns versus large cities. Greater charity in small groups is consistent with the view that the poverty is more visible when the group size is smaller.

hbak/iStock/Thinkstock Some goods and services generate a collective benefit but are privately produced. An outdoor concert is one example of this circumstance.

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Section 13.3 Income Redistribution

Benefits and Goals Citizens may support income redistribution for many reasons. First, some people have interdependent utility functions, which means that their well-being is dependent on the well-being of others. These people support programs to redistribute income because such redistribution increases their utility. Second, some people might view poverty as a negative external effect, like air pollution—something that makes the environment less appealing. This group supports redistribution to improve their surroundings. They might, for exam- ple, support food stamp legislation to help keep hungry people from begging on the streets. Finally, redistribution can be viewed as an insurance policy. People might support redistri- bution as a safety net, realizing that they might become poor at some time.

Choosing Between Equality of Opportunity and Equality of Results Should the goal of redistribution be equality of opportunity or equality of results? A goal of equality of opportunity might impose penalties on employers who discriminate or mandate government investment in human capital through technical schools, student loans and grants, or training programs.

Government or private programs that reduce unemployment and improve the match between workers and jobs are also indirect forms of poverty relief. Not only do these programs increase total output, they generally improve job opportunities and earnings for workers at the lower end of the wage scale. Anything that the government does to promote economic growth and reduce cyclical fluctuations will also reduce unemployment for all groups. Since the poor are so often the last hired and first fired, they would benefit more than most from such programs. Even programs that reduce the obstacles to working, such as those that improve public trans- portation or subsidize day care, help the poor who can work. The goal of equality of opportu- nity is to offer the working poor a chance to improve their earnings and escape from poverty.

Giving everyone an equal chance at success in the labor market is consistent with the values of freedom, incentives, and individual choice implicit in a market economic system. However, equality of opportunity does nothing to help those who have to care for very small children and those who are too old, too young, too sick, too disabled, or too unskilled to participate in the market as workers. The only programs that will reach these poor are programs that are aimed directly at equality of results.

The fraction of the poor outside the labor force, or not expected to work, has risen dramati- cally in the past 50 years. In 1939 less than one third of poor households were composed of persons not able to work for one of the reasons listed above. Today closer to two thirds of poor households are headed by a person who is elderly, a student, disabled, or a female with one or more preschool children. These people do not benefit from a rising tide of economic growth and increased job opportunities unless there is a deliberate effort to share those gains through redistribution.

289

Section 13.4 Government Transfer Programs in Practice

Redistribution to the Middle-Income Class Not all income redistribution is to the poor. Nobel laureate George Stigler points out that peo- ple try to use government policy as a way to redistribute income to themselves rather than to others. The government has the power to extract resources that would not be provided voluntarily. Any group that can gain control of the government can use this power to its own benefit. Stigler argues that the group that controls government policy making is the middle class. Thus, most public expenditures and tax breaks are made for the benefit of the middle class—programs such as college loans, tax deductions for mortgage interest, subsidies for highways and airports heavily used by the middle class, and grants to state and local govern- ments to build water and sewer systems (Stigler, 1970). Interestingly enough, at the 2012 presidential nominating conventions, the Democrats used the phrase “middle class” 47 times per 25,000 words, whereas the Republicans said it only 6.9 times per 25,000 words (Bostock, Carter, & Ericson, 2012).

Economics in Action: At the National Conventions, the Words They Used

Check out an interactive graphical comparison of how often speakers at the two presidential nominating conventions used different words and phrases, based on an analysis of transcripts from the Federal News Service: https://archive.nytimes.com/www.nytimes .com/interactive/2012/09/06/us/politics/convention-word-counts.html?#Business.

13.4 Government Transfer Programs in Practice Until the 1930s, programs to relieve poverty were small scale, provided mainly by local gov- ernments and private charities. During the Great Depression of the 1930s, state and local governments were swamped with demands, and the present system of federal and feder- ally assisted income transfer programs was born. These programs include Social Security for workers who are retired or disabled, unemployment compensation for those temporarily unemployed, and welfare programs for those unable to work. Today transfer programs are a federal–state partnership, with the larger share of the funding at the federal level.

Social Security Social Security was established in 1935 as an old-age pension system. It was later expanded to include survivors’ benefits (1939) and disability insurance (1950). Social Security was designed to relieve poverty for three groups likely to be poor: the old, the dependent survi- vors of deceased workers, and the disabled. In 1965 a program of health care for the elderly (Medicare) was added to Social Security. Except for Medicare, Social Security is a cash transfer program with no in-kind benefits.

https://archive.nytimes.com/www.nytimes.com/interactive/2012/09/06/us/politics/convention-word-counts.html?#Business

290

Section 13.4 Government Transfer Programs in Practice

Social Security payments are financed by a tax on workers and employers; currently, each pay an equal amount. Workers do not have a choice about participating. However, microeconomic theory suggests that at least part of the other half of the tax paid by employers is actually borne by workers.

The actual division of the tax burden between worker and employer depends not on legisla- tion that says half on each, but on the relative elasticities of supply and demand for labor. The majority of the tax will fall on the worker because the market supply of labor is very inelastic.

Social Security is the largest income redistribution program in the United States. It also has some insurance features in the form of disability and survivors’ benefits. Workers must con- tribute to the program for a specified minimum period of time in order to be eligible for benefits. The size of the benefit received is independent of any nonearned income such as interest, dividends, and private pensions. However, retirees younger than the full retirement age face a reduction of benefits if they earn above a certain wage income. This policy discrimi- nates against poorer retirees, because the only way most of them can supplement their Social Security retirement income is with wages. Higher income retirees collect interest, dividends, and private pensions without loss of Social Security benefits.

Social Security taxes are paid into the Social Security Trust Fund. This name is misleading, because it is simply a fund into which current workers pay and from which current beneficia- ries receive payments. Unlike private pensions and annuities, no money is held and invested for workers as the source from which they will later receive income. The Social Security sys- tem is a tax-and-transfer mechanism. Individuals are taxed during their working years to pay benefits to those who are currently retired, disabled, or surviving dependents of covered workers.

Several reforms to the Social Security system were enacted in 1983. Noting that there would have to be increased outlays in the period after the year 2000, as the postwar baby boomers began to reach retirement age, a special presidential commission proposed increasing Social Security taxes to build up a surplus in the Social Security Trust Fund. Since Social Security taxes are collected and benefits are paid out by the federal government, the taxes appear as revenue and the benefits as expenditures in the combined federal budget. Technically, Social Security funds are separate, but the reported overall budget deficit or surplus has included these funds since 1967. As a result, a large part of the debt is held by federal agencies, chiefly the Social Security Trust Fund.

Can today’s workers rely on promised future Social Security payments? Many people are concerned about whether they will receive those future benefits. Policy reforms since 1985 have strengthened the stability of the system. In 1993 Social Security collected $436 billion in payroll taxes and paid out $305 billion in benefits, a surplus of $131 billion. In 2016 Social Security collected roughly $957 billion in payroll taxes and paid out $922 billion in benefits, a surplus of $35 billion that was added to the $2.85 trillion in reserve funds (Board of Trust- ees, Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds, 2017). However, as the American population continues to age and more people retire, the cushion of surplus funds will be needed to pay these benefits.

291

Section 13.4 Government Transfer Programs in Practice

Global Outlook: Income Security in Other Industrial Countries

Policy makers often explore what other countries do in order to find workable solutions to problems like welfare reform and growing Social Security costs. All governments provide some mix of transfer payments and social services in their social welfare systems. Some of these programs are based on a means (needs-based) test, and others go to all citizens. Children’s allowances in Canada, for example, are provided to all families. Since these grants are taxable income, some funds are recovered in tax payments from higher income families. Education up to a certain level is traditionally provided to all citizens in industrial countries regardless of income.

All major industrial countries have some type of publicly funded pension system and some provision for unemployment and disability insurance. Health care is more likely to be provided at public expense in European nations. Public housing has been an important component of social welfare in Britain, where until the late 1990s, upward of 28% of the population lived in “council houses” (public housing rented at subsidized rates). In Scandinavian countries, the political consensus is that a basic standard of living is a right. Therefore, certain basic social services and social insurance programs (unemployment, disability, and so on) are provided to everyone.

Support for the welfare state peaked in European countries and in the United States during the 1960s and 1970s. Today U.S. social welfare expenditures are a lower share of GDP than in most other industrial countries, except for Japan. Japan spends a lower percentage of its total income on welfare programs because the family is expected to assume greater responsibility for both the young and the elderly.

In the 2000s the emphasis on individualism and concern over work incentives that pervaded the U.S. welfare policy debate has also received increased attention from policy makers elsewhere. The formerly Communist nations of eastern and central Europe have struggled to dismantle their extensive welfare systems. As immigration into Sweden continues, the Swedish government is being forced to reconsider how much it can afford to provide. Germany found that a high payroll tax required to cover social welfare costs made its labor very expensive and cut into its global competitiveness. Thus, those who debate fundamental changes in U.S. welfare policies are not alone. From Japan, to Canada and the United States, to Germany, Sweden, and many other countries, social welfare systems are one of the most pressing and difficult political and economic issues of the 21st century.

monkeybusinessimages/iStock/Thinkstock Industrial countries, regardless of income, traditionally provide a certain level of education to all citizens.

Transfers to the Elderly In the past 50 years, the economic well-being of those over age 65 has increased greatly in the United States. In 1959 the largest segment of the poor were people over 65. By 2015 fewer than 9% of those over 65 were below the poverty line (Proctor et al., 2016). If in-kind trans- fers are counted, the number falls even lower.

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Section 13.4 Government Transfer Programs in Practice

Medicare is another major transfer program benefiting the elderly. When it was established in 1965, Medicare was projected to cost $8.8 billion in 1990. Even after adjusting for inflation, that estimate was far off the mark. In 1990 Medicare cost $111 billion in 1965 dollars. By 2017 Medicare cost the federal government over $609 billion. Social Security and Medicare are the two largest federal programs, accounting for 36% of federal expenditures in 2017 (U.S. Department of Health and Human Services, 2017a).

Unemployment Compensation Unemployment compensation is a transfer program financed by a tax on employers and administered by the states, which set benefit levels and eligibility requirements. Costs are shared between the states and the federal government. In 2017 there were about 6.2 mil- lion beneficiaries on average, receiving benefits that totaled $32 billion (U.S. Government Accountability Office, 2017).

Unemployment compensation is intended to be a temporary replacement of lost income while a worker is between jobs or temporarily laid off. The program has been criticized as providing “paid vacations” while workers go through the motions of searching for jobs. It has also been praised as providing a safety net for unemployed workers while they match their skills to the best available jobs, making labor markets more efficient. Of all income transfer programs, this one is typically the least criticized because benefits are of a temporary nature.

Welfare The group of programs lumped together as “welfare” began in the 1930s with Aid to the Aged, Aid to the Disabled, and Aid to Dependent Children (later Temporary Assistance for Needy Families, or TANF). These programs identify groups of people not expected to work. Costs are shared between the federal and state governments. There are different eligibility require- ments and benefit levels in different states. In the 1960s these programs were expanded and new ones were added as part of President Lyndon Johnson’s War on Poverty. Aid to the Aged, Aid to the Disabled, and several smaller programs were merged into Supplemental Security Income, a federally funded program, in 1972.

In-kind welfare programs include food stamps, public housing, Medicaid, legal aid, Head Start for preschool children, and job-training programs. These efforts to improve the welfare of the poor were designed to ensure that they consumed the “right mix” of goods and services, especially in the areas of health, nutrition, education, and training.

Although welfare policy gets a great deal of attention, these cash and in-kind programs are relatively small compared to Social Security. In 2017 total U.S. government spending on wel- fare at the federal, state, and local level was almost $1.1 trillion (U.S. Government Spending. com, n.d.). The welfare system consists of more than 80 federal programs providing cash, food, housing, medical care, social services, training, and targeted education aid to poor and low-income Americans. More specifically, the federal programs include programs that pro- vide food aid, social services, educational assistance, housing assistance, cash assistance, vocational training, medical assistance, energy and utility assistance, and child care and child development programs (Rector, 2012).

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Conclusion

The Welfare Reform Policy Debate Welfare reform is, of course, high on the political agenda. With spending totaling almost 6% of GDP in 2017, welfare has been one of the fastest growing components of the federal budget in recent years, spurring discussion of reform. Critics of welfare programs argue that they dis- courage work. It is very likely that a welfare client who takes a job will actually be worse off. Welfare recipients who take jobs lose not only cash benefits but also medical help, subsidized housing, and other benefits from overlapping programs. They also have to pay Social Security taxes and possibly income taxes. Changes in income tax laws have provided some tax relief for the working poor, and they are able to keep food stamps until their income rises beyond a certain threshold.

Workfare Programs Various states have developed a number of experimental programs aimed at providing work incentives while containing costs. These workfare programs encourage or require welfare recipients who are able to work to take jobs as a condition for continuing to receive benefits. Workfare programs appeal to both liberal and conservative politicians. They combine the lib- eral approach of giving where there is need with the conservative approach of giving to those who make an effort to support themselves. State workfare programs involve job training, day care, and help with job searches, as well as penalties for refusing to accept training or seek work. Sometimes the jobs are in the public sector, and some programs also include education programs that should lead to jobs.

Conclusion C. K. has worked long enough to be eligible for Social Security disability if she meets the stringent tests to ensure that she is genuinely unable to work. At 2018 rates, she will receive about $1,320 a month from Social Security and may work part time earning up to another $1,420 a month. The combined income will provide a modest but adequate standard of living. If she is not able to work at all, her income is low enough to make her eligible for food stamps. After 2 years, she will be eligible for Medicare to meet her medical expenses. C. K. is fortunate to qualify for a program designed specifically for workers who become unable to work.

C. K. still has an incentive to work part time, but only up to a ceiling. The biggest work disin- centive is in health care. If she recovers sufficiently to return to work full time, she will lose not only her disability benefits but also her Medicare coverage. With a chronic disease, she will find it difficult to find other health care coverage.

J. T. is the typical TANF recipient that most welfare reform has tried to reach. She is eligible for TANF benefits, Medicaid for herself and her children, and food stamps. The combined value of TANF and food stamps varies greatly from one state to another. Depending on the state, J. T. may be strongly encouraged to obtain her high school diploma, get job training, and look for work.

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Conclusion

If she works, however, her standard of living may not improve very much. Remember, a full-time, year-round job at the minimum wage of $7.25 only pays $14,500 a year, which is still below the poverty level for a family of three. J. T., under current rules in most states, will lose one dollar in benefits for every dollar she earns from working. She will still receive food stamps but will probably lose her eligibility for Medicaid. She will also incur child care costs and working expenses. Unlike C. K., J. T. has a powerful incentive not to work at all.

As you can see, designing a social welfare system that meets the needs of and provides appropriate incentives for people in different situations, like C. K. and J. T., is not easy. Many economists disagree about the extent of the problem and what should be done about it. Our income redistribution system will likely be an ever-evolving attempt to get it right.

Key Ideas

1. The Lorenz curve and the Gini coefficient measure the relative distribution of income in an economy. Neither measure, however, reflects the life-cycle pattern of income earning and may therefore give a false impression of how much income inequality exists over time.

2. The poverty threshold in the United States was established in 1965 and is adjusted regularly for inflation. This measure is used to determine changes in the amount of poverty in the United States. For families, the poverty threshold determines eligibil- ity for certain kinds of benefits, such as food stamps. The poverty measures have been criticized because they fail to take into account the value of benefits other than cash payments.

3. To the extent that discrimination exists in the labor market, total output is lower than it could be if all resources were used in the most efficient manner. Market forces will work against discrimination, because discrimination is costly and entrepreneurs can reduce the costs of production by not discriminating.

4. Income redistribution can be viewed as a public good that is underprovided because of free-riding behavior. Critics of government redistribution argue that it crowds out private charity, destroys work incentives, and results in redistribution to the middle class and the rich rather than those who are truly needy. Programs that promote equality of opportunity encourage work and are less costly to taxpayers than those that promote equality of results. However, the latter programs are more likely to reach the elderly, disabled, and children. Economists consider cash redis- tribution more efficient, but the public prefers in-kind redistribution to ensure that the program results in particular forms of consumption and reaches the intended beneficiary.

5. Poverty relief policies in the United States have taken three forms: training and job opportunities, social insurance, and direct assistance to those who are unable to work because of age and health problems. Poverty among the elderly has largely been eliminated because of the Social Security system. Social Security, however, is now under some financial pressure because of the changing age distribution of the population. In-kind transfers have expanded in the past 40 years and reduced the incidence of poverty in the United States. Current welfare policy reform proposals center on cost control and work incentives.

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Conclusion

Critical-Thinking Questions

1. What is the Gini coefficient, and what does it tell us about income inequality? 2. How is the official poverty level of income determined? Is it a meaningful measure? 3. Why might an economist believe that the market for labor will work to undermine

discrimination? 4. What does it mean to have an interdependent utility function? How would this char-

acteristic make someone more favorable toward income redistribution? 5. Why should a society redistribute income to the poor? What are the potential prob-

lems? Why is private charity likely to be inadequate? 6. Which groups of people are more likely to fall below the poverty line? What do these

groups have in common? 7. How is income redistribution similar to an insurance policy? 8. How are Social Security taxes levied on the employer and employee? Who really pays

the Social Security tax? Explain. 9. Public education is an in-kind transfer to all people in certain age groups. Who ben-

efits more, the poor or the wealthy? 10. Would you be more inclined to favor equality of opportunity or equality of results?

Why? 11. Why would cash transfers typically be preferred by recipients over in-kind transfers?

What are the pros and cons of each from a government perspective? 12. Should society be concerned with relative poverty or absolute poverty? How would a

policy designed to reduce relative poverty differ from one designed to reduce abso- lute poverty?

13. How do income redistribution policies in the United States compare to those of other industrialized countries?

14. Which programs are designed to help the elderly? How have these programs impacted the percentage of elderly people below the poverty line?

15. What problems with the welfare system are workfare programs designed to solve? Provide an example.

Key Terms Gini coefficient A numerical measure of income inequality equal to the area between the diagonal and the Lorenz curve divided by the area of the triangle that is below the diagonal in the Lorenz curve diagram.

interdependent utility functions Prefer- ence patterns in which the welfare of some individuals depends on the well-being of others.

Lorenz curve A graph showing the cumu- lative percentages of income received by a given percentage of households.

personal distribution of income A mea- sure of how total income is divided among individuals or households.

workfare programs State welfare pro- grams requiring beneficiaries to take jobs or participate in training in order to remain eligible for benefits.