Economics 141A Economics of Government Behavior I

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Economics 141AEconomics ofGovernment Behavior I
Professor Francesca MazzolariFall 2006Lecture 7
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Outline

• Justifications for redistribution
• Inequality and poverty in the U.S.
• Welfare programs in the U.S. (cont.)
• Moral hazard costs
• Role of categorical programs
• Role of ordeal mechanisms
• Role of outside options
• Benefits of redistribution
• Welfare reform

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IV. Moral hazard costs

• Okuns leaky bucket
• Administrative costs
• Dead weight loss from taxation
• Behavioral responses of beneficiaries (moral
  hazard costs)

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Means-tested transfer system
IV.

• Pure means-testing with non-negative transfers
• B b if bgt0
• 0 if b0
• b G t x Earnings
• B actual benefits received
• G maximum benefit guarantee
• t benefit reduction (or take-back) rate

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Poverty elimination strategy
IV.

• Setting G equal to the poverty line (and t
  1) would eliminate poverty
• the government would pay any family below the
  poverty line the difference between the poverty
  line and their income

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Static costs
IV.

• The poverty gap provides a naïve estimate of
  the cost of this program
• 7.2 million families below the poverty line
• Poverty line for a family of four 19,000
• ? Static cost calculation is 98 billion
• ( 14,000 per family)

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Behavioral response
IV.

• Work decision in the absence of welfare
• Maximum hours of 2,000 per year
• Leisure hours (L) Work hours (H) 2000
• Market wage (w) 10 per hour
• Earnings (E) wH

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Behavioral response
IV.

• Work decision in the absence of welfare

Annual consumption
Budget constraint in the absence of the welfare
program C w(2000-L)
20,000
18,000
Slope -w
200
Annual Leisure
2000
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Behavioral response
IV.

• Work decision in the absence of welfare

Optimal choice of labor supply depends on
relative preference for leisure
Annual consumption
20,000
CL
UL
High taste for leisure
CH
UH
LH
LL
2000
Annual Leisure
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Behavioral response
II.

• Work decision in the presence of welfare
• G 10,000
• t 1 (100 benefit reduction rate)
• Break-even earnings level
• b B 0
• G t x E 0
• E G/ t 10,000

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Behavioral response
IV.

• Work decision in the presence of welfare
• Budget constraint with welfare and t 1
• If EltG C w(2000L) G tw(2000L)
• G
• If E G C w(2000L)

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Behavioral response
IV.

• Work decision in the presence of welfare

Individuals who are mechanically eligible should
stop working
Annual consumption
20,000
10,000
UH'
CH
UH
LH
1000
2000
Annual Leisure
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Behavioral response
IV.

• Work decision in the presence of welfare

Individuals opting to work gtgt 1000 hours
pre-program are unaffected
Annual consumption
20,000
CL
ULUL'
10,000
LL
1000
2000
Annual Leisure
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Behavioral response
IV.

• Work decision in the presence of welfare

Some individuals will stop working to become
eligible
Annual consumption
20,000
CM
UM'
10,000
UM
LM
1000
2000
Annual Leisure
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Costs with moral hazard
IV.

• The cost of eliminating poverty incorporating
  these behavioral responses may be three times as
  large as the poverty gap

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The iron triangle
IV.

• A natural solution to the moral hazard problem
  may appear to be to lower the benefit reduction
  rate
• Consider a reduction to t 0.5
• Budget constraint with this reform
• C w(2000L) G tw(2000L)
• 0.5w (2000L) G
• Ebreak-even G/ t 10,000/ 0.5 20,000

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The iron triangle
IV.

• Work decision under the new program

Annual consumption
Slope -5
20,000
10,000
UH''
CH
UH
LH
1000
2000
Annual Leisure
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The iron triangle
IV.

• Work decision under the new program

Annual consumption
20,000
CZ''
UZ''
10,000
CZ
UZ
LZ
LZ''
2000
Annual Leisure
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The iron triangle
II.

• Work decision under the new program

Annual consumption
20,000
20,000
CM
UM''
10,000
UM
LM''
LM
2000
Annual Leisure
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The iron triangle
IV.

• Work decision under the new program

Annual consumption
20,000
20,000
CL
UL''
UL
10,000
LL
LL''
2000
Annual Leisure
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The iron triangle
IV.

• There is no way to change either the benefit
  reduction rate or the 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.

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Reducing moral hazard
IV.

• Other policy instruments that can overcome these
  moral hazard problems
• Categorical welfare payments
• In-kind programs (and ordeal mechanisms)
• Increasing outside options