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More on income distribution. Today: Family income distribution Should we redistribute income? Why? Some government programs. Reminder on Test 2. Test 2 Wednesday 65 minutes Restrictions on calculators are the same as for Test 1. Income distribution. How is income distributed?

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More on income distribution

Today: Family income distribution

Should we redistribute income? Why?

Some government programs


Reminder on Test 2

  • Test 2 Wednesday

  • 65 minutes

  • Restrictions on calculators are the same as for Test 1


Income distribution

  • How is income distributed?

    • Is there such a thing as “too much” income inequality?

    • Why should there be redistribution?

    • In-kind versus cash transfers

      • When income is redistributed, should recipients be forced to consume a minimum amount of certain goods?

    • What are the problems of redistribution?


Mean income table (families)

  • Real income growth, 1980-2000

    • Bottom 20% has been flat

    • Top 20% has seen huge growth (59%)

Source: “Principles of Microeconomics” 3rd edition, by Frank and Bernanke

Note: More recent figures show that family incomes in the bottom 60% have stayed about the same since 2000 (source: http://www.census.gov/hhes/www/income/histinc/h01AR.html)


The gap between rich and poor widens

  • The rich are getting richer, but the poor are not getting poorer

  • The middle class has seen moderate real growth in income

    • 16-29% growth for the categories in the middle 60%

  • Some of this is due to more middle-class families having two incomes


Problems with annual income figures

  • Ignores number of workers in a household

    • General trend from one earner to two

    • Expenses, such as child care, could be higher within two-worker households

  • In-kind transfers ignored

  • Taxes change over time

    • Disposable income changes over time (given the same income)

  • Income changes over time

    • If a rich person earns no income in a calendar year, should she be considered “poor?”


Is there “too much” income inequality

  • Some people would argue no

    • “When economic incentives to make a good living go away, the economic pie becomes smaller”

      • Think about communist systems

    • “People that have a good work ethic and work hard should make more money”

    • “There are plenty of opportunities for anybody born today in the US to become successful”

      • Free K-12 education; subsidized colleges and universities


Arguments for less income inequality

  • “Marginal utility of income is lower for somebody with high incomes”

  • “Each person has a right to a minimum standard of living”

  • “Social unrest may occur unless each person is above the poverty line”


Other problems with income inequality

  • Those that are relatively poor may feel inferior

    • This problem may perpetuate to their children

  • Jealousy towards other people

  • Envy towards other people’s accomplishments


More on fairness

  • There are different views of fairness

    • Additive social welfare function

    • “Veil of ignorance”

      • Social welfare function should be minimum utility of all people in a society

    • Commodity egalitarianism


Different views of fairness

  • Some people believe that utility, not income, should be maximized within a population

    • Additive social welfare functionW = U1 + U2 + … + Un


0

Implications for additive utilities

This is the net gain to society

Paul gains this much utility

Paul’s marginal utility

Peter’s marginal utility

e

f

Peter loses this much utility

d

c

Take ab from Peter and give to Paul

Social welfare maximized

MUPeter

MUPaul

Paul’s income

Peter’s income

0

0’

b

a

I*

Paul’s income

Peter’s income


Different views of fairness

  • Others believe that social welfare should be the minimum of the utilities of each person in society

    • “Veil of ignorance” argument developed by John Rawls

      • Conceals knowledge and talents from people

      • Risk averse people will want to have income equality under these conditions

      • No inferiority, jealousy or envy based on income


Problem

  • The “economic pie” will shrink with Rawls’ ideas

  • If income was guaranteed to be equal to everyone, nobody will have an economic incentive to gain human capital

    • Smaller “economic pie”

      • Less human capital

      • People work less


Optimal amount of income inequality?

  • Impossible to answer

  • Different people have different opinions about effectiveness of realistic ways to redistribute income


Different views of fairness

  • Commodity egalitarianism

    • Some things should be made available to everyone without restrictions

      • Right to vote (if 18 or older)

      • Basic education

      • “Needed” items such as food, shelter, and clothing

      • Basic medical care

        • Recall issues presented in Chapters 9 and 10


Some other factors

  • Income redistribution does not directly take into account other factors

    • Number of hours worked

      • If our goal is to maximize utility from income, why not reduce leisure?

        • Not necessarily, since additional leisure likely increases utility

      • Income depends on number of hours worked

    • Does relative income matter?

      • Does someone get a decrease in utility when his income remains the same and someone else’s increase?


In-kind versus money transfers

  • With some views, such as commodity egalitarianism, in-kind transfers have more appeal than monetary ones

  • How does this affect individual utility?


In-kind Transfers

H

420

Other goods per month

E3

340

A

F

U

300

E1

260

B

D

20

60

150

210

Pounds of cheese per month


In-kind Transfers

H

420

Other goods per month

A

F

300

E5

168

E4

136

B

D

82

126

150

210

Pounds of cheese per month


If income redistribution is good…

  • …then how do we move money from one person to another?

    • Welfare payments

      • We will spend most of our time on this

    • The earned-income tax credit

    • Negative income tax

    • Minimum wage

    • Public employment of the unemployed


Some methods of income redistribution

  • Welfare payments

    • Little economic incentive to get off of welfare without time limits

  • Many types of programs

    • TANF

    • Supplemental Security Income

    • Medicaid

    • Unemployment insurance


TANF

  • Temporary Assistance for Needy Families

    • Federal government provides block grants to states for welfare spending

    • Over 80% of recipients in every state must be on TANF for five years or less

    • States face penalties if a substantial percentage of recipients are not working or in work preparation programs


TANF

  • TANF replaced Aid to Families with Dependent Children (AFDC)

    • Under AFDC, some argued that many women on AFDC had children out of wedlock to continue get benefits and not have to work

      • If the mother had to work once the child reached kindergarten, then there would be an economic incentive to have another child


TANF and benefit reduction rates

  • TANF benefits are reduced when income reaches a certain level

    • Example: In California, recipients can earn up to $225 per month before benefits are reduced at a rate of 50% of money earned

  • How do people respond to these incentives in the short run?


0

Work incentives

B = G – tE

B = 0 if E = G/t

The Basic Trade-offs

G – basic grant if not working

t – rate at which grant reduced when recipient earns money

B – benefit received


Analysis of work incentives

D

|Slope| = w

Income per month

c

Time Endowment

b

2w

w*

a

0

T

Hours of leisure per month


Analysis of work incentives

D

|Slope| = w

Income per month

E1

G

iii

ii

Income

Leisure

Work

i

0

T

F

Hours of leisure per month


Analysis of work incentives

In this example, someone can get $100 in TANF benefits if not working

Between point Q and point S, an implicit tax rate of 25% is imposed

Note that there are some incentives to work while still receiving benefits

D

|Slope| = w

Income per month (= earnings + transfers)

|Slope| = 3/4w

S

G

Hours after TANF

Hours before TANF

Q

$100

0

T

V

F

K

Hours of leisure per month


Analysis of work incentives

In this case, a 100% implicit tax rate is imposed after a benefit of $338 is received

D

Budget constraint with t = 100%

0 hours of work selected

P1

P

Income per month (= earnings + transfers)

S

R

G

$338

0

T

F

Hours of leisure per month


Analysis of work incentives

This person is indifferent between working and receiving benefits

D

E2

Income per month (= earnings + transfers)

R

P

G

Hours worked (if working)

0

T

M

Hours of leisure per month


Analysis of work incentives

This person prefers working to receiving benefits

D

E2

Income per month (= earnings + transfers)

R

P

G

Hours worked

0

T

M

Hours of leisure per month


Supplemental Security Income (SSI)

  • Federal program that provides benefits for the aged, blind, and disabled with little or no assets

  • In 2003, average benefit was $342

  • SSI recipients can earn up to $65 per month without loss in benefits

    • After $65 is earned, additional earnings have a 50% implicit tax rate


Medicaid affects incentives to work

Under old incentive structures, people often lost eligibility once they earned enough money to get off of welfare

This created a “Medicaid notch”

For main details about Medicaid, see Chapter 10

Medicaid


The Medicaid notch

M

Income per year

D

R

S

Z

N

$1,000

0

T

X

Hours of leisure per year


Solving the Medicaid notch problem

  • In recent years, families that earn enough to leave welfare can often stay on Medicaid

    • 12 month coverage after leaving TANF

    • Low-income children and pregnant women


Unemployment insurance (UI)

  • States provides insurance for unemployment due to adverse selection and moral hazard reasons

  • Benefits

    • Average weekly benefit in 2005: $266

    • Maximum length of benefits in most states: 26 weeks

  • Typically financed by a payroll tax on employers

  • Empirical studies find that increasing benefits increases the duration of unemployment


EITC

  • The earned income tax credit

    • A success story for the working poor

    • Provides credits to workers within low incomes

      • Essentially a negative income tax for some levels of income


EITC

  • How it worked in 2006 for a family with 2 or more kids

    • 40% credit for first $11,340 earned

    • No additional credit for next $5,470 earned

    • Phased out at a 21.06% rate after $16,810 is earned, until the credit is gone at $38,348 earned


The earned income tax credit


What has the EITC done?

  • Households with nobody working

    • Encourages one person to work

  • Households with one person working

    • Additional work not encouraged once a family with 2+ kids earns $11,340

      • Does not encourage additional hours of work of the person already working

      • Does not encourage a second worker in the household to work


Other ideas

  • Negative income tax

    • Supply a lump sum to everyone, then tax income more heavily

    • Problem: Incentive to work for pay diminishes

      • Some people will stop working and will pay no taxes

  • Minimum wage

    • Unemployment


What about public employment?

  • Public employment of the unemployed

  • To be successful…

    • Needs to have enough incentives for unemployed people to want to work

    • Needs to have incentives low enough for employed people to stay in their old job


Future of social insurance?

  • Academics are starting to study alternate ideas to help the poor

    • Providing benefits to those most in need, rather than those that are already “in the system”

    • “One-stop shopping” for help

    • Faith-based support

      • Government provides cash to the faith-based organization, and the organization provides the service


Overview


Summary: Welfare programs for the poor

  • Many programs exist to support poor people

  • Some programs give little economic incentive to work

    • Exception: Earned income tax credit


Recall Timothy

  • Timothy is currently working 1,500 hours per year

    • Hourly wage is $10

    • He also receives government health care, valued at $3,000 per year

  • Timothy could work a second job for 700 hours per year

    • Hourly wage is $8

    • With the second job, Timothy would make too much money for government health care


Now we add value to leisure

  • New problem

    • Tabitha has 24 hours per day

      • Each hour can be used only for labor (L) or leisure (l)

      • Tabitha’s wage is $10 per hour worked

      • She receives $5 in Medicaid benefits per day if she earns no more than $60

      • M denotes the daily earnings plus Medicaid benefits, if any

    • Tabitha has the following utility function

      • U(M, l) = 2(M½) + l


Tabitha’s problem

  • Two cases

    • No Medicaid benefits

    • Work 6 hours or less and receive Medicaid benefits


No Medicaid benefits

  • Maximize 2(M½) + l

    subject to (M/10) + l = 24

  • Same as Maximize 2(M½) + l

    subject to l = 24 – (M/10)

  • Same as Maximize 2(M½) + 24 – (M/10)

  • FOC set equal to 0: 1/M½ – 1/10 = 0

  • M = 100

    • 10 hours worked, 14 hours of leisure


What is Tabitha’s utility w/o Medicaid?

  • 10 hours worked, 14 hours of leisure

  • U(100, 14) = 2(100½) + 14 = 34


What about if she works less?

  • Notice that this problem is almost the same

  • Maximize 2(M½) + l

    subject to (M/10) + l = 24.5

    • The Medicaid benefit acts like 0.5 hour of work benefits

  • Using the same steps as previously, M = 100

    • We can’t work that much to get the benefit, so the closest we can get is by working 6 hours

      • Total M is 65 ($60 in wages, $5 in Medicaid benefits)


What is Tabitha’s utility with Medicaid?

  • 6 hours worked, 18 hours of leisure

  • U(65, 18) = 2(65½) + 18 = 34.12


What should Tabitha do?

  • If she works 10 hours (no Medicaid benefit)…

    • U(100, 14) = 2(100½) + 14 = 34

  • If she works 6 hours (with a Medicaid benefit)…

    • U(65, 18) = 2(65½) + 18 = 34.12

  • Tabitha should work 6 hours and accept the Medicaid benefit

$5


How do we solve poverty?


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