More on income distribution

1. More on income distribution Today: Family income distribution Should we redistribute income? Why? Some government programs

2. Reminder on Test 2 • Test 2 Wednesday • 65 minutes • Restrictions on calculators are the same as for Test 1

3. 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?

4. 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)

5. 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

6. 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?”

7. 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

8. 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”

9. 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

10. 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

11. Different views of fairness • Some people believe that utility, not income, should be maximized within a population • Additive social welfare functionW = U1 + U2 + … + Un

12. 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

13. 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

14. 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

15. Optimal amount of income inequality? • Impossible to answer • Different people have different opinions about effectiveness of realistic ways to redistribute income

16. 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

17. 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?

18. 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?

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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?

26. 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

27. Analysis of work incentives D |Slope| = w Income per month c Time Endowment b 2w w* a 0 T Hours of leisure per month

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. The Medicaid notch M Income per year D R S Z N $1,000 0 T X Hours of leisure per year

36. 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

37. 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

38. 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

39. 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

40. The earned income tax credit

41. 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

42. 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

43. 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

44. 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

45. Overview

46. 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

47. 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

48. 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

49. Tabitha’s problem • Two cases • No Medicaid benefits • Work 6 hours or less and receive Medicaid benefits

50. 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