Public Finance ( MPA405 )

1. Public Finance (MPA405) Dr. Khurrum S. Mughal

2. Lecture 16: Government Subsidies and Income Support for the Poor Public Finance

3. Economic Analysis of the Effects of Government Transfers • Effect on Resource allocation • Consumer may consume where MSB is less that MSC • Loss of willingness to work if after work income is less • Analysis highlights the equity-efficiency trade-off

4. Price Distorting Subsidies • Price Distorting Subsidies lower the price of the particular good relative to others for eligible people.

5. Price Distorting Subsidies • Example of Housing subsidy • Hiring apartment at below the market rent • Govt pays the difference • Subsidized Mortgage loans

6. A Price Distorting Subsidy L I E3 N3 E1 N1 E2 Expenditure on Other Goods per Month (Dollars) N2 U3 U1 U2 Subsidy S H1 H2 H3 A L' 0 B Housing Services per Month

7. Price Distorting Subsidies • Implications: • Induces to purchase a larger amount of housing that he/she would normally do • Higher level of utility in presence of cash grant equal to the subsidy • Spending on other goods can also be increased • Dead weight loss • Difference between E2 and E3

8. Price Distorting Subsidies and Market Effects • Example of Housing Market • Operates on constant cost • Long run supply curve is perfectly elastic • Government agrees to pay half the rent

9. Excess Burden of a Subsidy: Market Effects Excess Burden of Subsidy S = MSC S’ D = MSB B E A 400 Rent (Dollars per Month) C F E’ 200 0 Q1 Q2 Number of Apartments Rented

10. Dead Weight Loss or Excess Burden • Dead Weight Loss (sometimes called Excess Burden ) is the measure of the dollar value of the distortion that exceeds the amount transferred to the recipient.

11. Implications • Induces low-income people to increase their consumption – increased demand • More resources are allocated for building more houses • But value exceeds the benefits • Important to compare costs to tax payers and the benefits accruing to low income tenants

12. Implications • Cost of Subsidy to tax payers • $200 multiplied by increase in apartments rented after subsidy Area BAE`C

13. Excess Burden of a Subsidy: Market Effects Excess Burden of Subsidy S = MSC S’ D = MSB B E A 400 Rent (Dollars per Month) C F E’ 200 0 Q1 Q2 Number of Apartments Rented

14. Implications • Benefits to Low Income Tenants • Those who would rent one bedroom apartment even without the subsidy. • $200 multiplied by Q1 (Area BEFC) • Those who would rent after the subsidy. Net benefit would be the difference between MB they assign to housing and $200 (Area EE`F)

15. Excess Burden of a Subsidy: Market Effects Excess Burden of Subsidy S = MSC S’ D = MSB B E A 400 Rent (Dollars per Month) C F E’ 200 0 Q1 Q2 Number of Apartments Rented

16. Implications • Total Benefit: Area BEFC + EE`F • Total Cost: Area BAE`C • So the cost is greater than the benefit and there is excess burden

17. Price Distorting Subsidies that Lowers the Price to Zero • Medicaid – Largest program of assistance to Poor in USA • Reduced the cost of medical services to “zero” • Assuming annual quantity of medical care consumed can be measured by number of hospital visits • Supplied by perfectly competitive industry • MSC doesn’t increase when more is made available

18. Full Subsidization of Medical Services B E1 A 25 = P* Price (Dollars per Month) Excess Burden MBL E2 Q* QG 0 Medical Office Visits per Year

19. Implications • Increase in Consumer Surplus • Part of increase is already what would have been acquired anyway • Excess burden is the due to subsidy in kind • Medicaid recipients would be better off with cash subsidy

20. Additional Effects of Subsidies: The Case of Increasing Costs • Medicaid not only costs taxpayers money to pay for the program, it also increases the amount they pay for medical services by increasing demand for those services.

21. The Impact of The Medicaid Program on Price: The Case of Increasing Cost S = MSC D' M DM = MSB DO DL Q' O E2 140 Price (Dollars) E1 100 QL QO QI QG Q2 0 Medical Office Visits per Year

22. Implications • Increase in Prices of Medical Services • Tax payers finance the program • Tax payers face the higher medical service prices for themselves • Overall decrease in real incomes of tax payers • Losses in efficiency as well as changes in income distribution

23. Subsidizing Housing • Providing an Apartment: This subsidy allocates a standard apartment to an eligible recipient. With this type of subsidy the recipient cannot supplement the subsidy with their cash. It is a “take it or leave it” option. • Housing Vouchers: This subsidy allows the recipient a particular allotment of vouchers to rent housing but the recipient may supplement the subsidy with their cash. • Cash: This subsidy is not restricted to spending on housing.

24. Public Housing • Government constructed low cost housing for low income families • Rented at well below market rates • Public Housing are expected to increase recipient's housing consumption • Might reduce housing consumption due to lack of freedom of choice • Suppose Government offers housing at $30 per room where the rent for 3 bedroom apartment is 90 $ • The same goes for rent in the market for $300

25. Eligibility for Public Housing and the Effect on Housing Consumption I' 800 = I 210 90 G M 210 E2 Expenditure on Other Goods per Month (Dollars) H J 400= F E1 U3 U1 U2 A B 0 1 2 3 4 5 6 7 Housing per Month (Number of Rooms Rented)

26. Refusing a Public-Housing Subsidy I G M E1 J U2 U3 Expenditure on Other Goods per Month (Dollars) 0 1 2 3 4 5 6 7 A Housing per Month (Number of Rooms Rented)

27. Subsidizing Food • Food Stamps are the subsidy that allows the recipient a particular allotment of vouchers to buy food but the recipient may supplement the subsidy with their cash. It is illegal to sell the food stamps though it may be in the recipients interests for them to do so.

28. The Impact of an In-Kind Transfer: Food Stamps E1 C C E2 E1 E1 Q* 1 A B B B F L I I U3 Expenditure on Other Goods per Month (Dollars) M1 U2 M2 U1 M1 U2 U1 QF 0 QF QF1 QF2 A A' 0 QF2 QF1 A A' Food per Month

29. The Impact of Government Assistance Programs on Work • Transfers could cause people to work more or less depending on whether leisure is a normal good.

30. International Food Subsidies • Several nations use a price-reducing subsidy to make food more affordable. • Programs that reduce the price of food benefit higher-income people as well. • Some nations only subsidize food that is typically consumed by the poor. • Some nations distribute food directly.

31. The Income Effect of a Transfer U3 U2 G U1 E2 E1 D Transfer Payment F C E3 A Income per Day 0 L1 L2 24 Leisure Hours per Day

32. A Transfer that Declines with Earned Incomee.g. T=$300-.7IE A C E2 U2 E1 D U1 Maximum Daily Transfer B Income per Day L* L1 L2 24 Leisure Hours per Day

33. Empirical Evidence • A 10% increase in welfare payments to individuals decreases work effort by 2%.

34. A Negative Income Tax • A Negative Income Tax is a system where there is no status test but there is an income guarantee and a take-back rate. • T = IG– tNIE Where • IG= Income guarantee • tN= take back rate • IE= earned income • T = Transfer

35. Break-Even Income 0 = IG– tNIB IB= IG/tN

36. Negative Income Tax

37. Wage Rate Subsidies • Wage Rate Subsidies are government additions to wages designed to increase the pay of the working poor.

38. Wage Rate Subsidies