U.S. Welfare System

1. U.S. Welfare System • Aid to Families with Dependent Children (AFDC) and Temporary Assistance to Needy Families (TANF) • Personal Responsibility and Work Opportunity Reconciliation Act (PRWORA) replaced AFDC in 1996 with TANF • Aimed to “end welfare as we know it” • Under AFDC, eligibility and benefit schedule determined by federal government; under TANF, determined by states • Under AFDC, federal government matched state AFDC spending dollar-for-dollar; under TANF, states receive federal block grants • Under AFDC, anyone could apply for AFDC and all eligible received AFDC; under TANF, states can deny eligible people • Recipients required to work after receiving TANF for 2 years • Recipients cannot receive TANF for more than 5 years over life

2. Michigan TANF • Family Independence Program (FIP) • The TANF program in Michigan is called the Family Independence Program (FIP) • The monthly welfare benefits an FIP recipient in Michigan receives is equal to: where countable income is • For example, consider a single mother of two in Ingham County who earns $500 a month from working, $100 a month in child support payments, and no other nonwelfare income. The $500 is considered earned income while the $100 is considered unearned income. Her countable income is 0.8($500 - $200) + $100 = 0.8($300) + $100 = $240 + $100 = $340. • The payment standard for a single mother of 2 in Ingham County is $489. Since her countable income is $340, her monthly TANF benefit is $489 - $300 = $189. Monthly benefit = Payment standard – Countable income Countable income = .8[Earned Income Over $200] + Unearned Income

3. Michigan TANF • Family Independence Program (FIP) • The monthly welfare benefits an FIP recipient in Michigan receives is equal to: where countable income is • Note that the above schedule implies that a welfare recipient’s countable income does not change at all for each $1 she earns from working up to $200 a month. This means that a welfare recipient does not lose any FIP benefits for each $1 she earns from working up to $200. In economic terms, this is equivalent to saying that the benefit reduction rate on earned income up to $200 is 0. • But also that the above schedule implies that a welfare recipient’s countable income increases by 80 cents for each $1 she earns from working beyond $200 a month. This means that a welfare recipient loses 80 cents of FIP benefits for each $1 she earns from working beyond $200. In economic terms, this is equivalent to saying that the benefit reduction rate on earned income over $200 is 0.8. Monthly benefit = Payment standard – Countable income Countable income = .8[Earned Income Over $200] + Unearned Income

4. The Budget Constraint with FIP Let’s consider the budget constraint for a single mother of 2 in Ingham County who can work as many or as few hours as she wishes at the federal minimum wage of $5.15 an hour and has no unearned nonwelfare income. She has T hours a month to divide between labor and leisure. In the absence of FIP, she faces a simple budget constraint with no non-labor income. Consumption equals zero if labor supply equals zero and leisure equals T, and the slope of the budget constraint equals the wage of $5.15. Michigan TANF c slope = 5.15 0 T l (L=0)

5. The Budget Constraint with FIP Now, let’s consider the effect of FIP on her budget constraint. If she does not work, her leisure equals T and her quantity of labor supplied equals 0. She also earns no wages and her earned income is zero. Since her earned income and unearned income are both zero, her monthly FIP benefit equals the payment standard of $489. Her total monthly income equals her earned income plus her unearned nonwelfare income plus her welfare income, or $0 + $0 + $489 = $489. This means she can buy $489 in goods and services, so her consumption is $489 a month. Michigan TANF c slope = 5.15 $489 0 T l (L=0)

6. The Budget Constraint with FIP Now suppose she decides to work for a few hours. What happens? Recall that the first $200 in earned income is not countable income. This means that she loses no FIP benefits for each $1 in income she earns in a month below $200. This also means that, as long as her earned income is under $200 for a month, she receives $5.15 in income and loses no FIP benefits for each extra hour she works. This also means that, as long as her earned income is under $200 a month, she “nets” $5.15 worth of goods and services for every extra hour of leisure she gives up. Michigan TANF c slope = 5.15 $489 0 T l (L=0)

7. The Budget Constraint with FIP This means that, as long as her earned income is under $200 a month, the slope of her budget constraint—the rate at which she can exchange extra leisure for extra consumption—is 5.15. At an hourly wage of $5.15 an hour, she would have to work 39 hours in a month to earn $200 in earned income. Therefore, as long as her quantity of labor supplied is between 0 and 39 hours and (consequently) her leisure is between T – 39 and T, the slope of her budget constraint is 5.15. This is illustrated at right. Michigan TANF c slope = 5.15 slope = 5.15 $489 0 T-39 T l (L=39) (L=0)

8. The Budget Constraint with FIP So now suppose she works for 39 hours a month. She earns 39 x $5.15 = $200 in earned income, $0 in unearned nonwelfare income, and $489 in FIP benefits. (Her welfare benefits are still $489 because they were not reduced by her earning income up to $200; if you still don’t understand, try plugging the appropriate numbers into the equations 5 slides back.) Her total monthly income is $200 + $0 + $489 = $689. This means she can buy $689 a month in goods and services, so her consumption in a typical month equals $689. This, too, is illustrated at right. Michigan TANF c slope = 5.15 slope = 5.15 $689 $489 0 T-39 T l (L=39) (L=0)

9. The Budget Constraint with FIP What happens if she decides to work more than 39 hours a month? Recall that 80% of earned income beyond $200 is countable income. This means that she loses 80 cents of FIP benefits for each $1 she earns from working above $200 until her FIP benefits run out entirely. This means that, as long as her earned income is above $200 and her FIP benefits have not run out entirely, she receives $5.15 in wages and loses $4.12 in FIP benefits for each extra hour she works. Michigan TANF c slope = 5.15 slope = 5.15 $689 $489 0 T-39 T l (L=39) (L=0)

10. The Budget Constraint with FIP This means that, as long as her earned income is greater than $200 and her FIP benefits have not run out entirely, she “nets” only $5.15 - $4.12 = $1.03 worth of extra goods and services for each hour of leisure she gives up. This means that, as long as her earned income is greater than $200 and her FIP benefits have not run out entirely, the slope of her budget constraint—the rate at which she can exchange extra leisure for extra consumption—is 1.03. Michigan TANF c slope = 5.15 slope = 1.03 slope = 5.15 $689 $489 0 T-39 T l (L=39) (L=0)

11. The Budget Constraint with FIP We already know that she earns $200 in earned income when she works 39 hours. This implies that she works more than 39 hours a month if her earned income is greater than $200 Her FIP benefits run out when her earned income equals $811. To earn $811 at $5.15 an hour, she would have to work 157 hours. This implies that she works less than 157 hours a month if her FIP benefits have not yet run out. Therefore, she must work 39 to 157 hours for her earned income to be below $200 and for her FIP benefits to have not yet run out Michigan TANF c slope = 5.15 slope = 1.03 slope = 5.15 $689 $489 0 T-39 T l (L=39) (L=0)

12. The Budget Constraint with FIP This means that, as long as her quantity of labor supplied is between 39 and 157 hours and her leisure time is between T – 157 and T – 39, the slope of her budget constraint—the rate at which she can exchange extra leisure for extra consumption—is 1.03. When she works 157 hours, she earns $811 in earned income, $0 in unearned income, and $0 in FIP benefits, so her monthly income is $811. This means she can buy $811 worth of goods and services in a typical month, so her typical monthly consumption is $811. All the above is illustrated at right Michigan TANF c slope = 5.15 slope = 1.03 $811 slope = 5.15 $689 $489 0 T-157 T-39 T l (L=157) (L=39) (L=0)

13. Implications of FIP Note that FIP has caused our welfare recipient’s budget constraint to shift up and to the left This means that consumption-leisure combinations that offer more consumption and leisure have become available to her Since people like a balanced mix of consumption and leisure, this means that she is likely to increase her consumption and leisure both Increasing her leisure requires reducing her quantity of labor supplied FIP has a negative income effect on quantity of labor supplied Michigan TANF c slope = 5.15 slope = 1.03 $811 slope = 5.15 $689 $489 0 T-157 T-39 T l (L=157) (L=39) (L=0)

14. Implications of FIP Note that FIP hasnot changed the slope of the budget constraint of our welfare recipient if she works between 0 and 39 hours a month This means that FIP has not changed the rate at which extra consumption can be exchanged for extra leisure This means that FIP has not created any incentive to substitute leisure for consumption or vice versa FIP has no substitution effect on the quantity of labor supplied of welfare recipients who work between 0 and 39 hours a week Michigan TANF c slope = 5.15 slope = 1.03 $811 slope = 5.15 $689 $489 0 T-157 T-39 T l (L=157) (L=39) (L=0)

15. Implications of FIP Note that FIP has reduced the slope of the budget constraint of our welfare recipient if she works between 39 and 157 hours a month This means that FIP has reduced the amount of extra consumption she would have to give up to enjoy an extra hour of leisure This means that FIP has created an incentive to her to increase her leisure, which requires reducing her quantity of labor supplied FIP has negative substitution effect on quantity of labor supplied of welfare recipients who work between 39 and 157 hours a week Michigan TANF c slope = 5.15 slope = 1.03 $811 slope = 5.15 $689 $489 0 T-157 T-39 T l (L=157) (L=39) (L=0)

16. Implications of FIP Note that FIP had a negative income effect on the quantity of labor supplied of our welfare recipient regardless of how many hours she worked But also note that FIP had a negative substitution effect on the quantity of labor supplied of our welfare recipient only when she worked a comparatively great number of hours per month This implies that FIP has the most negative effect on the quantity of labor supplied of FIP recipients who are working, earning income, and on the verge of leaving FIP. Michigan TANF c slope = 5.15 slope = 1.03 $811 slope = 5.15 $689 $489 0 T-157 T-39 T l (L=157) (L=39) (L=0)

17. Michigan TANF • Welfare to Work Requirements • Most welfare recipients required to participate in employment related activities including employment, schooling, and/or training • Schooling option only available to teenagers finishing high school • Single parents must participate 30 hours/week, 20 hours/week if child is under age 6 • Parents in two-parent families must participate 55 hours/week total • Exemptions from requirement: age under 16 or over 65; mothers with children under age 3 mos.; mothers in absence of child care; disability; temporary incapacity; caregiver for disabled; domestic violence; local office discretion • Noncompliance with welfare to work requirements carries penalty of reduction of benefits, closure of case

18. Cut the benefit reduction rate What can be done to reduce the work disincentives of welfare? One possibility would be to reduce the benefit reduction rate (brr), or the amount by which welfare benefits are reduced for each dollar a welfare recipient earns. This will increase what recipients “net” from an hour of work. For example, suppose a recipient can earn $5.15 in wages for each hour worked. If the brr is 0.8, she loses $4.12 in benefits and “nets” $1.03 for each hour worked. In contrast, if the brr is 0.6, she loses $3.09 in benefits and “nets” $2.06 for each hour worked. Options for Reform c Tw slope = w slope = w(1 – brr) g T l

19. Cut the benefit reduction rate If reducing the brr increases what welfare recipients “net” from an hour of work, it also increases the slope of their budget constraints, or the rate at which they can trade leisure for extra consumption. But also note that, with welfare benefits reduced by less as nonwelfare income increases, people with higher incomes and higher quantities of labor supplied become eligible for welfare Higher break-even point results More people receiving welfare benefits means more people losing welfare benefits as a consequence of working and earning income Options for Reform c Tw slope = w slope = w(1 – brr) break- even point g T l

20. Cut the benefit reduction rate When the brr is reduced, the slope of the budget constraint becomes steeper for people who had already been on welfare before the brr reduction. These are the people whose optimum consumption and leisure were below and to the right of the old break even point—i.e., people within the dotted lines at right. This means that, for people who had already been on welfare, a reduction in the brr increases the amount of extra consumption gained from working and giving up an extra hour of leisure Options for Reform c Tw slope = w slope = w(1 – brr) g T l c, l of those on welfare before brr reduction

21. Cut the benefit reduction rate This means that, for people had already been on welfare, a reduction in the brr creates an incentive to give up more leisure and work more hours Therefore, a reduction in the brr has a positive substitution effect on the quantity of labor supplied of people who had already been on welfare beforehand. Options for Reform c Tw slope = w slope = w(1 – brr) g T l c, l of those on welfare before brr reduction

22. Cut the benefit reduction rate The story is different for people who were not on welfare before the brr reduction but are brought into the welfare system as a result of the brr reduction. These are the people whose optimal consumption and leisure before the brr reduction was above and to the left of the old break-even point but whose optimal consumption and leisure after the brr reduction is below and to the right of the old break-even point—i.e., people within the dotted lines at right Options for Reform c Tw slope = w slope = w(1 – brr) g T l c, l of those not on welfare before brr reduction, on welfare after

23. Cut the benefit reduction rate Before the brr reduction, these people received no welfare benefits and did not lose welfare benefits when they worked more hours and earned more income. After the brr reduction, these people do receive welfare benefits and lose benefits when they work more hours and earn more income. Since they now lose welfare benefits as a result of working more hours, the income they “net” from working an hour decreases This means that the amount of extra consumption they must give up to enjoy an extra hour of leisure decreases Options for Reform c Tw slope = w slope = w(1 – brr) g T l c, l of those not on welfare before brr reduction, on welfare after

24. Cut the benefit reduction rate This creates an incentive to these people to increase the amount of leisure they enjoy, which requires reducing the number of hours they work Therefore, a reduction in the brr has a negative substitution effect on the quantity of labor supplied of people newly brought into the welfare system as a result of the brr reduction. So now we know that the effect of a reduction in the brr is on groups of workers. What is the effect of a reduction in the brr on the quantity of labor supplied of all workers in total? Options for Reform c Tw slope = w slope = w(1 – brr) g T l c, l of those not on welfare before brr reduction, on welfare after

25. Cut the benefit reduction rate It has a positive substitution effect on the quantity of labor supplied of people who were already on welfare before the brr reduction It has a negative substitution effect on the quantity of labor supplied of people who were not on welfare before the brr reduction who were brought into the welfare system by the brr reduction It has a negative income effect on the quantity of labor supplied of all because it shifts the budget constraint up and to the right Total effect of a reduction in the brr on quantity of labor supplied of all workers adds up to about 0 Options for Reform c Tw slope = w slope = w(1 – brr) g T l

26. Cut the benefit reduction rate So merely cutting the benefit reduction rate does not reduce work disincentives or increase the quantity of labor supplied. It reduces work disincentives for people who had already been in the welfare system, but it creates work disincentives for a whole new group of people it brings into the welfare system. So what if we cut the benefit reduction rate, but kept the break-even point the same to avoid bringing new people into the welfare system? Options for Reform c Tw slope = w slope = w(1 – brr) g T l

27. Cut the benefit reduction rate, but keep old break-even point In order to reduce the benefit reduction rate but maintain the old break-even point, the guarantee must be reduced, as at right. Because the brr has been reduced, welfare recipients lose fewer benefits as they work more and earn more income. But, because the guarantee has also been reduced, a reduction in the rate at which benefits are reduced as income increases does not draw higher-income people into the welfare system because there are fewer benefits to be reduced in the first place. Options for Reform c Tw slope = w slope = w(1 – brr) g g T l

28. Cut the benefit reduction rate, but keep old break-even point With nobody new brought into the welfare system, we can exclusively concentrate on the effect of the reduction in the brr on people who were already on welfare before. The reduction in the brr increases the amount of income welfare recipients “net” from working an hour. This increases the steepness of the welfare recipients’ budget constraints, or the amount of extra consumption welfare recipients receive in exchange for giving up an extra hour of leisure and working an extra hour. Options for Reform c Tw slope = w slope = w(1 – brr) g g T l

29. Cut the benefit reduction rate, but keep old break-even point This creates an incentive to welfare recipients to give up more hours of leisure and work more Therefore, cutting the benefit reduction rate and the guarantee together has a positive substitution effect on the quantity of labor supplied. Also note that the budget constraint is shifted inward by the brr and guarantee reductions This means that cutting the benefit reduction rate and the guarantee together also has a positive income effect on the quantity of labor supplied. Options for Reform c Tw slope = w slope = w(1 – brr) g g T l

30. Cut the benefit reduction rate, but keep old break-even point Therefore, cutting the guarantee and brr together unambiguously reduces work disincentives and increases the quantity of labor supplied of welfare recipients. So why don’t we cut both the guarantee and the brr down to 0 and eliminate welfare entirely? It must be because we care about more than work disincentives and the quantity of labor supplied In particular, welfare programs reduce poverty, and reducing the generosity of welfare programs by reducing the guarantee will increase poverty Options for Reform c Tw slope = w slope = w(1 – brr) g g T l

31. Welfare policy So welfare policy is ultimately a trade-off between tolerating work disincentives and tolerating poverty The advantage of reducing the generosity of welfare programs is reduced work disincentives; the disadvantage is increased poverty The advantage of increasing the generosity of welfare programs is reduced poverty; the disadvantage is increased work disincentives Ultimately, when formulating welfare policy, we need to decide which is more important, and how much more of one we are willing to trade off for the other Options for Reform c Tw slope = w slope = w(1 – brr) g g T l