Gruber4e ch17

Public Finance and Public Policy Jonathan
CopyrightGruber
© 2010Fourth
WorthEdition
Publishers
Copyright © 2012 Worth Publishers 1 of 35
Income Distribution and Welfare Programs 17
17.1 Facts on Income Distribution in the United States
17.2 Welfare Policy in the United States
17.3 The Moral Hazard Costs of Welfare Policy
17.4 Reducing the Moral Hazard of Welfare
17.5 Welfare Reform
17.6 Conclusion
PREPARED BY
Dan Sacks
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers 2 of 35
CHAPTER 17 ■ INCOME DISTRIBUTION AND WELFARE PROGRAMS
17
Income Distribution and Welfare Programs
• Personal Responsibility and Work Opportunity

Reconciliation Act reformed welfare in 1996.
• Before, states received matching grants, gave time-
unlimited cash benefits to low-income single mothers.
• After, states received a lump-sum block grant, to
provide time-limited benefits to a broader range of
low-income families.
• This chapter explores the reasons for and results of
welfare reform.
17
Welfare Caseloads in the United States, 1960−2011
17.1
Facts on Income Distribution in the United States:
Relative Income Inequality
• Relative income inequality has increased in the United

States.
• Relative income inequality: The amount of income
the poor have relative to the rich.
Income share of: 1967 1980 1990 2000 2010

Lowest 20% 4 4.3 3.9 3.6 3.3
Second 20% 10.8 10.3 9.6 8.9 8.5
Third 20% 17.3 16.9 15.9 14.8 14.6
Fourth 20% 24.2 24.9 24 23 23.4
Highest 20% 43.8 43.7 46.6 49.8 50.2
Top 5% 17.5 15.8 18.6 22.1 21.3
17.1
Facts on Income Distribution in the United States:
Relative Income Inequality
17.1
Relative Income Inequality: Select OECD Countries
Income Quintile
Bottom Second Third Fourth Highest Top 10%
Sweden 10.7 14.4 17.6 21.5 35.7 10.9
Austria 8.4 12.4 16.8 22.3 40.1 13.6
France 9.4 12.9 16.3 21 40.4 15.2
UK 7.9 11.2 15 20.6 45.4 19.8
USA 3.3 8.5 14.6 23.4 50.2 21.3
Mexico 4.6 7.8 11.6 18.3 57.6 32.3
OECD
8.5 12.2 16 21.1 42.2 16.7
Average
17.1
Absolute Deprivation and Poverty Rates
• Inequality does not measure absolute deprivation.

o Absolute deprivation: The amount of income the
poor have relative to some measure of “minimally
acceptable” income.
• Measured by the share of people below poverty line.
o Poverty line: The federal government’s standard
for measuring absolute deprivation.
o Originally 3*(cost of minimally nutritionally
accepted diet).
17.1
Poverty Lines by Family Size (2012)
Size of Family Unit Poverty Line

1 $11,170
2 15,130
3 19,090
4 23,050
5 27,010
For each additional person, add 3,960
17.1
Poverty Rates over Time in the United States
17.1
APPLICATION: Problems in Poverty Line
Measurement
Three problems in determining where poverty begins:

1. Bundle has changed.
o Health care important, but only food price
mattered in initial poverty line.
2. Differences in cost of living.
o Rents differ enormously across areas.
3. Income definition is incomplete.
o Medicaid does not count toward poverty line.
17.1
APPLICATION: Problems in Poverty Line
Measurement
• In the early 1990s, a National Academy of Sciences

panel proposed changes to correct these problems.
• But there are practical difficulties:
o How to quantify the value of Medicaid in adjusting
income?
o Implementing these changes would lead to huge
redistribution from the South and Midwest to the
East and West.
17.1
What Matters—Relative or Absolute Deprivation?
• Why does it matter how much money the rich have?

o The “minimal” standard of living may be best
defined relative to the standard of living of others.
o Inequality itself may make people unhappy.
17.2
Welfare Policy in the United States
Welfare programs can be categorical or means-tested.

• Categorical welfare: Welfare programs restricted by
some demographic characteristic, such as single
motherhood or disability.
• Means-tested welfare: Welfare programs restricted
only by income and asset levels.
17.2
Welfare Policy in the United States
They can also be cash or in-kind.

• Cash welfare: Welfare programs that provide cash
benefits to recipients.
o Benefit guarantee: The benefit for people with no
other income. May be cut as income increases.
o Benefit reduction rate: The rate at which welfare
benefits fall per dollar of other income earned.
• In-kind welfare: Welfare programs that deliver goods,
such as medical care or housing, to recipients.
17.2
Cash Welfare Programs
Two prominent cash welfare programs:

• Temporary Assistance for Needy Families (TANF)
o Low-income families, one parent absent.
o Benefit guarantee and benefit reduction rate vary
across states.
• Supplemental Security Income.
o Serves aged, blind, and disabled.
17.2
Means-Tested In-Kind Welfare Programs
• Food Stamps
o Provides a debit card that can be used to buy food.
• Medicaid
o Largest categorical welfare program.
• Public Housing
o “Section 8 vouchers” subsidize housing.
• Other Nutritional Programs
o WIC; school lunch program…
17.3
Moral Hazard Effects of a Means-Tested Transfer
System
• Means-tested transfer systems cause moral hazard.

• Consider a simplified version of TANF, with benefits B:
𝐵 =𝐺−𝑡×𝑤×ℎ
• G is the guarantee, t the benefit reduction rate, w
wages and h hours worked.
• Setting G = $10,000 and t = 1, it would cost $218
billion to eliminate poverty, less than Social Security
spending.
• But this ignores behavioral responses.
17.3
Moral Hazard Effects of a Means-Tested Transfer
System
$ of consumption
per year
A
$25,000
Z Slope = wage = −12.50

20,000
Y
12,170 D
G = 11,170
B
5,000
X
C
0 400 1,027 1,106 1,600 2,000 Hours of leisure
per year
17.3
Solving Moral Hazard by Lowering the Benefit
Reduction Rate
$ of consumption
per year
$25,000
A Z1
22,500 B2
22,340 Slope = net wage = −6.25
Z2
Y2
Y1 X2
12,170 D
G = 11,170
B1
Slope = wage = −12.50

5,000
X1
C
0 200 268 1,027 1,106 1,600 2,000 Hours of leisure
per year
17.3
The “Iron Triangle” of Redistributive Programs
• Reducing the benefit rate ends up redistributing less.

• This illustrates the “Iron Triangle” of redistributive
programs.
• Iron triangle: 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.
17.4
Moving to Categorical Welfare Payments
• Moral hazard arises because the government wants to

redistribute to poor people, but people control their
income.
• If we could target benefits to earnings capacity, there
would be no moral hazard.
• People with disabilities, single mothers two targets.
• What Makes a Good Targeting Mechanism?
o No way to change behavior in order to qualify.
o Targets people with low earning capacity.
17.4
Targeting by Single Motherhood
17.4
Using “Ordeal Mechanisms”
• Ordeal mechanisms: Features of welfare programs

that make them unattractive, leading to the self-
selection of only the most needy recipients.
• The Paradox of Ordeal Mechanisms
o If the government provides a benefit that is not
attractive to the non-needy but helps out the truly
needy, then targeting will be more efficient.
o The paradox of ordeal mechanisms is therefore
that apparently making the less able worse off can
actually make them better off.
17.4
APPLICATION: An Example of Ordeal Mechanisms
• In setting up a soup kitchen to support the needy, the

government can:
o Hire many workers, keeping wait times down.
o Hire few workers, producing long lines.
• The long line might discourage high-earners from
using the soup kitchen.
• The ordeal mechanism works because the target
population has a relatively high value for the good
(soup) and a relatively low cost for the ordeal.
17.4
Increasing Outside Options
$ of consumption
per year
E
$35,000
Slope = wage = −17.50
A
25,000
Y2
17,500
Slope = wage = −12.50 Y1

12,170 B F D
G = 11,170
C
0 1,000 1,106 1,381 2,000 Hours of leisure
per year
1,027
17.4
Increasing Outside Options
• Training
o Modest declines in welfare use, earnings increases.
• Labor Market Subsidies
o Increase employment, reduces welfare use.
• Child care
o Increase’s mother’s employment.
• Child Support
o Shifts burdens to “deadbeat dads.”
17.4
Remove “Welfare Lock”
• For many low-income mothers, health insurance is

tied to non-work, through Medicaid.
• Unlinking cash and in-kind benefits increases the value
of working.
• Under current system, working more than a small
amount produces a large penalty from lost Medicaid
benefits.
17.4
Remove “Welfare Lock”
$ of consumption
per year
$25,000 A E Slope = net wage = −6.25

24,340
22,340 B
F
Health insurance =
G = 11,170 $2,000
D
Slope = net wage = −12.50 Cash =

$11,170
C
0 268 2,000 Hours of leisure
per year
17.4
EVIDENCE: The Canadian Self-Sufficiency Project
• Randomized evaluation of a work subsidy program.

• Offered large wage subsidies to a (random) group of
Canadians on welfare for more than one year.
• The subsidy increased employment by 43% in the
short-run, relative to control group.
• The rate of welfare enrollment fell by roughly the
same amount.
• After five years, the impact on employment welfare
use fell to zero.
17.5
Changes Due to Welfare Reform
1. Cash welfare was changed from an entitlement to a

block grant.
2. States were allowed, and encouraged, to experiment
with alternative structures of cash welfare payments.
3. Time limits were imposed on welfare recipients.
4. Work requirements were imposed on welfare
recipients.
5. New efforts to limit unwed motherhood were
introduced.
17.5
EVIDENCE: Estimating the Impact of Welfare
Reform
• PRWORA is difficult to evaluate, because it was

implemented all-at-once across the states.
• Different states faced different policy changes, but
each state pushed for its own policies, suggesting that
comparisons may be biased.
• Two prominent approaches:
o Compare outcomes of single mothers to others.
o Look at states that experimented with alternative
policies before national reform.
17.5
Effects of the 1996 Welfare Reform
Overall conclusion of evaluations:

• PRWORA led to a large financial windfall for the states.
• Single mothers as a group have not seen a drop in their
income or their consumption.
• There has been no noticeable effect of welfare reform
on fertility rates.
17.5
Was Welfare Reform a Success?
“Success” depends on whether:

• Increased costs for a small share of women exceed the
gains from reduced government welfare spending.
• Value of fallen leisure of single mothers.
• How well the new program fares in the recession, as
opposed to the boom in which it was passed.
• How it affects children in welfare-eligible families.
17.6
Conclusion
• Welfare programs have been a source of contentious

debate for many years, and the past decade has
witnessed the most radical reform of cash welfare
since the program’s inception.
• Despite the apparent success of the 1996 welfare
reform, welfare debates will no doubt continue in the
future.

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Public Finance and Public Policy Jonathan

• Personal Responsibility and Work Opportunity

• Relative income inequality has increased in the United

Income share of: 1967 1980 1990 2000 2010

• Inequality does not measure absolute deprivation.

Size of Family Unit Poverty Line

Three problems in determining where poverty begins:

• In the early 1990s, a National Academy of Sciences

• Why does it matter how much money the rich have?

Welfare programs can be categorical or means-tested.

They can also be cash or in-kind.

Two prominent cash welfare programs:

• Means-tested transfer systems cause moral hazard.

Z Slope = wage = −12.50

Slope = wage = −12.50

• Reducing the benefit rate ends up redistributing less.

• Moral hazard arises because the government wants to

• Ordeal mechanisms: Features of welfare programs

• In setting up a soup kitchen to support the needy, the

Slope = wage = −12.50 Y1

• For many low-income mothers, health insurance is

$25,000 A E Slope = net wage = −6.25

Slope = net wage = −12.50 Cash =

• Randomized evaluation of a work subsidy program.

1. Cash welfare was changed from an entitlement to a

• PRWORA is difficult to evaluate, because it was

Overall conclusion of evaluations:

“Success” depends on whether:

• Welfare programs have been a source of contentious

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