chap19 - government redistribution programs.pdf

CHAPTER 19 Government Redistribution Programs 354

CHAPTER 19 Government Redistribution Programs

Chapter 18 Illustrated that there are a number motivations for government redistribution programs but that often the programs once established, fail to achieve their, stated goals. This might be because of the political decision-making process involved in designing the programs. Sometimes, special interests can distort the design of a program so it hat it provide little benefit to the stated beneficiaries. Other times, programs may fail to achieve their goals because their designers do not, fully understand the incentives involved, so they do not see how people will actually be affected by the programs they design. This chapter will use economic analysis to examine the design of government redistribution programs to see what effects they can be, expected to have. The analysis begins by looking at some simple questions. Should redistribution be offered to recipients in cash or in kind? In-kind redistribution offers recipients: goods and services, such as food, shelter, and health care, whereas cash redistribution offers money so that recipients can decide for themselves how to best allocate their incomes. If redistribution is offered in cash, how should eligibility be determined, and what is the best way to get the cash to recipients? If income is offered in kind, how should it be distributed to recipients? Should they be given food or be, given food stamps with which to buy food? Should they be given government housing or be given rent vouchers so they can rent their, own housing? Chapter 18 looked at the broader, questions of why one would want to have redistribution programs and what their general effects might be. This chapter looks more closely, at the details to see how redistribution programs work. CASH VERSUS PAYMENT IN KIND Redistributive activities tend to be financed from taxation, but the redistribution itself can be paid either in cash or in kind. Both types of redistributive methods are used in programs in the United States. Unemployment compensation and Aid to Families with Dependent Children (AFDC) are examples of programs that distribute cash to recipients. The redistribution increases the income of the recipients who can then spend the cash as they see fit. Other programs, such as food stamps, housing vouchers, and Medicaid, are designed specifically to provide in-kind benefits in the form of food, housing, and medical care. The object of in-kind programs is to help the recipient receive a certain specific benefit instead of general income. Cash Payments and Utility Maximization If increasing the utility of the recipient is the only criterion by which the type of benefit to be paid is determined, a cash payment will always be at least as good as, and possibly better than, the in-kind transfer. One reason is that from an administrative standpoint, it is much cheaper to distribute cash than in-kind benefits. But more significantly when considering the well-being of the recipients, they know their utility functions better than anyone else and therefore are in the best position to decide how the transfer should be spent to increase their utility. If food is what will enhance the recipient's utility the most, then the recipient can buy it, but if something else


will provide more utility, then the recipient will purchase whatever provides the greatest utility for the money. This idea can be explored in a more analytical framework within the context of figure 19.1. The vertical axis measures the quantity of the good paid in kind, and the horizontal axis measures all other goods. The solid line through point A is the budget constraint with no government payment, and the utility-maximizing individual would locate at point A with K1 of the good on the vertical axis and G1 of all other goods consumed. Now consider a government program that provides a payment in kind of Ks of the good on the vertical axis. If the recipient were to consume the amount paid in kind in addition to the amount of the good that would have been bought without the subsidy, the individual would consume K2 of the good. But the individual is more likely to apply some of the income formerly used to purchase K for other goods now that some of good K is being given to the individual as an in-kind transfer.

Figure 19.1 is drawn under the assumption that the payment in kind provides the individual with more of the subsidized good than the individual would have consumed without the subsidy. If the payment in kind is less than the individual would have spent on the good without the subsidy, then the in-kind payment can be used as a substitute for cash by the recipient. For example, assume that an individual normally spends $100 per month on food and is given $75 per month in food stamps. The individual could easily spend the $75 in food stamps and $25 in cash to buy the same food as before and have $75 left over to buy other things (including, perhaps, more food). The point is that if the subsidy is less than the individual would have spent anyway, the individual can use the in-kind subsidy just like a cash payment. As figure 19.1 is drawn, however, the subsidy is for more than the individual otherwise would have spent and allows the individual to consume Ks, which is the in kind transfer, on good K and use all other income to buy other goods, which locates the individual at point B. The


individual is better off at point B than at A because the individual is on a higher indifference curve. However, the individual could be better off still if it would be possible to transfer some of the in-kind subsidy into cash to buy less of the subsidized good and more of all other goods. If the subsidy was instead given in cash, the individual’s new budget constraint would pass through point B, parallel to the original budget constraint. With this new budget constraint giving cash instead of the in-kind payment, the individual then could move to point C, which is on a higher indifference curve than B. At this point, the individual would consume K3 of good K and G3 of all other goods. The cash transfer would place the individual on a higher indifference curve and make the individual better off than with the payment in kind. With a cash transfer, the individual could take the entire amount and spend it on good K, in which case the individual would be indifferent between the cash transfer and the in-kind transfer. The in-kind transfer would never give the individual more utility than an equal-sized cash transfer and could give the individual less utility. Thus, an income transfer could never make the individual worse off than a payment in kind and could make the individual better off, using the individual’s own utility function as a measure of the individual’s well-being. The Rationale for In-Kind Payments If income transfers are at least as good as, and sometimes better than, in-kind benefits for recipients, how can in-kind transfers ever be justified? To answer this question, recall the argument that charity has some of the characteristics of a collective consumption good. In the context of in-kind payments, this means that the goal of the redistributive program is to increase the well-being not only of the recipient but also of the taxpayer, who benefits by knowing that the recipient is better off with the redistributive program. The taxpayer may only care about the utility of the recipient, in which case the payment of cash will be the best way to redistribute income. However, many taxpayers are willing to help the less fortunate buy food, shelter, and medical care, but they do not want to contribute toward their buying cigarettes or playing video games. Therefore, rather than give money that can be spent on activities the donors feel are undesirable, the payment is made in kind. The food stamps can be used to buy food, as the donors have intended, but not clothes or radios. Payments in kind can only be justified by considering the utility of the taxpayer as well as the utility of the recipient. If only the recipient’s utility is considered, a cash payment will always be at least as good as, and maybe better than, a payment in kind. The argument for payment in kind does lose some of its force when the fungibility of money is considered. Recall the earlier example showing how, if the in-kind transfer is less than the individual would have bought anyway (less in food stamps given the recipient than the recipient would have paid for food without the stamps), then the in-kind transfer will be equivalent to cash for the recipient. However, because in-kind transfers have higher overhead costs, less will be transferred for the same cost. Thus, even when donors would prefer to make in-kind transfers to make sure the transfer is used in a certain way, it still might not be used as the donors wish. Another aspect of in-kind transfers is that they are paternalistic. Essentially, the recipients are told that their government wants to make them better off but does not trust their judgment on how they might spend their income. Therefore, the government will make that decision for them. Government policy seems to imply that if people are poor, they are also not smart enough to make their own choices. And by making choices for them, the government increases their


dependency on the system by limiting their ability to make decisions that determine how they will live their lives. There seems to be some inconsistency to insist on the one hand that the government make people’s choices for them and on the other to push them to become more independent of the welfare system. THE NEGATIVE INCOME TAX One redistribution program that has been considered from time to time is a negative income tax. The negative income tax is worth considering on its own merits as a policy option to simplify the transfer system. It is also worth studying from an academic standpoint because it is a very simple income transfer program that shares some characteristics with more complex redistribution programs. Thus, by understanding the negative income tax, we can better understand some of the characteristics of all re-distribution programs. A negative income tax works in the following way: If a person’s income falls below a certain level, then the government pays the person an income supplement. The lower the person’s income, the larger the supplement. Thus, the payment is largest if the person’s income is zero and decreases as income rises. The operation of a negative income tax is illustrated in figure 19.2, where I* is the level of income below which the negative income tax is paid and 10 is the amount the individual receives if the individual has no other income. For example, the negative income tax might pay a person with no income $5,000 per year and reduce the payment by 50 cents for each additional dollar of earned income. Thus, for a person earning $2,000, the payment is $5,000!.5($2,000) = $4,000. With this example, I0 is $10,000Cthe level at which the negative income tax payments would endCand 10 is equal to $5,000. The budget constraint without the negative income tax is the line starting at 24 Hours and extending to IN. With the negative income tax, the budget constraint becomes INAB.


The negative income tax can be analyzed with the same principles used to analyze the personal income tax. In this case, there is an income effect because the low-income individual has a higher income when receiving the payment. With the higher total income, the individual in the diagram not only increases his monetary income from I1 to I2, moving from point C to point D, but also consumes more leisure, which increases from L1 to L2' Some of the extra income increases the income the person has to spend, but some of it is used to buy more leisure time. The income subsidy is shown by the bracketed amount T in the figure. Note that the increase in income from I1 to I2 is less than the amount of the subsidy because of an increase in leisure. This substitution into leisure occurs because the relative price of leisure in terms of income has gone down. Because the recipient must give up 50 cents in benefits for every extra dollar of income earned, there is a substantial tax on the earning of income, which induces the substitution into leisure. The Incentive to Substitute into Leisure The income effect in the negative income tax makes the recipient better off, but the substitution effect always creates the incentive to substitute leisure for income-earning activity. By reducing the subsidy by 50 cents for every dollar of income earned, the recipient is placed in a 50 percent tax bracket. The disincentive effects from losing income the income transfer are no different from the disincentive effects of a tax on earned income. Because welfare programs are targeted to the needy, this substitution effect is inevitable in any program in which the transfer will be removed if the person is no longer needy. Indeed, it is possible that the substitution of leisure for income might be great enough to actually reduce the total money income of the recipient. This case is illustrated in figure 19.3, in which the recipient substitutes so much leisure for income-earning activity that total income drops from I1, to I2. The recipient is better off with the transfer program because the negative income tax places the recipient on a higher indifference curve, but the dollar amount of income of the recipient, including the payment from the government, is lower than it would be without the redistribution program. Programs that transfer income do not necessarily result in higher income for the recipients, as figure 19.3 shows. Redistribution and the Income of the Poor This type of analysis illustrates a general principle about redistributive activity. Redistributive programs increase the well-being of the recipients, but they may not appear to do so if only simple dollar figures are examined. The reason is that to qualify for the programs, it is necessary to be poor (or unemployed, or in some other way disadvantaged), which provides an incentive for people to substitute out of income-earning activities. In the case of the negative income tax, figures 19.2 and 19.3 clearly illustrate this phenomenon. In figure 19.2, the person receives a payment of T, but the person’s total income rises by less than that amount. Thus, for example, if the person were receiving $100 a month from the government, it would be incorrect to conclude that without the payment the person’s income would be $100 less. Although this may be true in some specific cases, in general the elimination of the $100 government payment would reduce the person’s income by less than $100 because the person would have an increased incentive to earn other income. As figure 19.3 illustrates, the substitution effect can be strong enough that the person’s money income may actually fall as a result of the government's redistribution


program. If the program were eliminated, the person would have an increased incentive to work and would earn more income than before in that example.

Although this discussion has focused on the negative income tax, the same principles apply to any redistribution program that reduces the benefits paid as the person earns more income. Redistributive programs can make the recipients better offCplacing them on higher indifference curvesCeven though the recipients’ measured incomes, including transfers, are lower than if the transfers were not made. But because there is an incentive to substitute out of income-earning activities, it is misleading to look at a recipient’s well-being in simple dollar terms because the income distribution may not change, or may become even more skewed, due to the redistributive programs. Chapter 18 noted that since the growth of widespread federal antipoverty programs in the 1960s, the poverty rate has remained unchanged, even though before those programs were established it was steadily declining. The incentives of the programs have a lot to do with that result. Clearly, redistributive programs do not simply add the amount of redistributed income to the income that the recipients would have had without the programs. The Excess Burden of a Negative Income Tax The substitution effect embodied in a negative income tax creates an excess burden in just the same way as with any tax on income. The excess burden of a negative income tax can be illustrated in figure 19.4, which is similar to the previous two figures. As before, the budget constraint with the negative income tax is INAB, and the utility-maximizing recipient locates at point X. If the same amount of income were transferred to the individual as a lump sum transfer (with no excess burden) rather than through the negative income tax, the budget line would pass through point X but would be parallel to the budget line IN24 Hours. Thus, with the lump sum transfer, the individual’s budget line is CD. The utility-maximizing individual locates at point Y


on CD, giving the individual more utility and more total income with the lump sum transfer than with the negative income tax.

The difference in utility at point X versus point Y is the excess burden of the negative income tax. To get the subsidy, the individual has an incentive to earn less income, which gives the recipient the incentive to substitute leisure for work. Note that at point Y, with the lump sum transfer, the individual earns more income and takes less leisure than at point X, with the negative income tax that makes the same dollar transfer to the recipient. This excess burden is easy to see with a negative income tax, but the same principle applies to any transfer program that reduces benefits to individuals who are less needy. Payments to individuals based on need have the unfortunate side-effect that they give people an incentive to meet the criteria of the programs to receive the to payments. The negative income tax makes an interesting case for study because it is conceptually simple yet illustrates many principles that hold true for redistribution in general. Despite the drawbacks noted here, the negative income tax has the virtues that it would be relatively simple to administer, that it could take the place of many other programs so it could cut the total number of transfer programs, and that it would provide a cash transfer which, as discussed earlier, provides the greatest utility gain for the money to the recipients. The remainder of the chapter will discuss characteristics of several other redistributive programs to illustrate how they might affect the allocation of resources. The primary transfer programs designed to aid those with low incomes are Aid to Families with Dependent Children (AFDC), food stamps, Medicaid, and public housing programs. Medicaid will be discussed in chapter 21 on health care. This chapter will consider the other three programs.


AID TO FAMILIES WITH DEPENDENT CHILDREN The AFDC program provides a cash income transfer to families with children under eighteen years old. The program was established in 1935, along with the Social Security program, but remained relatively small until the 1960s when benefits increased substantially and the number of AFDC families increased along with the increased benefits.1 The real benefit level peaked around 1970, and, about 1975, the increase in AFDC recipients stabilized. Despite the fact that real benefit levels have declined by about 25 percent since 1970, there has been no substantial decline in the percentage of the population receiving AFDC. AFDC expenditures in 1990 were $21.2 billion and provided assistance to 11.4 million recipients. Approximately one out of every twenty-two Americans receives AFDC payments. The average monthly benefit in 1990 was $392. The AFDC program is run jointly by the state and federal governments. Both share in funding the program, and both share in the responsibility for determining the rules and benefits. The maximum state share of AFDC payments is 50 percent, and the state share declines as income goes down. States with per capita incomes at the national average pay 45 percent of the total cost, with the federal government picking up the other 55 percent. The program is means-tested, so families must have low incomes, low levels of financial assets, and dependent children to qualify. The qualification levels are set by individual states. In about half the states, families headed by married couples can qualify for AFDC, but the primary income earner in the household must be unemployed. Less than 10 percent of AFDC families have a married head of household. The overwhelming majority of AFDC families are headed by a single woman. Benefit levels are also set by the states, with the result that there are large differences among states. In 1989, the maximum benefit for a family of four in California was $788, while a family of the same size in Mississippi received only $144. As the earned income of recipient families rises, the benefits are reduced according to a schedule set by the federal government. Although the reduction in benefits could be designed to work like a negative income tax, in practice it has been so steep that any labor income earned by recipients would be offset by a reduction in AFDC payments. The incentives created by the AFDC program work against giving recipients the ability to escape poverty. Not only do recipients have to have low incomes, but also they have to have low wealth, providing the incentive to consume wealth to qualify and taking away the incentive to save and accumulate wealth while on the program. Furthermore, the program gives single parents an incentive to remain single to continue qualifying for the program. A single woman receiving AFDC and contemplating marriage to a working man would incur a substantial financial penalty through the loss of AFDC benefits, providing the incentive for her to remain unmarried. Another factor in the decision to remain on AFDC is that the federal government mandates that anyone receiving AFDC payments is also eligible for government-financed health care through Medicaid. Thus, if one tries to escape AFDC by taking a job that does not provide medical coverage, the recipient would lose medical benefits in addition to the AFDC income. This is one of the arguments in favor of providing federally guaranteed universal health care coverage. With universal coverage, the AFDC recipient would not lose medical benefits by taking a job.


Figure 19.5 depicts the choice that confronts someone on AFDC who is contemplating getting a job. Receiving AFDC, the person is at point A, devoting no time to earning income and receiving AFDC payments equal to the amount labeled AFDC on the income axis of the figure. The recipient may be able to find a job paying more than the AFDC benefits that would pay an income equal to the amount labeled JOB, but, to do so, the recipient would have to devote time to work and would lose the AFDC benefits, so even if the person could earn more with a job and locate at point B on the diagram, the person would have less utility than by remaining on welfare. Figure 19.5 illustrates the nature of the trade-off and shows that a job would have to pay considerably more than AFDC for it to appear desirable. This is especially true when other welfare benefits, such as Medicaid and food stamps, might also be lost, and when the person must give up some personal freedom to remain on a work schedule, not to mention commuting costs and other possible job-related expenditures.

When asked, most people on welfare say that they would like to get off, but given the incentives, it is difficult for them to do so. High marginal tax rates create a disincentive for earning income, and people on welfare face the highest marginal tax rates of anyone in the economy because when they earn income, they rapidly lose their entitlement payments. FOOD STAMPS The food stamp program was established in 1964 as a part of the U.S. Department of Agriculture to further the goals of increasing the demand for agricultural products and


providing better nutrition for low-income individuals. Food stamps are financed by the federal government, but the program is administered by the states. From modest beginnings, the program grew rapidly in the 1970s, and in the early 1990s, approximately one in twelve Americans received food stamps. Total expenditures on the food stamp program in 1990 were $17.7 billion. The program provides benefits in kind because the food stamps can be redeemed only for food, but the distribution of benefits works something like a negative income tax. The federal government establishes a level of entitlement for people with no income, and for every additional dollar of income, the entitlement falls by 30 cents. Thus, the marginal tax rate from the food stamp program alone is 30 percent. For most recipients, the amount of food stamps received is less than they would have spent on food without the food stamps, so the food stamps act like an income transfer even though they can only be used to buy food. This is illustrated in figure 19.6. Without food stamps, the individual's budget constraint is G'F', and food stamps allow the individual to buy amount of food Fs. With food stamps, the individual’s budget constraint begins at point A, where all money income is used to buy amount G' of all other goods, and the individual would consume FS amount of food, bought only with food stamps. The individual can choose to buy additional food with some of his income, however, so the budget line continues from point A to F", and the new budget line with food stamps, AF", has the same slope as the original budget line G'F', indicating that the relative prices the individual faces are unchanged with food stamps.

As the figure is drawn, the individual wants to consume more food than FS, so he spends some additional income on food, giving up some of all other goods, to locate at point B. At this point, the individual consumes F* of food and G* of all other goods. As is the case with most food stamp recipients, the individual wants to buy more food than just the amount that could be


purchased with food stamps. In this case, the receipt of food stamps is no different to the individual than the receipt of a cash transfer. The individual uses some of the income that would have been used to buy food to purchase other goods instead. Consider this result in the context of the goals of the food stamp program. Because food stamps act like a cash transfer, they do little to increase the demand for agricultural products. Recipients may spend more on food because they have higher incomes, but this is partially offset by the fact that taxpayers have lower incomes. Additional expenditures on food may enhance the nutrition of low-income individuals, but there is little restriction on the type of food that can be bought with food stamps, so even this is not necessarily so. In a wealthy society like the United States, even the low-income population is relatively well off, and the most common nutritional problem of poor people in the United States is obesity. A simple analysis of the food stamp program suggests that its effects would be little different if it were replaced by a cash transfer to those who qualify, and a cash transfer would be much easier to administer. As long as the individual in figure 19.6 wants to consume more than quantity Fs of food, the program acts like a cash transfer, but a few individuals would want less food, and, for them, the fact that food stamps have to be spent on food acts as a constraint. One option is to consume more food. (Because food stamps are redeemable for a certain dollar’s worth of food, this may mean buying more expensive food rather than consuming more calories.) Another option would be to sell the food stamps. In the underground market, food stamps typically sell for half their face value, so above point A the recipient has the option of trading a dollar’s worth of food for 50 cents. For individuals who want less than Fs in food stamps, they can extend their budget constraints beyond point A as illustrated in figure 19.7.


Figure 19.7 is drawn similarly to figure 19.6. The recipient gets food stamps of amount Fs but desires to sell some in exchange for all other goods. If the recipient could get a dollar for a one-dollar food stamp, the recipient's budget constraint would include the dashed line above point A on budget constraint AF". However, if the recipient can sell the food stamps only for half their face value, the budget constraint would rotate inward at point A, reaching the All Other Goods axis at G". Thus, the budget constraint is G"AF" and has a kink at point A. Below point A, a dollar can buy a dollar’s worth of food. Above point A, a one-dollar food stamp can be exchanged for 50 cents. The individual buys all his food consumption with food stamps and buys some other goods, too, so he consumes F* amount of food and G* amount of all other goods. If the individual received cash instead of food stamps, the individual's budget constraint would include the dashed segment above point A, in which case the recipient could have reached a higher indifference curve.

Most individuals will be like the person depicted in figure 19.6 and will use all their food stamps and some additional money to buy food, but some may be like the person depicted in figure 19.7 and desire less food. Still, there is a substantial underground market for food stamps, partly because of fraudulent claims by recipients. People apply for benefits under more than one name, or under the same name at several different offices, to receive more benefits than they are entitled to. Although exact numbers are hard to come by, some estimates suggest that 10 percent to 15 percent of food stamps are issued to individuals who are not entitled to them.


HOUSING SUBSIDIES Governments at all levels run a variety of housing subsidy programs. Sometimes the government builds low-income housing and rents it to those whose incomes qualify at below-market rents. The government also provides rent subsidies to low-income individuals to allow them to rent their own housing using the subsidy as partial payment. The government has also provided low-interest loans so that low-income people could buy their own homes. Governments at all levels spent $17.5 billion on housing programs in 1990, and most of the money went toward rent subsidies. The Section 8 rent subsidy program, discussed later, cost $10.6 billion, while expenditures on public housing were$3.9 billion. The remaining $3 billion in housing subsidies went to low-interest loans or interest subsidies to enable low-income people to buy their own homes. This section considers the two most common forms of governmental housing assistance: public housing and rent subsidies. Public Housing Public housing provides a government-owned apartment at a below-market rent. The individual who qualifies can choose the government housing, taking the subsidy in the form of the below-market rent, or can choose to obtain housing in the market without the subsidy. The nature of this choice is illustrated in figure 19.8. If the individual does not take public housing, the budget constraint will be G1H1, but public housing offers the individual housing amount H* in exchange for giving up income represented by the distance from G1 to G*. (If the individual did not have to pay anything for the public housing, then G* would equal G1 and point A would be higher.) The individual can then locate at point A with public housing, at a higher indifference curve than could be reached at any point on G1H1, so the individual takes the public housing. With public housing, the recipient must either take the housing offered by the government or forgo the subsidy. If the individual had the option of receiving a cash transfer equal to the value of the subsidy, the individual’s budget line would extend from point A to H', and the individual could be better off by taking the money and renting housing of higher quality than the public housing. As this figure is drawn, the individual would be better off spending more on housing and having a nicer place to live but chooses public housing because of the subsidy. With a cash transfer, the budget constraint would also extend in the other direction from point A, and some individuals might prefer lower-quality housing and more money to spend on all other goods. As figure 19.8 shows, public housing will increase the utility of recipients, but, by choosing the level of housing recipients must accept, public housing is unlikely to provide the same level of benefits as a cash transfer would. Rent Subsidies Some of the drawbacks to public housing are avoided when the government provides subsidized rent to those who qualify rather than publicly provided housing. The government spends approximately three times as much on rent subsidies as on public housing, and, although public housing is produced by state and federal governments, rent subsidies are almost entirely federal government expenditures. The federal government has a long history of subsidizing rent, and the


largest rent subsidy program provides what is called Section 8 housing because it was authorized in Section 8 of the 1974 Housing and Community Development Act. The Section 8 program has a formula that determines the amount of subsidy that each recipient is eligible for. Essentially, the program sets an income level at which recipients can get a certain amount of money to subsidize their rent payments. The amount is determined by the relationship of their income to the median and by the cost of housing in the area where they live. This subsidy is then reduced by 25 cents for each additional dollar of income that the recipient earns. This feature of the program creates a disincentive for earning income, as discussed earlier in the chapter. Recall that those on food stamps lose 30 percent of their benefit for each additional dollar of income, so a food stamp recipient in Section 8 housing faces a 55 percent marginal tax rate on these two programs alone. Unlike public housing, the recipient of a Section 8 rent subsidy can spend the money to rent any qualifying apartment. To qualify, the property (and the rent charged) must be approved by the government. A potential problem arises because the government pays the rent for the renters, so renters have less incentive to shop carefully to get good value for their rent money. Thus, there is a government bureaucracy that must oversee the transactions to protect the program against fraud. The drawbacks to rent subsidy programs lie in how both renters and housing must qualify to receive the subsidy. Weighed against these drawbacks is the advantage that the renter can choose among different housing qualities at different prices. The options facing the renter with the rent subsidy are illustrated in figure 19.9. The renter qualifies for a subsidy of Hs in the diagram. The renter could use just the subsidy to rent an apartment and use the remainder of her income for all other goods, in which case the individual would locate at point A. The individual whose indifference curve is drawn through point A would choose that option, consuming H. amount of housing and G1 amount of all other goods. If the individual desired to spend more on housing, the rent subsidy could be combined with some of the individual’s own income, and the individual’s budget constraint would be AH'. Thus, the rent subsidy will not push the recipient into lower-quality housing than the individual would choose with an equal cash transfer, as could be the case with public housing.


As the individual’s indifference curve is drawn in figure 19.9, the individual would actually prefer a cash transfer to use some of the money for rent and some of it to increase the consumption of all other goods beyond G,. The rent subsidy prevents the renter from doing that, so all the subsidy must be used on housing.2 But when the renter desires better housing than the subsidy could provide, the program acts like an income transfer. HOMELESSNESS Governments in the United States provide a substantial safety net for those who are least well off, but some people do slip through the net. The most obvious of those who have fallen through the safety net are the homeless, who are most visible in the streets of America’s major cities. Most homeless people suffer from problems of drug and alcohol abuse or mental illness. As recently as the 1950s, many of the homeless would have been institutionalized in mental hospitals, but today they are left to fend for themselves. They have the opportunity to take advantage of many federal transfer programs (although often they pass up the opportunity), and survive by scavenging, begging, and working odd jobs.3 Why is the homelessness problem most visible in relatively wealthy regions of the country and in large cities? What has created a situation in which the homeless are unable to find a place to live? The problem can be analyzed within the same framework used to look at other issues in this chapter. Imagine an indifference curve diagram in which people have a budget constraint giving them a choice between housing and all other goods, as depicted in figures 19.8 and 19.9. Without any subsidy, one would expect an individual to devote some income to housing and some to all other goods. However, in urban areas where homelessness is most prevalent, housing is expensive. Thus, people cannot choose just any level of housing. They cannot spend less than the least expensive housing unit available. This alters the choice of the individual, as shown in figure 19.10. If any level of housing were available, the individual’s budget constraint would be G1H1, but assume that the minimum level of housing available in the area is given by amount HMin. In that case, if the individual rents the minimum level of housing available, the individual will be at point B consuming HMin of housing and G' of all other goods. The individual's alternative is to spend nothing on housing and buy G1 of all other goods. The individual whose indifference curve is drawn in figure 19.10 gets more utility from being homeless at point A than from buying the minimum level of housing and locating at point B. Figure 19.10 provides a framework within which to analyze the phenomenon of homelessness. What could be done that would help this individual find a home? Two things are suggested within the context of the diagram. First, if the individual had a higher income, the individual’s budget constraint would shift out to where the individual would prefer to consume at least HMin level of housing. Income transfer programs could help, but, as noted earlier, they create a disincentive to become self-sufficient. Second, if more inexpensive housing were available, HMin would be closer to the origin, making it easier for the homeless to afford some type of housing. Of course, more inexpensive housing will also be lower-quality housing, and many government programs work against the creation of lower-quality housing. Building codes and zoning laws set minimum requirements for housing, and urban renewal programs have destroyed much low-quality housing in cities. Although at first it may appear desirable to tear down low-quality housing, this also means removing a source of low-cost housing that would be available to those with very low incomes.4


In many areas, mobile homes can provide a source of inexpensive housing because they can be placed on small lots and do not have to meet the same building codes as other structures. But in cities like New York City, Washington, D.C., and San Francisco, there are no locations for such housing, and land prices are high in any event. Looking back at figure 19.10, the higher the level of HMin, the more likely it is that individuals will choose to forgo housing because of its cost. This is why the homelessness problem is so much more visible in higher-income urban areas than it is in parts of the United States that are much poorer. The illustration in figure 19.10 shows a person’s choice to be homeless at one point in time but does not depict the true magnitude of the problem facing the homeless. Once one is without a home, it is difficult to find work because it is harder to remain presentable, and it is hard to find work without a permanent address. Without a job, escape through drug and alcohol abuse becomes a less costly option. This makes it increasingly difficult on the homeless. From a policy standpoint, the best option is to keep people from becoming homeless to begin with, but, in many urban areas, public policy has worked to remove very inexpensive housing from the market. CONCLUSION This chapter has picked up where chapter 18 left off by looking in more detail at the way in which government redistribution programs work. When looked at from the vantage point of the recipient of redistribution, cash income transfers are preferable to income in kind. Recipients are sometimes better off with cash transfers but will never be worse off. Those who are paying for the transfers might prefer in-kind transfers, but an analysis of several redistribution programs has shown that in many cases, the recipient can use the transfer like cash regardless of the form in


which it is given. Cash transfers are simpler to administer than in-kind transfers, and one cash transfer program could replace many in-kind programs. This suggests that a simple cash transfer program would better be able to aid those with low incomes than would the many complex in-kind transfer programs the government now runs. The simplest type of cash transfer program would be a negative income tax that would transfer income to those with the lowest incomes, and whose payments would be phased out as income increased. An analysis of a negative income tax showed that it had the same disincentive effects toward earning income as a positive income tax had. Because the subsidy is reduced as income increases, people are discouraged from earning income. All means-tested redistribution programs face this same problem, whether one is considering AFDC, food stamps, housing subsidies, or any other program that requires people to have low incomes to qualify. Consider a person receiving a rent subsidy through Section 8 housing and receiving food stamps. For each additional dollar of income, the food stamp subsidy is cut by 30 cents and the rent subsidy by 25 cents, so the recipient faces a 55 percent income tax from those two programs alone. This is much higher than the highest personal income tax rate of 39.6 percent, which some people say creates too large an incentive against earning income. Add to this possible loss of AFDC payments and Medicaid, and the income tax rate faced by welfare recipients could well be over 100 percent. With Medicaid, either a person does or does not qualify, so earning enough to lose Medicaid benefits could create a substantial loss. The high marginal tax rates (in the form of benefit reductions because of earned income) are what create a situation of welfare dependency, in which recipients see little point in taking a low-paying job that eventually could lead to self-sufficiency. In the 1990s, there has been increasing dissatisfaction with the way in which the welfare system works. It is a cumbersome set of transfer programs that are hard to understand, that have high administrative costs, and that create incentives for welfare dependency. The problems are easy to see, but the solutions are more elusive. Fundamentally, the problem is that if means-tested programs require people to be poor to qualify for benefits, they create an incentive to be poor and to remain in poverty. The challenge is to design programs that help out those in need without giving people an incentive to remain in need. QUESTIONS FOR REVIEW AND DISCUSSION 1. Would recipients of income transfers rather receive their transfers as cash or as in-kind

payments? Explain the issues and use a diagram to show when it would matter to recipients and when it would not.

2. Would taxpayers who finance income transfers rather finance cash transfers or transfers in

kind? Explain what factors should be considered from the standpoint of those who are paying for the programs.

3. How would a negative income tax system work? Use a diagram to show the incentives

involved in such a system. 4. Will the recipient of an income transfer from a negative income tax necessarily have a higher

income with the program than without? Will the recipient necessarily be better off with the program than without? Use a diagram to help explain your answer.


5. It has been said that welfare recipients face the highest marginal income tax rates of any

individuals in the economy, yet often they pay no income tax and receive substantial benefits in the form of income transfers. With low incomes, how could they face high income tax rates?

6. Explain what is meant by welfare dependency. What keeps welfare recipients from finding

entry-level jobs so they can work their way up to better-paying jobs and escape the welfare system?

7. Since the AFDC program began paying increasingly generous benefits in the 1960s, there

have been a growing number of single-parent households that have qualified for AFDC. Does the increasing number of qualifying families demonstrate the need to continue the program? What factors might explain the growing number of single-parent households?

8. Are food stamps equivalent to cash for those who receive them? Explain, both from the

standpoint of those who receive more food stamps than they need to buy food and from the standpoint of those who must spend additional income to supplement their food stamps for food purchases. Use diagrams to help illustrate your answer.

9. Are people who live in public housing better off with the public housing than they would be

without it? Do they have a higher quality of housing than they would have without public housing? Use a graph to illustrate your answer.

10. Is a rent subsidy equivalent to an income transfer for the recipient? Explain the circumstances

under which the two will and will not be equivalent. Use a graph to help illustrate your answer.

11. There has been a great deal of publicity about the problem of homelessness in relatively

wealthy urban areas like San Francisco and New York, but the problem receives relatively little attention in poorer areas. Explain why homelessness is a bigger problem in upper-income areas than in lower-income areas.

12. What percentage of the population receives AFDC payments? What percentage receives food

stamps? Do you think too many people receive these benefits, or too few, or is the number about right?

13. What are the major problems that you see in the design of the government’s redistribution

programs? What recommendations to improve the system would you make? NOTES FOR CHAPTER 19 1. For an extensive discussion and literature review of the AFDC program and other

government transfer programs, see Robert Moffitt, “Incentive Effects of the U.S. Welfare System: A Review,” Journal of Economic Literature 30, no. 1 (March 1992): 1B61.


2. This neglects the possibility of fraud. If the landlord overcharged the renter for rent on a substandard apartment and then paid a kickback to the renter, both could benefit at the expense of the government, and the renter could consume more than G1 of all other goods. This is one reason why the government must monitor the program for abuse.

3. For some background on the problem of homelessness, see Philip W. Brickner, Linda Keen

Sharer, Barbara A. Conanan, Marianne Savarese, and Brian C. Scanlan, eds., Under the Safety Net: The Health and Social Welfare of the Homeless in the United States (New York: W. W. Norton, 1990).

4. See William Tucker, The Excluded Americans: Homelessness and Housing Policy

(Washington, D.C.: Regnery Gateway, 1990), for a discussion of the relationship between public policy and homelessness.

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