How Insurance Works

Lec 24 | MIT 14.01SC Principles of Microeconomics


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MIT OpenCourseWare at ocw.mit.edu. JON GRUBER: All right, so let’s
continue our discussion today of equity and
efficiency. We talked last time about the
equity efficiency trade-off and the problem of
the leaky bucket. And we talked about how society
would value transfers from one group to another and
what the sources of the leak in the bucket might be. In today’s lecture, we’re
actually going to talk about what governments actually do to
transfer resources across income groups and what
effect that has. Obviously this is a
very big topic. I’m sort of summarizing in one
lecture what takes about half a semester in the course I
teach on public policy. But this will give you sort of
an overview of kind of how we think about these transfer
issues in the US. And certainly if you want to
learn more about it, you can learn more in 14.41. So I want to start by talking
about the first side of the transfer equation, putting
money in the bucket, and that’s taxation. Talk about taxation, putting
the money in the bucket. We have a number of sorts
of taxation in the US. I mean, look at the first
page of the handout. This pie chart gives a breakdown
of where we raise our money as a government
in the US. So if you want to redistribute,
first you’ve got to raise money. How do we raise it? Well basically, the majority
of the money we raise is raised through the income tax. The income tax is a tax
on families’ incomes. And importantly, it’s what we
call a progressive, so the majority of money raised
from the income tax. The income tax is what we
call a progressive tax. What that means is the richer
you are, the higher share of income you pay in taxation. Progressive. As opposed to regressive tax,
is one where the richer you are, the lower the percentage
of your income you pay in taxation. And once again, obviously
progressive/regressive has some normative feel to it. And the notion is once again,
under most social welfare functions, we’re going to want a
function which redistributes from rich to poor. And that’s a progressive
income tax system does. So if you look at the next
page of the handout, this shows for current year, I think
it’s for 2010, maybe 2009, what tax rates look
like in the US. Now it’s important to remember a
distinction between marginal tax rates and the taxes
you actually pay. What this graph shows is
your marginal tax rate. What that means is for the next
dollar that you earn, what percent do you
pay in taxes? So for example, for someone who
earns less than $16,700, for every dollar they earn,
they pay $0.10 in taxes. In fact, everybody pays that on
the first $16,700 they pay. So Bill Gates, on the first
$16,700 he earns pays $0.10. Then on every dollar beyond
that, you pay $0.15 till you’ve earned $67,900. Then you pay $0.25 and so on
until on every dollar above $373,000, you’re paying $0.35. And the key point is these
are the marginal rates. So if your income is
$350,000, then your marginal rate is 33%. You’re on the next to
the last bracket. But along the way, you’ve
paid lower rates. You pay the 10% on your first
$16,700 and so on. But the bottom line, this is a
progressive system where the higher your income, the more
you pay in tax on the next dollar earned. OK, and that’s the way
the income tax works. And there’s a lot of
other complicated features we can get into. But roughly speaking, you take
your income and you tax it progressively. And that determines what
you pay the government. Now if we flip back to the first
page, the second major source of revenues for the US government is payroll taxation. This is different from income
taxation in that this is a flat percent tax. So this is not progressive or
regressive, it’s neutral. It a flat percent of
your income you pay in payroll taxation. So unlike the income tax where
the richer you are, the more you pay. Here you pay a certain
flat percentage regardless of income. And this money goes to finance
the nation’s– what’s called the nation’s
social insurance program. And we’ll focus on
that on Monday. But basically goes to finance
programs that help people if they suffer negative risks, like
get unemployed or need health care, et cetera. That’s financed by
the payroll tax. The third source of taxation
is consumption taxation. Consumption taxation. As we can see in the US, that is
the third largest source of revenues, about 15.7% of
government revenues come from consumption taxes. Now these are of two types. These are taxes on
consumption. There are two types. One type is the sales tax. So in Massachusetts this is the
6 and a quarter percent. Everything you buy in certain
categories, you pay 6 and a quarter percent extra that
goes to the state. The other is excise taxes, which
are specific taxes that are levied on specific goods. So there’s an excise
tax on cigarettes. You pay a certain dollar amount
per pack of cigarettes in excise tax. Excise tax on alcohol. Excise tax on gasoline. So these are specific
taxes on goods. And the important thing is these
consumption taxes are often called indirect taxes. Because unlike income and
payroll taxes where you earn $1, you pay tax on it. Here you don’t pay the tax
till you spend the money. So the consumption tax
does not tax you directly on your income. It taxes you as you use your
income to buy things. So it’s often called
the indirect tax. The fourth major source of tax
revenues is the property tax. This is a tax that you pay
on your actual wealth. This is the third kind of tax. So the first kind of tax we
tax you on your earnings, either through income
or payroll taxes. A second kind of tax, they tax
you on your consumption. A third kind of tax, they
tax you on your wealth. So literally every year, you pay
a certain fraction of the value of your house, for
example, in a property tax to your local government. So it’s another form
of taxation. That’s where we get about
10% of our revenues. And then finally, there’s
the corporate tax, which is a tax– this is sort of akin
to the income tax. But instead of levied on
individuals, it’s levied on corporations. It’s money that corporations
pay as they earn more in profits. So we tax lots of different
sources of income. We tax you lots of different
ways in the US. If you add it up overall,
we pay about 20% of our income in taxation. That is every dollar that’s
earned in the US, about $0.20 goes to the government
on average. Now obviously it’s different. If you’re richer, it’s higher. If you’re poor, it’s less. It depends on how much you
consume, et cetera. And your wealth, et cetera. But overall across everyone, on
average, about 20% of our income goes to taxation. About one fifth of our GDP. The problem we have right now
is if you look at government spending, that’s more
like a quarter. It’s 24% of GDP. So we collect about a fifth of
our national income in taxes, but we spend about a quarter. Thus we have a more
than trillion dollar national deficit. So the problem we have right now
is we’re collecting a lot less in taxes than we’re
spending as a government. Now, we’re not going to get
into what’s behind that. That has both some structural
sources, which we’ll talk about. Most notably the incredible rise
in medical care spending. And it has some cyclical
sources, which is in a recession, naturally you spend
more because people need more help from the government and you
tax less because there’s less income to be taxed. So some of the reason we have
this huge deficit is that we’re in a recession still. We haven’t come out of it yet. Some of it is more structural in
that we have fundamentally a system which is spending
beyond our means. And we’ll talk a bit
more about that. What I want to focus on now
is given this large set of different things we should tax,
I want to focus on one specific question. There’s lots questions
we could focus on. And once again, in 14.41, we
talk about a lot of them. But I want to focus today on
one question of particular interest. Which is, what
should we tax? I’ve just laid out here five
different things we can tax. We can tax your income,
either progressively or in a flat tax. We can tax your consumption. We can tax your property. We can tax corporations. What should we tax? If we’re going to raise this
20%, why do we do it in all these different ways? For example, in Europe, taxation
is very different. In Europe, they raise much less
through income taxation and much more through
consumption taxation. They have something in Europe
called the value-added tax. You guys may have dealt with it
if you’ve traveled there, traveled abroad– the VAT. The value-added tax is basically
their version of the sales tax. It’s basically a sales tax, but
each level of producer is tax on the value they
add to production. And so in Europe, they tax
consumption a lot more and income a lot less. Is that a good idea or not? For example, one of the two
major deficit commissions that’s just reporting these last
couple weeks on ways to get down the deficit, has
suggested we actually introduce a national sales tax
to move towards more like Europe and have more of our
taxation based on consumption and less based on income. What’s the major argument
for this? Well, the major argument for
taxing consumption instead of taxing income comes back to what
we talked about a couple lectures ago. Which is that it promotes
savings. Remember, income can
be defined as consumption plus savings. You take your income and you
either consume it or save it. OK When we tax income, then we tax
both your consumption and your savings. When we tax consumption only,
we don’t tax your savings. Assuming substitution effects
dominate, that will therefore promote savings. Taxing consumption rather
than taxing income will promote savings. Once again, assuming
substitution effects dominate. And the argument is, we know
through mechanisms we talked about last time how important
savings is as an engine of growth. So the notion is that by moving
from a system of taxing income to a system of taxing
consumption, we can say to individuals, hey, you will have
a tax benefit to saving rather than spending. And that tax benefit you
have from savings will cause you to save more. And therefore, we’ll
increase savings in society from doing this. And that’s why many economists
favor moving away from an income tax to a consumption
tax. Actually, this was first
proposed by the depressing philosopher Thomas Hobbes back
in 16-something where he said, “A man should be taxed– because it was all
men back then. “A man should be taxed not based
on what he earns, but what he takes out of society
through consumption.” That’s sort of the philosophical
underpinnings of saying let’s not tax people on what they
make, let’s tax them on what they use, which is their
consumption. So that’s got both a
philosophical merit to it and also this sort of efficiency
argument of promoting savings. So why not do this? Well, it’s our friend that we’ve
been talking about these two lectures, the equity
efficiency trade-off, which is a tax on consumption
is very regressive. It falls much more heavily
on the poor. And why is that? Well, quite frankly because
the poor don’t save and the rich do. The typical American lives
pretty much hand to mouth. They pretty much spend
what they earn. They don’t save a whole lot. Most of savings in society is
done by the richest people in our society. The vast majority of wealth is
controlled by a small share of the population. As a result, if you went from an
income tax system, which is progressive, to a consumption
tax system where you’re just taxing people on what they
spent, you would end up moving vastly towards a much more
regressive system. Now partly you could address
this by taxing consumption progressively. But at the end of the day, the
rich just don’t consume a lot of what they earn. They pass it on to their kids. So at the end of the day, the
rich will just pay a lot less in taxes if you move to a
consumption tax system. And that’s the issue. Now in Europe, what they do is
they address this problem by saying, fine, our tax system is
regressive, but we’re going to spend a lot of money
on the poor. So I talked last time about a
system making sure nobody lived in poverty. Everybody got $10,000. No one lived in poverty. That’s more of a European-style
system. So in Europe they say, yes, we
have a more regressive tax system, but a much more
progressive spending program. And put together, it’s
a fairer system. And that may be something
to consider. But within the tax realm alone,
moving to consumption taxation will probably
promote efficiency, but would hurt equity. And once again, we have
that trade-off that we’re always facing. Questions about that? A more interesting case where
this trade-off might not be quite so stark or a little more
subtle is thinking about excise taxation of “sin goods.”
“Sin goods.” So if we think about what’s taxed by
excise taxation, they’re on things like cigarettes,
alcohol, gasoline. Basically, goods which produce
what we call negative externalities. What a negative externality
is, is an activity which produces a negative consequence
that is not borne by the person engaged
in the activity. It’s not borne by the person
engaged in the activity. There’s a negative externality
that’s associated with these goods. So for, example let’s
take smoking. When I smoke, part of what I’m
doing is just killing myself. And that’s not an externality. I’ll come back to that. But if all you do through an
activity is hurt yourself, that’s not an externality. An externality is the cost
imposed on society. The key insight from basic
economics is that anything you do that hurts only you is
not society’s business. So for example, every cigarette
you smoke lowers your life by 7 minutes. Now not specifically, but on
average, every cigarette smoke lowers your life by 7 minutes. However, in a world with
rational consumers, the type we deal with in 14.01,
that’s not a problem. When you go to buy that pack of
cigarettes, you should say, look, in addition to the $5 I
have to pay, I’m lowering my life by 140 minutes. I will decide whether my
enjoyment of smoking is worth the shortening of my life plus
the money I have to pay. If it is, I’ll buy it. If not, I won’t. I’ll go off and smoke and
kill myself or not, but that’s my problem. That’s the standard economic
view of this, which is that basically what matters is not
the damage to yourself because that’s a trade-off you make. You have an indifference curve
across life and smoking. You have an indifference
curve. And if you like smoking a lot,
you’ll choose to have a shorter life to smoke. If you don’t like smoking,
you won’t. But that’s a choice you’ve made
and the government has no role to interfere with that. Where the government has a
role to interfere is when there’s a negative
externality. When the consequence of my
action affects other people and I don’t bear the cost. So, for example, when I smoke,
if I’m, for example, on Medicare, over 65. If I smoke and get sick, then
the medical costs that are borne are borne by
the taxpayer. Because I’m on public
insurance. So when I’m over 65 and I’m on
free public insurance, which a lot of people aren’t over 65. I’ll talk about that in
a couple lectures. And I smoke, than those costs
are borne by society because they have to pay the cost
of my medical bills. Or more relevantly, take
secondhand smoke. If I smoked in this classroom
and you all got lung cancer as a result, that would be an
externality because I wouldn’t be bearing the fact that you
got sick because I smoked. That’s a negative externality. Higher medical costs alone
associated with smoking are $80 billion a year. Not to mention the secondhand
cost of smoke. Take drinking. What’s the externality
for drinking? Now many, I would gather,
venture most people in this room have had consumed
alcohol. Often we’ve consumed it and
quite enjoyed it and consumed it responsibly. However, there’s enormous
negative externality associated with alcohol,
which is drunk driving. Every year about 13,000 people
a year are killed by drunk drivers and about 400,000
are injured. Once again, that’s an enormous
negative externality because I drink, I get drunk,
I kill someone. That’s a cost I’ve imposed on
society that I don’t bear. I’m going to be guilty and
stuff, but I’m not bearing that cost. That’s a negative
externality of drinking. Consuming gasoline clearly has
a negative externality, which is the more I drive, the more
carbon I emit into the atmosphere, and the more
I cause global warming. The externality is that
basically by the best estimates, global temperatures
due to global warming, which a large share of it is caused by
driving, global temperatures will be up 5 to 10 degrees by
the end of the century. Now if you’re from North Dakota
that may not sound like such a bad thing. But if you were say, from
Bangladesh, it might be because it’ll be underwater. Or if you happen to like
visiting Cape Cod, it might be because it will also
be underwater. And these are the aspects of
global warming that are largely caused by activities
such as driving. It’s a negative externality. By my driving, I’m putting
Bangladesh underwater. I’m not paying for that, so
that’s a negative externality. And then finally, we get to the
toughest one and the most interesting one. And perhaps the most
important one going forward, which is obesity. Individuals who overeat and get
fat and overweight as a result cause an externality
because they have extra medical costs that society
has to bear. Currently, one third of
our nation is obese. And one in three children born
today will get diabetes. Largely from overeating
or poor lifestyle. That’s an externality on society
and the extra medical costs that we’ll bear. Since society bears these costs,
society then has the right to say, well, I’m going
to tax you on the costs you’re imposing. We call that corrective
taxation. If you exert a negative
externality on society, then society has the right to come
and say, OK, we are now going to correct that by taxing
you on the cost you’re imposing on society. So that’s an argument for excise
tax that goes beyond the normal equity efficiency
trade-off. Any tax has the normal equity
efficiency trade-off. Sin goods have this extra
argument in the pro column, which is the negative
externalities. Which is that even aside from
the standard equity efficiency trade-off, because consuming
sin goods imposes negative externalities on society,
we should tax them more. And that’s why we have excise
taxes above and beyond our sales taxes. Questions about that? Now, traditional economics often
stops there, but I hope that my discussion of shortening
your life by smoking left you at least a
little bit uncomfortable. I hope that when I said, well,
you shorten your life by smoking, that’s your problem. You might say, well, gee,
that leaves me a little uncomfortable. And the reason you might say it
leaves you uncomfortable is you might think, well, maybe
people don’t understand that. Maybe people don’t realize
that every cigarette they smoke is shortening your
life seven minutes. And maybe they don’t realize it
in particular when they’re 16 and start smoking. And then they get addicted
and they can’t stop. In that case, we have actually
understated the argument for taxing these goods because then
we actually want to tax them to help you from
killing yourself. So for example, you take high
school seniors who smoke a pack a day of cigarettes. And ask them, will you be
smoking in five years? Of the ones that say, yes, I
will be smoking in five years, if you actually follow them up
five years later, 72% of them are smoking. So you got it pretty
much right. Of the ones that say no I will
not be smoking in five years, when you follow them up five
years later, 74% are smoking. They completely got it wrong. Clearly, the kind of underlying
rationality assumptions we make in
this course don’t hold in some context. In that case, there may be a
role for the government to tax these sin goods even above
and beyond externalities. Basically, there maybe a role
for the government in helping people help themselves,
which is a dangerous place to go for economics. We tend to think of the
government as rolling in and fixing mistakes that might
affect society. But people, what they do for
themselves is perfectly fine. If they want to do crazy things,
that’s their business. What behavioral economics leads
us to, where these sort of facts leads us to is
thinking, well, if people make mistakes, there may be a role
for the government in addressing those as well. That’s a new area that economics
is pushing in, is thinking about, well, gee, if
individuals are actually not behaving in the perfectly
rationally way we learned about in 14.01, then is there
an even more aggressive role for the government in correcting
their behaviors? And this is discussed a lot
in my course 14.41. It also is discussed a lot in
14.13 Behavioral Economics, which talks a lot about these
issues, about these sort of issues of sort of how moving
beyond 14.01 might actually impact our thinking about
the proper role of government policy. So the bottom line is, we should
clearly tax these sin goods more because
of the negative externalities they impose. Because they impose costs on
society through higher medical costs, or more drunk driving
deaths, or global warming. And perhaps we should tax them
even more than that if people are actually making mistakes
in their consumption decisions, and the government
has a role to come in and help correct those mistakes. Questions or comments on that? Now, I just talked about what we
should tax and some of the issues in deciding what
we should tax. The other, of course,
issue is, well, how much should we tax? So not just what’s the right
tax base, income or consumption or excise taxes
or whatever, but what’s the right tax rate? And this is, of course, a very
important issue today because the number one public policy
issue we’re dealing with now is the expiration the
Bush tax cuts. So if you go back to your chart,
the second page of the handout, the marginal
tax rates. Before 2001, these tax rates
were all about 5% higher. So the poorest paid 15% and
the richest paid 40%. In 2001 and in 2003, the Bush
administration cut tax rates a lot, cut these tax rates, cut
a bunch of other taxes, including corporate taxes, as
well as the property tax and other things. But everyone’s focused
right now on the individual tax rates. They did so, but to make– due to some sort of budgetary
trickery they had to do to make it work, those tax cuts
actually expire in a month. What that means is if nothing
is done in a month, everybody’s income tax
rate jumps up by 5%. So you can imagine that’s
not delightful politics. Politicians are very upset
and worried about this. I don’t know that people are so
much, but politicians are. And the current debate right now
is, well, what should we do about this? Should we extend the
Bush tax cuts? Should we continue to keep
tax rates lower? Or should we let them expire and
grab the extra revenues, as well the increased
progressivity that comes along with that? Well, should we? Well that depends on two issues,
equity and efficiency, the same issues we’ve
been discussing. The efficiency issue is, well,
what will the impact be on the economy from allowing
tax rates to rise? And in particular, some argue
there could be such a negative impact that you actually end up
hurting the government by allowing tax rates to rise. And this argument that appeals
to a famous notion known as the Laffer curve, named for a
conservative economist, Arthur Laffer, who advised Ronald
Reagan on his tax cuts in the early 1980s. The Laffer curve argument is
illustrated in Figure 24-3. So the point is, imagine
two tax– I want you to consider three
possibilities for tax rate: 0, 100, and something in between. A tax rate of 0 clearly
raises 0 revenues. But a tax rate of 100% also
clearly raises 0 revenues. Why? Because if you’re taxed 100%,
you’d never work. If literally everything you ever
made simply went to the government, people just
wouldn’t work. As long as leisure’s a normal
good, why would you work? Why would you reduce your
leisure if you didn’t get to see any increased consumption
from it? So at a tax rate of 0, the government collects no revenues. At a tax rate of 100%,
the government also collects no revenues. And the tax rates in between,
the government collects at least some revenues. Given those three facts, we
know there must be some function that looks like the
one that’s drawn here. Some parabolic function. We don’t know its exact shape. But basically where it hits the
x-axis at 0 and 100 and is above the x-axis in between. It’s just a theoretical
truism that you’ll get a curve this shape. The question is, which side
of this curve are you on? If you’re on what I’ve labeled
the correct side, then what that means is by raising taxes,
we raise revenues. But there is inevitably an
incorrect side, a wrong side, where taxes are so high
that by raising taxes, we lose money. How is that possible? Well, think about what
tax revenues are. Tax revenues are the tax rate
times the tax base. Well, what happens to tax
revenues when we increase taxes? dR d tau is equal to
B plus dB d tau times tau. That is, when you increase
taxes, you raise more money because you’re raising more
money on the existing tax base, but if the tax base
itself shrinks– this is negative– then there’s an offsetting
effect. The tax base could shrink
so much that you end up losing money. And that’s what happens
on the wrong side of the Laffer curve. Taxes get so high that when you
raise a tax rate, people work so much less it’s like the monopolist poisoning effect. The poisoning effect overwhelms
the initial effect and you actually lose money
by raising taxes. Just like a monopolist can lose
money by raising prices– by lowering prices. I’m sorry, a monopolist
can lose money. Here the government can lose
money by raising taxes through the same kind of poisoning
effect. And that’s how we get
this Laffer curve. The first issue is, where
are we on this curve? And the answer is that we’re
clearly currently on the correct side. We’re clearly at our current
rates, and even if the rates go up under the Bush tax
cut, we’re clearly on the correct side. Evidence is clear
on this point. More generally, the evidence is
that the efficiency cost of taxation today is around 40%. So the deadweight loss of
taxation is around 40%. That is for every dollar we put
in the bucket, about $0.40 leaks out by the time– for every dollar we try to get
from a rich guy, about $0.40 leaks out before we can
get to the poor guy. So we’ve got about a 40%
leak in the bucket. The Laffer curve would imply we
had more than 100% leak in the bucket. That we try to take a dollar
from the rich guy, we actually end up getting negative
money because we actually lose overall. So we’re clearly far
from the wrong side of the Laffer curve. But clearly there’s still
some leak in the bucket. And this comes to the issue
of, well, how do we feel about that? This is what we started
last lecture with. And that depends on our social
welfare function. So here’s the way to
think about it. Currently what the Democrats
have proposed, for example, is to get rid of the Bush tax cuts
for everyone making more than $250,000 a year. If you do that, you would
raise on the order of– you get about the fifth of the
money you get from getting rid of all the tax breaks. That is, if we extend the tax
breaks for people below the richest group, but get rid of
the tax breaks above the richest group. So basically, the tax code stays
the same except this top rate jumps up. So basically the top two rates,
about halfway through the next to the last bracket
and the last bracket, they jump up and everything else
would stay the same. You’d raise a lot of money. You’d raise about $700 billion
over the next decade, which would go a long way toward
solving the deficit problem. Not solve it, but go a
long way that way. And you do so in a highly
progressive fashion in the sense that you would only
tax the richest people. On the other hand, there’d be
a very big efficiency loss. So $0.40 on every
dollar raised. So the question is,
is it worth it? Well, that just depends on the
social welfare function. My guess is for a utilitarian
social welfare function, it would say it’s worth it. Because basically the marginal
utility of the rich would be so much lower than the marginal
utility of the poor, that even with a 40% loss,
it’d still be worth it. But you could certainly write
down social welfare functions where it’s not worth it. And that’s basically what the
debate needs to be about. The debate needs to be about,
how do we feel about the benefits of redistributing from
the rich to the poor and raising this money versus the
cost in terms of the leak in the bucket? And that’s essentially what the
debate needs to be about. Now it’s not what it is
about in Washington. It’s much more about
other political factors, not just economics. But that’s the right way to
think about evaluating it. Questions about that? Yeah. AUDIENCE: I don’t see how, if
you say the deadweight loss is 40%, it’s completely lost. If
people are choosing to go to leisure, they’re still getting
some value from that leisure. Couldn’t it actually be that
that prevents being [UNINTELLIGIBLE]. JON GRUBER: That’s right,
they’re getting value. This is above and beyond the
value from the leisure. So remember our deadweight
loss triangle. That very first person who
switches from work to leisure, you’re right there is
no deadweight loss. Because that person was
indifferent between working and being in leisure. But as your deadweight loss
triangle grows, remember now you’re talking to people who
are no longer indifferent. They would rather work
than be in leisure. So by forcing them out of work
by taxing them, you are losing the gap between how productive
they’d be at work and how much they value their leisure. So you’re right, if all this tax
did is take the one person in society and cause them not
to work, then we wouldn’t worry about it. It’s people away from that where
they’re really much more productive at work than
they are at home. That’s where the efficiency
loss comes from. Other questions or comments? So that’s one side. That’s putting the money
in the bucket. What about taking the money
out of the bucket? That’s the other side of the
efficiency story and the equity story. Well what about low income
transfers in the US? So we talked about
taxation, now let’s talk about transfers. We have several types
of transfers in the US that we make. The most prominent
is what we call categorical cash transfers. Or what’s often called
welfare. Now we use welfare in a
different context in this course, so it’s confusing. We’re hearing the term
“welfare.” What they mean is money that’s sent
to poor people. So when a regular person, not
an econ geek says welfare, they don’t mean social
well-being, they mean money that’s sent to poor people. A categorical cash transfer. The categorical term means that
we don’t in the US just send money to you because
you’re poor. We send to you because
you’re poor and other things are true. So for example, we have a
program called TANF, Temporary Aid to Needy Families. This is cash that’s sent to
single parent families who are low income. So if you’re low income plus you
only have one parent, then you qualify for TANF. Actually the biggest cash
transfer program we have is called SSI, Supplemental
Security Income. This is sent to families that
are poor and are disabled. Sent to people, I’m sorry, that
are poor and disabled. So if you’re just poor, we
don’t give you anything. But if you’re poor and disabled,
you get money. If you’re poor and a single
mom, you get money. Why? Why do we impose these
conditions? Why do we do this, what’s
called targeting? Why do we do this targeting
rather than just saying if you’re poor, you get money? Now basically, the reason is
because of what we saw the last lecture. Which is we saw in the last
lecture the hazards of just giving money to people
because they’re poor. Which if you just give money
to people because they’re poor, then people will people
poor to qualify. So we saw last time in that
diagram was we said anyone below $10,000 gets bumped up
to $10,000, then everyone quits and says, I’m a zero
income guy, give me $10,000. However, if we, for example,
knew for sure– let’s say that we are born with
stamped on our forehead our underlying earnings
ability. And I could look at you and
say, you’re a $5,000 guy. Here’s $5,000. You’re a $20,000, you
don’t get anything. OK, you’re a zero guy,
here’s $10,000. If I could read that off a
forehead, then there would be no efficiency loss from
transfers because I wouldn’t change people’s behavior. I’d know what they were going to
do anyway and I’d just give them the money. But there would be no
efficiency loss. There’d be no movement of people
could earn money moving to not earning money because I
wouldn’t give you any more money than you could earn. So if we could perfectly target,
we could get rid of the leak in the bucket that
comes from transfers. But of course, we can’t. So what do we do? We try to find things which are
correlated with having a low earnings ability. Like, for example,
being disabled. If you’re disabled, we know
you’re much less likely to earn a living than if
you’re not disabled. Therefore, we can transfer money
to you and cause less deadweight loss. So if we take someone who
literally we know for sure, someone who is mentally
incapacitated, quadriplegic, basically can’t function. We know for sure they’re
going to earn zero. So there’s no deadweight loss in
transferring money to them. There’s a deadweight loss
of raising the money. But in terms of their
behavior, there’s no deadweight loss. So the more we can target in
that way, the more we can safely redistribute. Now, the trick with this, of
course, is finding the targeting mechanism. And a good targeting mechanism
needs to have two features. The first is, it has to
find the poor people. You want a target on
something which is actually like being poor. Like we could say, I’m going to
redistribute to everybody who is a natural blonde and I
could have some test for a hair color. And that’s immutable. What your natural hair
color is immutable. But that wouldn’t redistribute
resources in the way you necessarily want in society. Natural blondes aren’t
necessarily any poorer than non-natural blondes,
or other people. So first, somebody
that’s poor. And second of all, we want
something ideally that’s unchangeable. That is, I could redistribute
to everyone who’s blonde. Let’s say blonde people
were poorer. But I can change that by dying
my hair if you can’t tell if I’m a natural blonde or not. So we want something which goes
to the poor, but which is also unchangeable. So for example, someone who’s
severely disabled, that’s a good example. Someone who’s severely disabled,
nobody’s going to become severely disabled to
qualify for some cash. Actually, there is
an exception. There was a place in Florida
they called Nub City where people were actually chopping
off their limbs to qualify to get cash benefits. There was a point in the US
where one third of all limb loss accidents in the
whole nation came from one city in Florida. So that disturbing example
aside, we don’t think people will disable themselves
to get cash. Plus, they’re poor people. Single motherhood, that’s
a bit trickier. Being a single parent, isn’t it
possible that people might become single parents to
qualify for the cash? Let’s say my wife
and I are poor. We say, look, let’s divorce. We won’t be married, we can
still see each other. But you’ll get a cash
transfer because you’ll be a single mom. Well then that isn’t
unchangeable. So the question then becomes
empirically, to what extent is single motherhood,
for example, a good targeting device? And the answer is,
it’s pretty good. It turns out there’s very
little of this behavior. We have lots of clever ways of
testing whether people are doing this. Turns out people
don’t do that. Single motherhood is something
people really don’t want. And basically if someone’s a
single mother, it’s a pretty unchangeable indication
that they’re poor. In fact, it turns out that the
biggest problem we have in targeting is not poor
disability, but another program we have, which tries to
target money to people who hurt themselves on their job,
something called workers’ compensation insurance, which
is insurance for people who get hurt on the job. Turns out there, it’s
pretty easy to fake getting hurt on the job. And as a result, that’s
not unchangeable. Even disability is not perfectly
unchangeable. There’s a lot of evidence
actually because most disabilities today are not
people who are quadriplegic or other severe, extremely
sad cases. It’s people who have things
which are hard to measure, like mental disability or back
pain where there’s no quantifiable, truly quantifiable
test. In that case, it’s hard to know if
you’re really targeting to someone who need its
or someone who’s just good at faking. And that leads once against, to
the difficult trade-offs in equity versus efficiency. On the one hand, we’d like
to target to people who really need it. On the other hand, if someone’s
just faking, we don’t want to be giving
them money. And that’s exactly the trick
that we have to face in these kind of transfer programs. Now in this world of difficulty,
there has emerged a clear winner. And the clear winner is
something we call the Earned Income Tax Credit, the EITC. So once again, the problem is if
we just give money to poor people, we have the problems
we said last lecture. If we try to target to needy
groups, we have a problem that sometimes targeting devices
aren’t perfect and people may change their behavior
to qualify. The third approach is something
called the EITC. Which is instead of just
giving people money, we actually give them a transfer
conditional on their work. This is a conditional
cash transfer. What the EITC is, is it’s
a wage subsidy. It’s literally the more you
work, the more you get from the government up to
a certain point. So to see this, let’s
go to the last figure in the handout. Figure 24-4 shows the structure
of the Earned Income Tax Credit. Here’s how it works. If your income is below $12,570,
this is for a family with two kids, I believe. If their income is below
$12,570, then for every dollar they earn, they get $0.40 extra
from the government. So it’s a negative tax. Instead of being taxed, they
actually get a subsidy for every dollar they earn. So for every dollar you earn,
you get $0.40 from the government. Until you’ve got the
maximum of $5,028. But then, once your income’s
above $16,400, that’s then taken away at a rate of $0.21
So it’s an after tax now of $0.21 per dollar you earn. Until by the time you’ve earned
$40,295 it’s gone. So this is what we
call a targeted conditional cash transfer. It’s targeted to low income
groups in that it phases out as your income goes up. But it rewards work by basically
saying that the more you earn up to a point,
the more you will get. Now the EITC effects are
somewhat complicated. I hope you can see right away. You might say, wait a second. This is a little bit
complicated. Because on the one hand, for
anyone earning less than $16,400, you’re subsidizing
their work. Or anyone earning, sorry, less
than $12,570, you’re seeing the more you earn,
the more you get. But once your income’s
above $16,400, then you’re actually taxed. Because we’ve given you
this check and we take it back away. That’s the same as taxing you. So for example, consider a guy
who’s at $16,400 who’s considering earning $100 more. Or consider a guy at– yeah, so a guy at $16,400. And he’s thinking about
earning $100 more. So currently his income is
$16,400 plus the $5,028 check he’s getting from
the government. So his income now is 21,248. I’m sorry, 5,428. My bad. A little dyslexia. 21,428 is his income. Now let’s say he decides
to earn $100 more. If he earns $100 more, his wage income goes up to $16,500. His wage will go
up to $16,500. But his EITC falls
by $21 to $5,007. So his income only goes
up to $21,507. His income goes up by less than
$100 when he earns $100. So while the EITC incentivizes
you to work when you’re low income, it disincentivizes work
when your income goes up. So this is once again why public
policy is fun and hard, which is there’s a trade-off. There’s always a trade-off
in this course. It’s really annoying. There’s a trade-off, which is
on the one hand, we want to target our program to give
the money to the lowest income groups. On the other hand, if you target
something, that means you have to take it away. Targeting equals taking away. What that means is by targeting
to the lowest income groups, we are taking it away
from these middle income people and taxing their work
just as we subsidize the work of the lowest income groups. Now, so how do we think
about this? Well, what we do in
this case is we go to empirical evidence. The EITC has grown enormously
over time. And nicely, it’s grown
differently for different groups. For example, it’s gotten a lot
bigger for families with lots of kids than for families
with no kids. So what we can do is we can
actually study what’s happened to those kinds of families
over time as the EITC has gone up. What’s happened to their
labor supply. And what you see, it’s
quite striking. Which is there’s been an
enormous increase in the share, especially of single
mothers who have gone from not working to working because
of the EITC. But you don’t see them working
less hard because of EITC. That is, you see a lot of people
pulled– if we go back to our diagram. See a lot of people pulled from
the zero earnings point into the positive
earnings range. But you don’t see a lot of
people in the positive range earning less. So the good part of the EITC
has worked and the bad part hasn’t really cost
us anything. Why is that? Well, there could
be two reasons. One could be because people are
a lot more responsive in their decision to
work than their decision how hard to work. For example, you may not even
choose how hard you work. Maybe you work 40 hours at
McDonald’s or you don’t work. So the first answer is the
decision to work or not may be the most elastic, more elastic
than how hard you work. The second could be that people
just don’t understand this program and they know they
get a check, but they don’t know how to do
this kind of math. So they say I now I get a
check if I go to work. I’m going to work. But they don’t figure, by the
way, if I work one hour less, maybe I’ll lower my
tax bill by $21. Whatever the reason, the
EITC has worked. It has solved the problem
of the leaky bucket. In fact, it’s put money into
the bucket at the bottom. In the sense that when the
government transfers you $1, you actually earn more rather
than earning less. So we’re not only ending the
leak in the bucket at the bottom of the income
distribution, we’re actually improving, offsetting some of
the 40% leak that comes from the top by getting people to
work harder under this EITC. We’re transferring in a way
which actually improves efficiency. So basically, EITC we can think
of as sort of a patch of the bucket. It’s a patch to the bucket. You’re actually helping address
leaks in the bucket by doing this. Now you might say
that’s great. That means that we have solved
our problems. We’ll just get money to the poor through the
EITC and there’s no leak to the bucket at the bottom. But the problem is, once again
it’s not that simple because some people truly can’t work. Some people truly can’t work. So you need to have something
for those that truly can’t work. So an ideal system would be one
where if you truly can’t work, we give you money. If you can work, you
get the EITC. Once again, the problem being
we have to decide who it is that truly can’t work
and who can work. And so basically, how leaky the
bucket is at the bottom will depend on how good a job
we can do at telling who the people are who can work, who the
people are who can’t work.


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