More on income distribution

Today: Family income distribution

Should we redistribute income? Why?

Some government programs

Reminder on Test 2

Test 2 Monday 65 minutes Restrictions on calculators are the same as

for Test 1

Income distribution

How is income distributed? Is there such a thing as “too much” income

inequality? Why should there be redistribution? In-kind versus cash transfers

When income is redistributed, should recipients be forced to consume a minimum amount of certain goods?

What are the problems of redistribution?

Mean income table (families)

Real income growth, 1980-2000 Bottom 20% has been flat Top 20% has seen huge growth (59%)

Quintile 1980 1990 2000

Bottom 20 percent $12,756 $12,625 $14,232

Second 20 percent $27,769 $29,448 $32,268

Middle 20 percent $41,950 $45,352 $50,925

Fourth 20 percent $58,200 $65,222 $74,918

Top 20 percent $97,991 $121,212 $155,527

Top 5 percent $139,302 $190,187 $272,349

Source: “Principles of Microeconomics” 3rd edition, by Frank and Bernanke

What is “middle class?”

This depends on who you ask Common answer

Lower middle class is usually about $40,000-$70,000 Mostly those in the middle 20% of incomes

Upper middle class is usually about $75,000-$150,000 Many people in the fourth and top 20% ranges

The gap between rich and poor widens The rich are getting richer, but the poor are notnot

getting poorer Recent Census figures show that family incomes in the

bottom 60% have stayed about the same since 2000 Working and middle class incomes have seen

moderate real growth in income 16-29% growth for the categories in the middle 60%

Some of this is due to more middle-class families having two incomes

Problems with annual income figures Ignores number of workers in a household

General trend from one earner to two Expenses, such as child care, could be higher within two-

worker households In-kind transfers ignored Taxes change over time

Disposable income changes over time (given the same income)

Income changes over time If a rich person earns no income in a calendar year, should

she be considered “poor?”

“Too much” income inequality? Some people would argue no

“When economic incentives to make a good living go away, the economic pie becomes smaller” Think about communist systems

“People that have a good work ethic and work hard should make more money”

“There are plenty of opportunities for anybody born today in the US to become successful” Free K-12 education; subsidized colleges and

universities

Arguments for less income inequality “Marginal utility of income is lower for

somebody with high incomes” “Each person has a right to a minimum

standard of living” “Social unrest may occur unless each person

is above the poverty line”

Other problems with income inequality Those that are relatively poor may feel

inferior This problem may perpetuate to their children

Jealousy towards other people Envy towards other people’s

accomplishments

More on fairness

There are different views of fairness Additive social welfare function “Veil of ignorance”

Social welfare function should be minimum utility of all people in a society

Commodity egalitarianism

Different views of fairness

Some people believe that utility, not income, should be maximized within a population Additive social welfare function

W = U1 + U2 + … + Un

Implications for additive utilities

Pau

l’s

mar

gina

l uti

lity

Pet

er’s

mar

gina

l uti

lity

Paul’s income Peter’s income

0 0’

MUPaulMUPeter

a

e

c

d

f

I*b

Paul’s income

Peter’s income

Take ab from Peter and give

to Paul

Paul gains this much

utility

Peter loses this much

utility

This is the net gain to

society

Social welfare

maximized

Different views of fairness

Others believe that social welfare should be the minimum of the utilities of each person in society “Veil of ignorance” argument developed by John

Rawls Conceals knowledge and talents from people Risk averse people will want to have income equality

under these conditions No inferiority, jealousy or envy based on income

Problem

The “economic pie” will shrink with Rawls’ ideas

If income was guaranteed to be equal to everyone, nobody will have an economic incentive to gain human capital Smaller “economic pie”

Less human capital People work less

Optimal amount of income inequality? Impossible to answer Different people have different opinions about

effectiveness of realistic ways to redistribute income

Different views of fairness

Commodity egalitarianism Some things should be made available to

everyone without restrictions Right to vote (if 18 or older) Basic education “Needed” items such as food, shelter, and clothing Basic medical care

Recall issues presented in Chapters 9 and 10

Some other factors

Income redistribution does not directly take into account other factors Number of hours worked

If our goal is to maximize utility from income, why not reduce leisure? Not necessarily, since additional leisure likely increases

utility Income depends on number of hours worked

Does relative income matter? Does someone get a decrease in utility when his income

remains the same and someone else’s increase?

In-kind versus money transfers With some views, such as commodity

egalitarianism, in-kind transfers have more appeal than monetary ones

How does this affect individual utility?

In-kind Transfers

Pounds of cheese per month

Oth

er

go

od

s p

er

mo

nth

300

260

20 150

B

A

D

21060

F

E1

U

E3

420

340

H

In-kind Transfers

Pounds of cheese per month

Oth

er

go

od

s p

er

mo

nth

300

136

82 150

B

A

D

210

F

E4

E5

420 H

168

126

If income redistribution is good… …then how do we move money from one

person to another? Welfare payments

We will spend most of our time on this The earned-income tax credit Negative income tax Minimum wage Public employment of the unemployed

Some methods of income redistribution Welfare payments

Little economic incentive to get off of welfare without time limits

Many types of programs TANF Supplemental Security Income Medicaid Unemployment insurance

TANF

Temporary Assistance for Needy Families Federal government provides block grants to

states for welfare spending Over 80% of recipients in every state must be on

TANF for five years or less States face penalties if a substantial percentage

of recipients are not working or in work preparation programs

TANF

TANF replaced Aid to Families with Dependent Children (AFDC) Under AFDC, some argued that many women on

AFDC had children out of wedlock to continue get benefits and not have to work If the mother had to work once the child reached

kindergarten, then there would be an economic incentive to have another child

TANF and benefit reduction rates TANF benefits are reduced when income

reaches a certain level Example: In California, recipients can earn up to

$225 per month before benefits are reduced at a rate of 50% of money earned

How do people respond to these incentives in the short run?

Work incentives

B = G – tE

B = 0 if E = G/t

The Basic Trade-offs

G – basic grant if not working

t – rate at which grant reduced when recipient earns money

B – benefit received

w*

Analysis of work incentives

Hours of leisure per month

Inco

me

per

mon

th

0 Ta

Time Endowment

D|Slope| = w

b

c

2w

Analysis of work incentives

Hours of leisure per month

Inco

me

per

mon

th

0 T

D|Slope| = w

i

iiiii

E1

F

G

Leisure WorkIncome

Analysis of work incentives

Hours of leisure per month

Inco

me

per

mon

th (

= e

arni

ngs

+ t

rans

fers

)

0 T

D|Slope| = w

Q

F

GS

$100

V

|Slope| = 3/4w

K

Hours before TANF

Hours after

TANF

In this example, someone can get $100 in TANF benefits if not working

Between point Q and point S, an implicit tax rate of 25% is imposed

Note that there are some incentives to work while still receiving benefits

Analysis of work incentives

Hours of leisure per month

Inco

me

per

mon

th (

= e

arni

ngs

+ t

rans

fers

)

0 T

D

P

F

G

$338

RP1

Budget constraint with t = 100%

S

0 hours of work

selected

In this case, a 100% implicit tax rate is imposed after a benefit of $338 is received

Analysis of work incentives

Hours of leisure per month

Inco

me

per

mon

th (

= e

arni

ngs

+ t

rans

fers

)

0 T

D

P

M

G

R

E2

Hours worked (if working)

This person is indifferent between working and receiving benefits

Analysis of work incentives

Hours of leisure per month

Inco

me

per

mon

th (

= e

arni

ngs

+ t

rans

fers

)

0 T

D

P

M

G

R

E2

Hours worked

This person prefers working to receiving benefits

Supplemental Security Income (SSI) Federal program that provides benefits for

the aged, blind, and disabled with little or no assets

In 2003, average benefit was $342 SSI recipients can earn up to $65 per month

without loss in benefits After $65 is earned, additional earnings have a

50% implicit tax rate

Medicaid

Medicaid affects incentives to work Under old incentive structures, people

often lost eligibility once they earned enough money to get off of welfare

This created a “Medicaid notch”

For main details about Medicaid, see Chapter 10

The Medicaid notch

Hours of leisure per year

Inco

me

per

year

0 T

D

M

N

R

S

X

Z

$1,000

Solving the Medicaid notch problem In recent years, families that earn enough to

leave welfare can often stay on Medicaid 12 month coverage after leaving TANF Low-income children and pregnant women

Unemployment insurance (UI) States provides insurance for unemployment due to

adverse selection and moral hazard reasons Benefits

Average weekly benefit in 2005: $266 Maximum length of benefits in most states: 26 weeks

Typically financed by a payroll tax on employers Empirical studies find that increasing benefits

increases the duration of unemployment

EITC

The earned income tax credit A success story for the working poor Provides credits to workers within low incomes

Essentially a negative income tax for some levels of income

EITC

How it worked in 2006 for a family with 2 or more kids 40% credit for first $11,340 earned No additional credit for next $5,470 earned Phased out at a 21.06% rate after $16,810 is

earned, until the credit is gone at $38,348 earned

The earned income tax credit

What has the EITC done?

Households with nobody working Encourages one person to work

Households with one person working Additional work not encouraged once a family with

2+ kids earns $11,340 Does not encourage additional hours of work of the

person already working Does not encourage a second worker in the household

to work

Other ideas

Negative income tax Supply a lump sum to everyone, then tax income

more heavily Problem: Incentive to work for pay diminishes

Some people will stop working and will pay no taxes

Minimum wage Problem: Increased unemployment

What about public employment? Public employment of the unemployed To be successful…

Needs to have enough incentives for unemployed people to want to work

Needs to have incentives low enough for employed people to stay in their old job

Future of social insurance?

Academics are starting to study alternate ideas to help the poor Providing benefits to those most in need, rather

than those that are already “in the system” “One-stop shopping” for help Faith-based support

Government provides cash to the faith-based organization, and the organization provides the service

Overview

-40%

-20%

0%

20%

40%

60%

80%

100%

$0

$5,0

00

$10,0

00

$15,0

00

$20,0

00

$25,0

00

$30,0

00

$35,0

00

$40,0

00

$45,0

00

$50,0

00

$55,0

00

Annual Earnings

Marg

inal

Tax R

ate

Source: Holt [2005, Part D, Figure 1].

Figure 13.10: Estimated effective marginal tax rates for a one-parent, two-child household residing in Wisconsin (2000)

Summary: Welfare programs for the poor Many programs exist to support poor people Some programs give little economic incentive

to work Exception: Earned income tax credit

Recall Timothy

Timothy is currently working 1,500 hours per year Hourly wage is $10 He also receives government health care, valued

at $3,000 per year Timothy could work a second job for 700

hours per year Hourly wage is $8 With the second job, Timothy would make too

much money for government health care

Now we add value to leisure

New problem Tabitha has 24 hours per day

Each hour can be used only for labor (L) or leisure (l) Tabitha’s wage is $10 per hour worked She receives $5 in Medicaid benefits per day if she

earns no more than $60 M denotes the daily earnings plus Medicaid benefits, if

any Tabitha has the following utility function

U(M, l) = 2(M½) + l

Tabitha’s problem

Two cases No Medicaid benefits Work 6 hours or less and receive Medicaid

benefits

No Medicaid benefits

Maximize 2(M½) + lsubject to (M/10) + l = 24

Same as Maximize 2(M½) + lsubject to l = 24 – (M/10)

Same as Maximize 2(M½) + 24 – (M/10) FOC set equal to 0: 1/M½ – 1/10 = 0 M = 100

10 hours worked, 14 hours of leisure

What is Tabitha’s utility w/o Medicaid? 10 hours worked, 14 hours of leisure U(100, 14) = 2(100½) + 14 = 34

What about if she works less? Notice that this problem is almost the same Maximize 2(M½) + l

subject to (M/10) + l = 24.5 The Medicaid benefit acts like 0.5 hour of work

benefits Using the same steps as previously, M = 100

We can’t work that much to get the benefit, so the closest we can get is by working 6 hours Total M is 65 ($60 in wages, $5 in Medicaid benefits)

What is Tabitha’s utility with Medicaid? 6 hours worked, 18 hours of leisure U(65, 18) = 2(65½) + 18 = 34.12

What should Tabitha do?

If she works 10 hours (no Medicaid benefit)… U(100, 14) =

2(100½) + 14 = 34 If she works 6 hours

(with a Medicaid benefit)… U(65, 18) =

2(65½) + 18 = 34.12 Tabitha should work 6

hours and accept the Medicaid benefit

Hours of leisure per year

Inco

me

per

year

0 T

D

M

N

R

S

X

Z

$5

How do we solve poverty?