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?