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Public Finance II

by: Alan Doyle

Public Finance II ECON 681

Marketplace > Yale University > Economcs > ECON 681 > Public Finance II
Alan Doyle
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This 19 page Class Notes was uploaded by Alan Doyle on Thursday October 29, 2015. The Class Notes belongs to ECON 681 at Yale University taught by Staff in Fall. Since its upload, it has received 13 views. For similar materials see /class/231030/econ-681-yale-university in Economcs at Yale University.


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Date Created: 10/29/15
Lectures Notes on Welfare and Social Security Reforms Hanming Fang February 9 2002 Contents 1 Welfare Reform 0 2 11 Some Institutional Details 2 12 Welfare Reform Bill of 1996 4 13 Incentive Effects of the Welfare System Mo itt 1992 5 14 Workfare versus Welfare Besley and Coate 1992 5 15 A Proposal for Welfare Reform Keane 1995 12 16 ls Timelimited Welfare Compassionate Fang and Silverman 2001 14 Social Security Reform 16 21 Institutional Background 16 211 Basics of Social Security 16 212 The Oftenementioned Reasons for Social Security Reform 19 213 What are the Proposals of Social Security Reform 21 22 Social Security Privatization 23 221 A Privatization Plan Mitchell and Zeldes 1996 23 222 Evaluating the Social Security Privatization Plan Greanakopolos7 Mitchell and Zeldes 1998 24 23 The Effects of Investing Social Security Fund in Equity Market Abel AER 2001 26 1 WELFARE REFORM 2 1 Welfare Reform 11 Some Institutional Details Welfare programs are programs that transfer cash and consumption goods to the poor and destitute 1n medieval Europe the Church took responsibility for the poor The milestones in the US welfare programs are 0 In 1935 the federal government established Aid to Families with Dependent Children AFDC program and Supplemental Security lncome SS1 program under Social Security Act In 1960s under President Johnson War on Poverty Medicaid was established to prof vide medical assistance to poor families which is now the largest assistance program in dollar terms 0 On August 22 1996 President Clinton signed the Personal Responsibility and Work Opportunity Reconciliation Act PRWORA which changed the name of the assis tance program from AFDC to TANF Temporary Assistance for Needy Families PRWORA and subsequent state legislations changes on welfare constitutes what we meant by welfare reforms The major welfare programs include the following 1 AFDC and TANF cash program a combination offedeml and state programs states administer AFDC set the bene t levels and have discretion over rules federal contrie bution to the programs varies from 12 to 34 depending on the per capita income of the state There are huge state variation in the level of bene ts for example Alaska s bene ts are seven times higher than Mississippi From 1970 to 1996 total expenditure increased from 19 billion in 1996 dollars to 22 billion and total number of bene e ciaries increased from 74 million to 126 million average bene ts per family declined almost by half It is a meansetested program that is the bene ts are reduced as in come rises this implies that the effective marginal income tax rate could be as high as 100 percent TANF replaced AFDC from 1997 Two major differences from AFDC rst matching grants are replaced by block grants a xed amount of money second TANF focused on moving individuals from welfare to work the use of TANF funds l WELFARE REFORM 3 3 9 4 has to be consistent with federal priorities of strong work requirements time limits to receiving assistance a reduction in welfare dependency and the encouragement of twoiparent families A useful website is the Department of Health and Human Services Administration for Children and Families at http www acf dlihs gov EITC earned income tax credit supplements the income of lowiincome families with children by an amount which depends on their income and number of children Baa sically if an eligible family s income is below certain level the government gives it a negative income tax tax credit that could be as high as 40 The rate varies across states and income After 28495 one receives no credit for extra dollars earned The total expenditure on EITC grew from 125 billion in 1975 to 25 billion in 1996 Food Stamps This is a federal program enacted in 1975 with uniform bene t levi els The bene t level depends on income adjusted and housing expenditures are deductible Food stamp bene ts are limited to workingiage adults without In 1996 the average monthly bene ts were 7330 per person and 175 per household In 1996 food stamp bene ts are limited to workingiage adults without children no more than three months in a thirtyisix month period if they have not worked twenty hours a week completed a job training program or participated in a workfare program Medicaid o Enacted in 1966 provides medical assistance to the poor medical care to dis abled and nursing home care to the aged 0 It is a federalistate matching program The federal portion is about 5083 depending on the state s per capita income 0 The states have considerable discretion in determining eligibility and coverage 0 Recently covers about 36 million lowiincome individuals including 18 million children Historically families receiving bene ts under AFDC were eligible for medicaid Hence eligibility for medicaid is based on a threshold test those with income above the threshold essentially the cutoff level of AFDC are not eligible This creates a welfare lock because many employers do not provide medical bene ts 1 WELFARE REFORM 4 to low income workers many of those on welfare nd themselves in a dilemma even if they would like to work they lose eligibility for medicaid bene ts if they accept a job This is particularly important for those with children requiring medical attention 0 A new program called Children s Health Insurance Program CHIP is created to deal with this issue An interesting question is why welfare reform commands so much attention recently There are a couple of factors 1 It was felt that welfare had created a dependency and there was wide agreement that welfare system has to be reconstructed to help those on welfare get off welfare and be productive in the labor force Clinton End welfare as we know it A hand up not a hand out making work pay 10 A misperception The federal de cit reached record during Bush administration There was a widespread impression that welfare was largely responsible In fact in 1996 total welfare expenditures account for less than 10 of total federal expendii tures and excluding Medicaid they were only 4 9 After the passage of PRWORA the federal government turned a large surplus and the welfare rolls declined dramatically These two phenomena are correlated but welfare roll decline did not contribute to the federal surplus at all 12 Welfare Reform Bill of 1996 Its of cial name is Personal Responsibility and Work Opportunity Reconciliation Act of 1996 PRWORA Two main changes 1 It replaced the AFDC system in which the federal government paid a fraction of the state expenditure with a block grants of TANF Temporary Assistance to Needy Families 2 It imposed a number of stringent requirements designed to encourage movement from welfare to workfare H WELFARE REFORM 5 The three most important features of 1996 welfare reform bill are 0 Block granting The federal government gives each state a block grant which is a xed amount in exchange for the state s promise to continue spending on welfare support at least 75 of the amount that they had spent previously on welfare 0 Time Limits Federal rules stipulate that federal TANF funds may not be received by a family which includes an adult who has received sixty months of TANF funds previously 7 A state may exempt up to 20 of its caseloads from the ve year limit based on hardship 7 States can choose to support all families beyond ve years if they choose 7 Many states adopted a shorter twoiyear welfare eligibility 7 The hope is that these time limits would not only push people off the welfare rolls but also that they would discourage people from joining in the rst place Workfare Adults had to engage in some form of work after a maximum of two years of TANF bene ts and to participate unless the state opted out in community services after two months 20 hours minimum in 199771998 and 30 hours after 2000 This work requirement does not apply to single parents of children under age 6 who can not obtain child care 13 Incentive Effects of the Welfare System Mof tt 1992 To be added later 14 Workfare versus Welfare Besley and Coate 1992 This is an applied theory paper which addressed the following question How does work requirements in povertyialleviation programs provide incentives Two arguments are provided 0 Screening argument Workfare will direct povertyialleviation support toward the truly needy For this argument to work we need to have a model with unobservable types of earning abilities H WELFARE REFORM 6 o Deterrent Argument Work requirement will encourage povertyireducing investments For this argument to work7 we need to have a model in which the earnings ability can be changed by incurring some investment THE MODEL The government is concerned to ensure that each individual gets a minimum income level 2 at minimum scal cost 71 individual The income generating ability7 a is either IL or 0 with aL lt 04 Thinking of a as individual s wage rates suppose that in the population a fraction 7 of the individuals is of type 1L Worker s utility function over income y and work I is given by yihm where h gt 07 h gt 0 o A Povertyialleviation Program PAP is a pair of bene ts packages bl7 Ci 7 i L7 H where 7 bl is a cash transfer for individuals with ability i 7 cl is the time of the public sector work requirement The public sector work requirement is assumed to be noniproductive The government s problem is minn ybL 1 7 39y bH st yH 2 z MBA where yl is the income of an individual with type 01 combining the transfer and the income from the labor market PRELIMINARY ANALYSIS l WELFARE REFORM 7 0 An individual of type ai chooses which bene t package to claim and the amount of labor to put in the private labor market Denote 04 as the solution to hl 11 the amount of labor supplied in the private labor market is ai 7cifc ai l 0 1i 0 otherwise That is the labor supply in the labor market is independent of b due to the separable utility function hence there is no income effect 0 Private sector earning is then 117 c if c S ai y C 1139 0 otherwise 0 To make the problem interesting assume that y0aH gt z gt y0aL That is without government intervention only type L group is poor 0 The indirect utility level for type i worker when accepting pair I c is given by Ubcai b y 0411 7 h Note that U I c 11 is increasing in b decreasing in c and increasing in 11 BENCHMARK CASE OBSERVABLE AND EXOGENOUS ABILITY If ability is unobservable then the government s problem is min 71 ybL 1 7 39y bH bLCLbHCH Ri st U bHcHaH 2 U 00aH U bLcLaL 2 U 00aL bL y char 2 z Note that we have only the individual rationality constraints no incentive compatibility constraints are needed because we assume that abilities are observable 1 WELFARE REFORM 8 Claim The optimal solution is given by DH 00H0 CL OybLZy07aL The proof is very simple and omitted Hence if income generating abilities are observable and exogenous then the cost minimizing PAP is a welfare program ie imposes no work requirement CASE II UNOBSERVABLE AND EXOGENOUS ABILITIES UNOBSERV ABLE PRIVATE SECTOR EARNINGS Suppose that the government can not observe the private sector earnings In this case the individuals can masquerade and continue to work as much as they like in the private sector The government s problem is minn ybL 1 7 39y bH H V St UbHCHaH 20bLCLaH A 3 V UbLCLaL 2 UbHCHaL bLyCL7aL2Z CA3 V Discussions 1 If the policy maker can not impose work requirements ie if CH and CL are restricted to be zero then the only IC PAP is bL 1 because of the monotonicity of U in its arguments 10 The work requirement can be used to screen workers of different types because high ability workers have a higher opportunity cost of satisfying the work requirement For example in Figure 1 the PAP pairs bL CL 0 0 is an incentive compatible bene ts package CLAIM If both ability and private market incomes are unobservable then one of the following PAP is costiminimizing o Welfare Impose no work requirement and offer both groups transfers of 27y 0 1L 1 WELFARE REFORM U OzovaH aHl v U bL7 CL7 IL 07 07 aLl CL mm mm Figure 1 Incentive Compatible Bene t Packages 1 WELFARE REFORM 10 U 0707 1H 0707 1L Z i y 0 1L Figure 2 Optimal Workfare Packages 0 Workfare Offer selficategorized 1H individuals no bene ts and no work require ment and offer selficategorized aL individuals a transfer of z 7 y cg7 IL in exchange for work requirement of 0 Where 0 is the unique solution to U 070411 U z 7 y ciaH 703mg See Figure 2 for the illustration 0 Moreover7 the workfare solution is optimal if and only if 1 77aH gt aL The authors also consider the case Where the private sector earnings are observable7 and come up With similar characterization of the minimum cost PAP THE DETERRENT ARGUMENT OBSERVABLE AND ENDOGENOUS EARNINGS ABILITIES Suppose that individuals can ex ante make efforts to change their earning ability type 1 WELFARE REFORM 11 0 Assume that the probability an individual is of type 1H is given by 7T 6 where 7T is an increasing and strictly concave function The government rst chooses a PAP then individuals make their effort choices lndividuals maximize 7T 5 U bHcHaH 1 7 7T 5 U bLcLaL 7 e The rst order condition is 77 5 l0 szcHzaH U bLycLyaLH 1 Denote A bL CL bHcH E U bH CH 1H 7 U bLcLaL We hence have 5 5 A bLcLbH 011 That is the incentives to exert effort is provided by A If A 0 then 6 0 o The expected cost of a PAP is now M1 7W AWL ma mm De ne the maximal work requirement CLM by M M U Ziy CL 70 70L MIL U0707GL That is CLM is the work requirement which if coupled with a transfer suf cient to get the poor to the poverty line 2 would make them just indifferent between status quo and participating in the program See Figure 3 for the determination of CLM CLAIM Suppose that abilities are observable but depends partly on effort Then the cost minimizing PAP either 1 imposes no work requirement and offers low ability individual a transfer of 27y 0 1L 01 2 imposes work requirement CLM on 1L and offers them a transfer of z H WELFARE REFORM 12 aL CLM Figure 3 Determination of CLM 15 A Proposal for Welfare Reform Keane 1995 Keane 1995 proposes a novel idea for welfare reform All single mothers who work at least part time receive a 23 per week work subsidy which is taxed away at a 7 rate as earned income increases He showed by simulations that such universal work subsidy can save costs make more people work and make women better off How can a universal work subsidy save money while also increasing the utility of single mothers This can be illustrated in Figure 4 In Figure 4 Line ABC is a typical budget constraint created by the AFDC and food stamp programs Line EDC is what the budget constraint might look like without any programs the usual linear budget constraint assumed in the labor supply literature Thus the distances AE and BD are the bene t amounts at 0 and 20 hours At 40 hours at C bene ts go to zero The introduction of the work subsidy for any single mother who works at least part time in the market shifts the budget constraint to ABB C The distance ET is the amount of the subsidy for partitime work Since the subsidy is taxed away with earnings the subsidy amount for fullitime work CC is smaller than B B As shown in Figure 4 the introduction of the work subsidy will cause women who were choosing nonwork and full bene ts under the original AFDC and Food Stamps program to shift to partitime work and move to a higher indifference curve The work subsidy saves money on these switchers because the combination of subsidy and welfare bene ts paid to 1 WELFARE REFORM 13 Weekly Income A C C B B A D 4 E 40 0 20 Weekly Hours 0fW0rk Figure 4 How a Universal Subsidy Can Affect the Decisions to Work 1 WELFARE REFORM 14 her if she works partitime B D is smaller than the bene ts she was receiving when she did not work AE Of course the work subsidy is costly because some women who would have worked in the market anyway now receive a subsidy for doing so This effect causes costs to increase The net cost implication of such a work subsidy policy depends on the proportion of women who will switch from noiwork to partitime work It turns out that there is a large fraction of single mothers on this margin So the cost saving effect from the switchers more or less cancels out the cost increasing effect of the workers will slight cost saving It is cost effective to target the subsidy to encourage partitime market work because AFDC and food stamps bene ts for a typical single mother drop by roughly twoithirds if she goes from nonwork to partitime work that is ED is about 13 of AE Therefore of the possible savings that accrue to the government from getting welfare recipients to work most can be achieved by getting them to work just partitime What is the difference between this work subsidy proposal and the EITC EITC is more expensive because these tax credit payments are proportional to earned income which means that they are roughly twice as great for fullitime as for partitime work 16 Is Timelimited Welfare Compassionate Fang and Silverman 2001 Proponents of the recent welfare reform often argued for the new eligibility restrictions in the name of compassion for the poor Prominent law and opinion makers emphasized the value of welfare time limits and other restriction to recipients rather than to taxpayers or to society at large They like Dole claimed that while perhaps tough time limits and other welfare eligibility restrictions were truly more compassionate than the previous rules By encouraging the poor to enter the workforce the restrictions would not just be good for taxpayers the reforms would be good for the poor themselves The question is how might time limits on welfare eligibility and work requirements bene t the welfare eligible It is a fundamental property of standard economic decision problems that adding constraints to an agent s choice set cannot make her better off Come passionate time limits are therefore precluded by the standard framework This truism motivates our departure from the standard setup We allow agents to have presentibiased preferences and thus introduce the potential for both problems of self control and utility gains from restricting choice sets H WELFARE REFORM 15 THE MODEL 0 Discrete time7 nite horizon model with periods t 17 T 0 In each period7 an agent chooses one and only one of the following options 7 Welfare Welfare bene t is m and it represents cash assistance and the monetary value ofinikind aid such as food stamps7 housing subsidies and medical insurance The time limit on welfare eligibility is denoted by L gt 0 7 Work We assume that if an agent works her wage depends only on the cumulai tive number of periods she has ever worked7 denoted by T The wage experience pro le is denoted by w T ASSUMPTION There exists 0 lt T lt T such that w T lt m if T lt 7 and wr 2mifr2r 7 Home The third choice is for an agent to stay home without work or welfare We assume that by staying home an agent can generate endowment income e7 which7 without loss of generality7 is normalize to zero 0 We adopt a simple7 and now familiar formulation of agents potentially timeiinconsistent preferences 7 3767preferences Phelps and Pollak7 19687 Laibson7 1994 De nition 1 3767preferenees are preferences that can be represented by T For all t Ut ut uT E m 5 Z 6 where 5 e 016 e 01 4 st1 We characterize the behavior of agents with time inconsistent agents with and without time limits Some examples are as follows Example 1 Lack of Commitment Outcome Let 5 127 6 1 The wage pro le is In this example7 the agent will be on welfare in all three periods in the absence of time limits If a time limit of one period is imposed7 then the agent will work in all three periods 2 SOCIAL SECURITY REFORM 16 Example 2 Now or Never Outcome Let 5 126 1 The wage pro le is In this example the agent will work from date 1 in the absence of time limits If a time limit of 1 period is applied then the agent will be on welfare on period 1 and start working from period 2 2 Social Security Reform 21 Institutional Background 211 Basics of Social Security The source of information is H Joseph Stiglitz Economics of the Public Sector Third Edition Chapter 14 Social Insurance 10 Richard C Leone and Greg Anrig Jr Editors Social Security Reform The Century Foundation Press 1999 9 Daniel Shaviro Making Sense of Social Security Reform University of Chicago Press 2000 Social security also known as OldeAge Survivors and Disability Insurance OASDl is part of the social insurance programs in the US and it was enacted in 1935 It is intended to provide a basic standard of living to the aged the disabled and their survivors Workers contribute nancially to the system during their careers and earn entitlement to family bene ts upon retirement disability or death The other social insurance programs are medicare which provided medical care for the aged unemployment insurance also enacted in 1935 provides income to individuals during shorteterm spells of unemployment The US Social Security System The US Social Security System is organized as a modi ed payeaseyouego basis What does it mean In a pure payeaseyouego system the payroll taxes of those working today pay for the bene ts received by the elderly today The 2 SOCIAL SECURITY REFORM 17 US system is called a modi ed payiasiyouigo system because revenues and expenditures are not required to balance out each year instead it is required to be balanced over a seventyi veiyem horizon The balance between receipts and expenditures is added to or subtracted from the social security trust fund In contrast a private pension is a fully funded system that is each age group s pension is supported by its own contribution How are Social Security Financed Social Security is nanced by an earimarked payroll tax that is paid partly by employees and partly by their employers The payroll taxes consist of two components the social security tax and the medicare tax As of 2002 the combined social security tax rate is 124 on the rst 84900 with the employee and the employer both paying 62 But of course it does not matter whether it is your left or right hand that pays the bill The combined medicare tax rate is 29 with no income limit The social security tax rate and the maximum tax base have increased dramatically since social security was enacted year 1937 1967 1974 1981 ss rate combined 2 88 117 133 ss max income 3000 6600 13200 29700 Also the social security tax is paid purely on an individual not a household basis Thus married couple who both work pays more social security taxes What is the Nature of Social Security Program It is very important to note that the Social Security is not just a pension program it is also a redistribution program It is true that the bene ts an individual receives are linked to hisher contributions by a complicated formula and the more an individual contributes the more heshe gets back 7 just as in the case of private insurance But in private insurance an individual who spends 10000 to by an annuity policy would approximately get about ten times more the bene t of someone who spends 1000 1n social security this is not the case poorer individuals or those who have made smaller contributions get back proportionately more and married couples in which only one individual worked get back proportionately more than do couples in which both worked and earned similar income Unfortunately the redistributive nature of the social security program is never made clear to the American citizens How are Bene t Levels Determined The determination of the social security retirement bene ts can be summarized as follows Take the PIA on your AIME adjust for your 2 SOCIAL SECURITY REFORM 18 retirement age and spousal bene ts and then just index it by CPI if you know that it means Now I explain To Qualify To qualify for social security bene ts you must have worked during at least forty quarters Average Indexed Monthly Earnings AIME AIME is your average monthly wage for the best thirtyi ve years in your career However only covered earnings or those subject to social security tax under theniapplicable annual ceilings are counted Covered earnings from before you reached age 60 are indexed for both real and in ationary wage growth until you turn 60 Years other than your top thirtyi ve are ignored for bene t purposes and they are commonly called dropout years Primary Insurance Amount PIA PIA is the basic monthly payment that social security will offer you indexed for in ation if you retire at age 65 and that is adjusted for early or late retirement Hence subject to these adjustments it is the bottom line 7 the actual dollar amount on the check you get each month from social security How is PIA determined from AIME PIA is computed from AIME via a threebracket decliningirate formula You get 90 percent of your AIME up to a low dollar amount 32 percent of your AIME from that point to an indeterminate amount and then 15 percent for remaining covered earnings The dollar amounts in the above rate brackets depend on your year of birth so they can be indexed to wage growth which prevents the rst two brackets from gradually disappearing over time For example for workers who were born in 1937 and thus will reach age 65 in 2002 the 90 percent reimbursement rate applies to annualized AIME AIME multiplied by 12 from 0 to 6060 the 32 percent rate from 6060 to 36516 and the 15 percent rate above 36516 From the PIA formula you can see the distributional effects of the social security Retirement Age Under current year 2002 rules you get 100 percent of the PIA each month if you begin receiving bene ts at age 65 the normal retirement age One has the option of retiring at age 62 and getting only 80 percent of the PIA from then on or at age 67 or 70 and getting somewhat more than 100 percent These bene ts adjustments for early or late retirement are said to be roughly actuarially fair in the sense of not greatly biasing the average participant s choice between the alternatives After 2002 the normal retirement age will slowly increase until it reaches 67 in the year 2025


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