Principlis of economics / principles_of_economics_gregory_mankiw

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IN THE NEWS

Should the Government Try

to Help Poor Regions?

first economic rule of urban poverty policy: Programs should be person-based, not place-based.

support on the basis of location. Examples of such policies are housing projects and enterprise zones. President Clinton’s recent Rural Housing and Economic Development Assistance for Kentucky or the new Empowerment Zone Grant for East St. Louis, Ill., are quintessential place-based policies.

The problem with place-based programs is that they create incentives to keep the poor in the ghetto. By subsidizing the place, not the person living there, these policies make it more attractive for the poor to stay in high-poverty areas. Indeed, current research shows that supposedly benevolent pro-poor housing and transfer policies play a major role in herding the poor into inner cities.

It’s hard to see the logic in artificially limiting migration and concentrating the poor in areas with low productivity. Movement out of low-productivity, highunemployment areas is one reason that unemployment rates in the U.S. stay low. Moreover, flight from the ghettos

enabled many African-Americans to the social costs of the inner city, black-white segregation in the U.S. declined substantially because of it. Place-based programs also suffer the fact that their benefits go dis-

proportionately to property owners in the areas—and not to the intended beneficiaries. If the government offers credits to firms that invest in a poor region, for instance, then firms will locate there, pushing up property values and rents. But the benefits of increased economic activity will evaporate as higher housing costs eat away the planned ben-

efits to the needy. . . .

If place-based policies are so bad, why are they so popular? A cynic might say that the residents of wealthy suburbs prefer that the poor remain in ghettos. A more practical explanation is that we have place-based politicians who lobby for place-based policies. . . .

A wise alternative to such faulty place-based poverty assistance would be a program that offers tax credits to companies that employ the disadvantaged. This would be a less distortionary means of assisting the poor.

SOURCE: The Wall Street Journal, August 12, 1999, p. A22.

NEGATIVE INCOME TAX

Whenever the government chooses a system to collect taxes, it affects the distribution of income. This is clearly true in the case of a progressive income tax, whereby high-income families pay a larger percentage of their income in taxes than do lowincome families. As we discussed in Chapter 12, equity across income groups is an important criterion in the design of a tax system.

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negative income tax

a tax system that collects revenue from high-income households and gives transfers to low-income households

Many economists have advocated supplementing the income of the poor using a negative income tax. According to this policy, every family would report its income to the government. High-income families would pay a tax based on their incomes. Low-income families would receive a subsidy. In other words, they would “pay” a “negative tax.”

For example, suppose the government used the following formula to compute a family’s tax liability:

Taxes owed (1/3 of income) $10,000.

In this case, a family that earned $60,000 would pay $10,000 in taxes, and a family that earned $90,000 would pay $20,000 in taxes. A family that earned $30,000 would owe nothing. And a family that earned $15,000 would “owe” $5,000. In other words, the government would send this family a check for $5,000.

Under a negative income tax, poor families would receive financial assistance without having to demonstrate need. The only qualification required to receive assistance would be a low income. Depending on one’s point of view, this feature can be either an advantage or a disadvantage. On the one hand, a negative income tax does not encourage illegitimate births and the breakup of families, as critics of the welfare system believe current policy does. On the other hand, a negative income tax would subsidize those who are simply lazy and, in some people’s eyes, undeserving of government support.

One actual tax provision that works much like a negative income tax is the Earned Income Tax Credit. This credit allows poor working families to receive income tax refunds greater than the taxes they paid during the year. Because the Earned Income Tax Credit applies only to the working poor, it does not discourage recipients from working, as other antipoverty programs are claimed to do. For the same reason, however, it also does not help alleviate poverty due to unemployment, sickness, or other inability to work.

IN-KIND TRANSFERS

Another way to help the poor is to provide them directly with some of the goods and services they need to raise their living standards. For example, charities provide the needy with food, shelter, and toys at Christmas. The government gives poor families food stamps, which are government vouchers that can be used to buy food at stores; the stores then redeem the vouchers for money. The government also gives many poor people health care through a program called Medicaid.

Is it better to help the poor with these in-kind transfers or with direct cash payments? There is no clear answer.

Advocates of in-kind transfers argue that such transfers ensure that the poor get what they need most. Among the poorest members of society, alcohol and drug addiction is more common than it is in society as a whole. By providing the poor with food and shelter, society can be more confident that it is not helping to support such addictions. This is one reason why in-kind transfers are more politically popular than cash payments to the poor.

Advocates of cash payments argue that in-kind transfers are inefficient and disrespectful. The government does not know what goods and services the poor need most. Many of the poor are ordinary people down on their luck. Despite their

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misfortune, they are in the best position to decide how to raise their own living standards. Rather than giving the poor in-kind transfers of goods and services that they may not want, it may be better to give them cash and allow them to buy what they think they need most.

ANTIPOVERTY PROGRAMS AND WORK INCENTIVES

Many policies aimed at helping the poor can have the unintended effect of discouraging the poor from escaping poverty on their own. To see why, consider the following example. Suppose that a family needs an income of $15,000 to maintain a reasonable standard of living. And suppose that, out of concern for the poor, the government promises to guarantee every family that income. Whatever a family earns, the government makes up the difference between that income and $15,000. What effect would you expect this policy to have?

The incentive effects of this policy are obvious: Any person who would make under $15,000 by working has no incentive to find and keep a job. For every dollar that the person would earn, the government would reduce the income supplement by a dollar. In effect, the government taxes 100 percent of additional earnings. An effective marginal tax rate of 100 percent is surely a policy with a large deadweight loss.

The adverse effects of this high effective tax rate can persist over time. A person discouraged from working loses the on-the-job training that a job might offer. In addition, his or her children miss the lessons learned by observing a parent with a full-time job, and this may adversely affect their own ability to find and hold a job.

Although the antipoverty program we have been discussing is hypothetical, it is not as unrealistic as it might first appear. Welfare, Medicaid, food stamps, and the Earned Income Tax Credit are all programs aimed at helping the poor, and they are all tied to family income. As a family’s income rises, the family becomes ineligible for these programs. When all these programs are taken together, it is common for families to face effective marginal tax rates that are very high. Sometimes the effective marginal tax rates even exceed 100 percent, so that poor families are worse off when they earn more. By trying to help the poor, the government discourages those families from working. According to critics of antipoverty programs, these programs alter work attitudes and create a “culture of poverty.”

It might seem that there is an easy solution to this problem: Reduce benefits to poor families more gradually as their incomes rise. For example, if a poor family loses 30 cents of benefits for every dollar it earns, then it faces an effective marginal tax rate of 30 percent. Although this effective tax reduces work effort to some extent, it does not eliminate the incentive to work completely.

The problem with this solution is that it greatly increases the cost of programs to combat poverty. If benefits are phased out gradually as a poor family’s income rises, then families just above the poverty level will also be eligible for substantial benefits. The more gradual the phase-out, the more families are eligible, and the greater the cost of the program. Thus, policymakers face a tradeoff between burdening the poor with high effective marginal tax rates and burdening taxpayers with costly programs to reduce poverty.

There are various other ways to try to reduce the work disincentive of antipoverty programs. One is to require any person collecting benefits to accept a

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IN THE NEWS

Welfare Reform

for work. The 1996 law limits families to two years of welfare income during any one spell and caps the total time on welfare over a mother’s lifetime at five years.

The number of recipients rose sharply from the early 1960s, to a peak in 1993, when over 4 million American families were on welfare. In that year, an incredible 1 million residents of New York City alone were receiving welfare, up from 250,000 in 1960.

Wisconsin, Massachusetts, New Jersey, and a few other states decided in the late 1980s that this upward trend in

welfare populations while at the same time improving the economic situation of single-parent families. Recently, a careful evaluation of the Massachusetts reforms by economists M. Anne Hill and Thomas J. Main of the City University of New York concluded that they not only greatly reduced that state’s welfare caseload but also encouraged more young women to finish high school and sharpen their economic skills.

What worked in Massachusetts and other pioneering states was applicable throughout the nation, but the reassessment of federal welfare policy

government-provided job—a system sometimes called workfare. Another possibility is to provide benefits for only a limited period of time. This route was taken in a 1996 welfare reform bill. Advocates of time limits point to the falling poverty rate in the late 1990s as evidence supporting this approach. Critics argue that time limits are cruel to the least fortunate members of society and that the falling poverty rate in the late 1990s is due more to a strong economy than to welfare reform.

QUICK QUIZ: List three policies aimed at helping the poor, and discuss the pros and cons of each.

CONCLUSION

People have long reflected on the distribution of income in society. Plato, the ancient Greek philosopher, concluded that in an ideal society the income of the richest

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was opposed by many intellectuals. Some members of President Clinton’s team quit after the 1996 federal law, over what they considered a betrayal of the welfare state. They argued that most women forced off welfare would become homeless or destitute, since they supposedly are too mentally or physically handicapped or lacking in requisite skills to obtain and hold jobs.

However, this law has been highly successful in reversing the large growth in the number of welfare recipients in the United States. Most mothers forced off welfare found work and provide financial support for their children.

Certainly, the huge decline—by over 40 percent—in the number of single mothers on welfare from the 1993 peak is partly due to the booming economy of the past seven years. However, most of this decline took place in the two years after the passage of the 1996 act. The study of Massachusetts’ experience cited earlier confirms the importance of

the new approach to welfare, since the authors’ research attributes more than one-third of the decline in that state’s welfare role since 1995 to the reforms and not simply to its buoyant economy.

The federal law recognizes that the number of families in need of assistance always rises sharply during bad economic times. This is why each welfare spell is allowed to last up to two years, and mothers with dependent children can have multiple spells, up to a total of five years over their lifetimes. It further acknowledges that some women are handicapped and unable to work. What it aims to discourage is the attraction of welfare to able-bodied women during good times when jobs are available.

The act also recognizes that many poor working mothers will not earn enough to provide a decent standard of living for their families. Children of unmarried working mothers continue to be eligible for Medicaid and food stamps, and they benefit from the earned-income

tax credit that is available only to poorer working parents with children.

One of the most important, if hardest to document, gains from taking families off welfare is their greater self-respect when they provide for themselves. Mothers on welfare convey the impression to their children that it is normal to live off government handouts. In such an environment, it is difficult for children to place a high value on doing well at school and preparing for work by seeking out training on jobs and in schools.

Welfare reform has been a resounding success in inducing unmarried mothers to find jobs. This revolutionary approach to welfare is based on the appreciation that the vast majority of families do much better when treated as responsible adults and offered effective incentives to help themselves.

SOURCE: Business Week, May 24, 1999, p. 18.

person would be no more than four times the income of the poorest person. Although the measurement of inequality is difficult, it is clear that our society has much more inequality than Plato recommended.

One of the Ten Principles of Economics discussed in Chapter 1 is that governments can sometimes improve market outcomes. There is little consensus, however, about how this principle should be applied to the distribution of income. Philosophers and policymakers today do not agree on how much income inequality is desirable, or even whether public policy should aim to alter the distribution of income. Much of public debate reflects this disagreement. Whenever taxes are raised, for instance, lawmakers argue over how much of the tax hike should fall on the rich, the middle class, and the poor.

Another of the Ten Principles of Economics is that people face tradeoffs. This principle is important to keep in mind when thinking about economic inequality. Policies that penalize the successful and reward the unsuccessful reduce the incentive to succeed. Thus, policymakers face a tradeoff between equality and efficiency. The more equally the pie is divided, the smaller the pie becomes. This is the one lesson concerning the distribution of income about which almost everyone agrees.

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Summar y

Data on the distribution of income in our society. The richest fifth of ten times as much income as the

Because in-kind transfers, the transitory income, and economic important for understanding difficult to gauge the degree of using data on the distribution of When these factors are taken into suggest that economic well-being distributed than is annual income

Political philosophers differ in of government in altering the Utilitarians (such as John Stuart

distribution of income to maximize everyone in society. Liberals (such

distribution of income as if we were ignorance” that prevented us from

stations in life. Libertarians (such as have the government enforce

ensure a fair process but then not be inequality in the resulting distribution

to help the poor—minimum-wage income taxes, and in-kind

each of these policies helps some poverty, they also have unintended side financial assistance declines as income

face effective marginal tax rates that high effective tax rates discourage escaping poverty on their own.

Key Concepts

poverty rate, p. 442 poverty line, p. 442 in-kind transfers, p. 444 life cycle, p. 444

maximin criterion, p. 448 libertarianism, p. 450 welfare, p. 452

negative income tax, p. 454

Questions for Review

1.Does the richest fifth of the U.S. four, or ten times the income of

2.How does the extent of income States compare to that of other

3.What groups in the population poverty?

4.When gauging the amount of transitory and life cycle variations difficulties?

a liberal, and a libertarian income inequality is permissible?

and cons of in-kind (rather than cash)

antipoverty programs can discourage the How might you reduce this

are the disadvantages with your

Problems and Applications

1.Table 20-2 shows that income inequality in the United States has increased during the past 20 years. Some factors contributing to this increase were discussed in Chapter 19. What are they?

2.Table 20-4 shows that the percentage of children in families with income below the poverty line is almost twice the percentage of the elderly in such families. How might the allocation of government money across

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different social programs have contributed to this phenomenon? (Hint: See Chapter 12.)

3.Economists often view life cycle variation in income as one form of transitory variation in income around people’s lifetime, or permanent, income. In this sense, how does your current income compare to your permanent income? Do you think your current income accurately reflects your standard of living?

4.The chapter discusses the importance of economic mobility.

a.What policies might the government pursue to increase economic mobility within a generation?

b.What policies might the government pursue to increase economic mobility across generations?

c.Do you think we should reduce spending on current welfare programs in order to increase spending on programs that enhance economic mobility? What are some of the advantages and disadvantages of doing so?

5.Consider two communities. In one community, ten families have incomes of $100 each and ten families have incomes of $20 each. In the other community, ten families have incomes of $200 each and ten families have incomes of $22 each.

a.In which community is the distribution of income more unequal? In which community is the problem of poverty likely to be worse?

b.Which distribution of income would Rawls prefer? Explain.

c.Which distribution of income do you prefer? Explain.

6.The chapter uses the analogy of a “leaky bucket” to explain one constraint on the redistribution of income.

a.What elements of the U.S. system for redistributing income create the leaks in the bucket? Be specific.

b.Do you think that Republicans or Democrats generally believe that the bucket used for redistributing income is more leaky? How does that belief affect their views about the amount of income redistribution that the government should undertake?

7.Suppose there are two possible income distributions in a society of ten people. In the first distribution, nine people would have incomes of $30,000 and one person would have an income of $10,000. In the second distribution, all ten people would have incomes of $25,000.

a.If the society had the first income distribution, what would be the utilitarian argument for redistributing income?

b.Which income distribution would Rawls consider more equitable? Explain.

c.Which income distribution would Nozick consider more equitable? Explain.

8.The poverty rate would be substantially lower if the market value of in-kind transfers were added to family income. The government spends more money on Medicaid than on any other in-kind transfer, with expenditures per recipient family amounting to roughly $5,000 annually.

a.If the government gave each recipient family a check for this amount instead of enrolling them in the Medicaid program, do you think that most of these families would spend that much to purchase health insurance? (Recall that the poverty line is below $15,000 for a family of four.) Why?

b.How does your answer to part (a) affect your view about whether we should determine the poverty rate by valuing in-kind transfers at the price the government pays for them? Explain.

c.How does your answer to part (a) affect your view about whether we should provide assistance to the poor in the form of cash transfers or in-kind transfers? Explain.

9.Suppose that a family’s tax liability equaled its income multiplied by one-half, minus $10,000. Under this system, some families would pay taxes to the government, and some families would receive money from the government through a “negative income tax.”

a.Consider families with pre-tax incomes of $0, $10,000, $20,000, $30,000, and $40,000. Make a table showing pre-tax income, taxes paid to the government or money received from the government, and after-tax income for each family.

b.What is the marginal tax rate in this system? (See Chapter 12 if you need to review the definition of marginal tax rate.) What is the maximum amount of income at which a family receives money from the government?

c.Now suppose that the tax schedule is changed, so that a family’s tax liability equals its income multiplied by one-quarter, minus $10,000. What is the marginal tax rate in this new system? What is the maximum amount of income at which a family receives money from the government?

d.What is the main advantage of each of the tax schedules discussed here?

10.John and Jeremy are utilitarians. John believes that labor supply is highly elastic, whereas Jeremy believes that

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labor supply is quite inelastic. How do you suppose their views about income redistribution differ?

11.Do you agree or disagree with each of the following statements? What do your views imply for public policies, such as taxes on inheritance?

a.“Every parent has the right to work hard and save in order to give his or her children a better life.”

b.“No child should be disadvantaged by the sloth or bad luck of his or her parents.”

T H E T H E O R Y O F

C O N S U M E R C H O I C E

When you walk into a store, you are confronted with thousands of goods that you might buy. Of course, because your financial resources are limited, you cannot buy everything that you want. You therefore consider the prices of the various goods being offered for sale and buy a bundle of goods that, given your resources, best suits your needs and desires.

In this chapter we develop the theory that describes how consumers make decisions about what to buy. So far throughout this book, we have summarized consumers’ decisions with the demand curve. As we discussed in Chapters 4 through 7, the demand curve for a good reflects consumers’ willingness to pay for it. When the price of a good rises, consumers are willing to pay for fewer units, so the quantity demanded falls. We now look more deeply at the decisions that lie behind the demand curve. The theory of consumer choice presented in this chapter provides

IN THIS CHAPTER YOU WILL . . .

See how a budget constraint

r epr esents the choices a consumer can af for d

Learn how indif fer ence cur ves

can be used to r epr esent a consumer’s pr efer ences

Analyze how a consumer’s optimal choices ar e

deter mined

See how a consumer r esponds to changes in income and changes

in prices

Decompose the impact of a price change into an income ef fect and a substitution ef fect

Apply the theor y of consumer choice to four questions about household behavior

463

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a more complete understanding of demand, just as the theory of the competitive firm in Chapter 14 provides a more complete understanding of supply.

One of the Ten Principles of Economics discussed in Chapter 1 is that people face tradeoffs. The theory of consumer choice examines the tradeoffs that people face in their role as consumers. When a consumer buys more of one good, he can afford less of other goods. When he spends more time enjoying leisure and less time working, he has lower income and can afford less consumption. When he spends more of his income in the present and saves less of it, he must accept a lower level of consumption in the future. The theory of consumer choice examines how consumers facing these tradeoffs make decisions and how they respond to changes in their environment.

After developing the basic theory of consumer choice, we apply it to several questions about household decisions. In particular, we ask:

Do all demand curves slope downward?

How do wages affect labor supply?

How do interest rates affect household saving?

Do the poor prefer to receive cash or in-kind transfers?

At first, these questions might seem unrelated. But, as we will see, we can use the theory of consumer choice to address each of them.

THE BUDGET CONSTRAINT :

WHAT THE CONSUMER CAN AFFORD

Most people would like to increase the quantity or quality of the goods they con- sume—to take longer vacations, drive fancier cars, or eat at better restaurants. People consume less than they desire because their spending is constrained, or limited, by their income. We begin our study of consumer choice by examining this link between income and spending.

To keep things simple, we examine the decision facing a consumer who buys only two goods: Pepsi and pizza. Of course, real people buy thousands of different kinds of goods. Yet assuming there are only two goods greatly simplifies the problem without altering the basic insights about consumer choice.

We first consider how the consumer’s income constrains the amount he spends on Pepsi and pizza. Suppose that the consumer has an income of $1,000 per month and that he spends his entire income each month on Pepsi and pizza. The price of a pint of Pepsi is $2, and the price of a pizza is $10.

Table 21-1 shows some of the many combinations of Pepsi and pizza that the consumer can buy. The first line in the table shows that if the consumer spends all his income on pizza, he can eat 100 pizzas during the month, but he would not be able to buy any Pepsi at all. The second line shows another possible consumption bundle: 90 pizzas and 50 pints of Pepsi. And so on. Each consumption bundle in the table costs exactly $1,000.

Figure 21-1 graphs the consumption bundles that the consumer can choose. The vertical axis measures the number of pints of Pepsi, and the horizontal axis