, , , , , , , , , , , , , , , , , , , , ,

welfare cliff

People respond to incentives. That does not, in and of itself, make some people “energetic” and others “lazy”. To the contrary, it really means they are responsive and capable of calculating rewards. Critics of the welfare state are sometimes accused of labeling welfare recipients as “lazy”, which is absurd and a cop-out response to serious questions about the size, effectiveness, and even the fairness of means-tested benefits. The structure of welfare benefits in the U.S. often penalizes work effort and market earnings. That being the case, who can blame a recipient for minimizing work effort? From their perspective, that is what society wants them to do. Note that this has nothing to do with the provision of a social safety net for those who are unable to help themselves.

The welfare incentive phenomenon is explored by Zero Hedge under the Fight Club nom de guerre Tyler Durden in “When Work Is Punished: The Ongoing Tragedy Of America’s Welfare State“:

At issue is the so-called “welfare cliff” beyond which families will literally become poorer the higher their wages, as the drop off in entitlements more than offsets the increase in earnings.

The cliff looks different in different states and even differs by county. The chart at the top of this post is for Pennsylvania, from the state’s Secretary of Public Welfare, though I saw it on this post from LiberalForum. (Go to the link if the image is not clear). The Zero Hedge post linked above includes a dramatic illustration for Cook County in Illinois. Not many welfare recipients participate in all of the programs shown in the charts, but the point is that many of the programs create nasty incentives that tend to “trap” families at low income levels. Often, these workers and their families would be better off in the long-run if they were to suffer the consequences of the cliff in order to gain more work experience. Unfortunately, few have the resources to ride out a period of lower total income precipitated by the cliff. Another obvious implication is that increases in the minimum wage would actually harm some families by pushing them over the cliff.

Welfare cliffs differ by the recipients’ family structure (one- versus two-parent households, number of children) and do not apply to every welfare program. For example, the Earned Income Tax Credit (EITC) is very well-behaved in the sense that additional work and/or wage income flows through as a net gain the household. While most welfare programs involve a benefits cliff, incentives are undermined even before that point. A flattening in the level of total income as earned income rises indicates that the recipient faces an increasing marginal tax rate. The chart above shows that total income is relatively flat over a range of earned income below the income at which they’d encounter the cliff. This flat range starts at an earned income of $15,000 to $20,000 and extends up to the severe cliff at almost $30,000.

Zero Hedge quotes a report from the Illinois Policy Institute:

We realize that this is a painful topic in a country in which the issue of welfare benefits and cutting (or not) the spending side of the fiscal cliff have become the two most sensitive social topics. Alas, none of that changes the matrix of incentives for Americans who find themselves facing a comparable dilemma: either remain on the left side of minimum US wage and rely on benefits, or move to the right side at far greater personal investment of work, and energy, and… have the same (or much lower) disposable income at the end of the day.

Another interesting take on this issue is offered by Dan Mitchell, who cites a recent National Bureau of Economic Research (NBER) paper, which finds:

…the decline in desire to work since the mid-90s lowered the unemployment rate by about 0.5 ppt and the participation rate by 1.75 ppt. This is a large effect…

The findings suggest that the welfare reforms of the 1990s actually had positive effects on work effort, though even the EITC creates some incentive problems for second earners. Worst of all is the incentive impact of expanded disability benefits, which have undone some of the gains from reform. Newer programs like Mortgage Assistance and now, Obamacare, have added to the work disincentives. Mitchell cites other research that reinforce these conclusions.

The welfare cliff harms economic efficiency by distorting the offer price of labor, by increasing costs to taxpayers, and by reducing the availability of productive resources. It is grossly unfair because it consigns its intended beneficiaries to a life of dependency. What a waste! Here is Mitchell’s prescription:

Regarding the broader issue of redistribution and dependency, I argue that federalism is the best approach, both because states will face competitive pressure to avoid excessively generous benefits and because states will learn from each other about the best ways to help the truly needy while minimizing the negative impact of handouts on incentives for productive behavior.

A side effect of negative welfare incentives is that they increase the relative benefits of participating in illegal income-earning activity. The “War on Drugs” exacerbates this effect by driving up drug prices. Of course, this activity is untaxed, and because it is unreported, it does not push the recipient toward the benefits cliff. This is another example of different government policies working at cross purposes, which is all too common.