The Distribution of Income: Losses in Efficiency Caused

Losses in Efficiency Caused by In-Kind Transfers In addition to losses in production from reduced work incentives, welfare programs also can cause overconsumption of subsidized goods. Some in-kind welfare benefits, like food stamps, give eligible recipients the right to consume a certain amount of food per year. The cash these people would have spent on food thus is freed for other uses. If the value of food stamps is no more than the recipients would have spent on food anyway, then the stamps are just like cash. However, if the cash value exceeds the amount recipients want to spend on food, then the stamps are worth less than their cash value. The recipients would be better off if they could sell the stamps for cash to use for items other than food. If the recipients do spend the entire value of the stamps on food, then some of them are forced by the program to spend more on food than they want. The value of food stamps received by most recipients is at such a modest level, however, that most recipients would spend that much on food anyway. Economists therefore believe that the food-stamp program causes little, if any, overconsumption of food. The medicaid program is fundamentally different from the food-stamp program in its effect on incentives. Rather than giving recipients the right to consume a certain amount of services, the program allows recipients to consume almost all the medical services they desire at zero price. The graph in Box 7 shows the impact of the medicaid program on the choices made by recipients. Given the price of medical services, such as an office visit at $25, a typical low-income person would consume five visits per year if he or she had to pay. This is the number of visits for which the marginal benefit just equals the $25 price. At zero price the person chooses to consume 10 visits per year, the number for which the marginal benefit of a visit equals zero. The availability of medicaid increases consumption of medical services by breaking the link between the price of the services and the right to enjoy their benefits. This tends to increase the overall demand for medical services and is likely to raise the price of these services to other consumers (shown in Box 8). Equity Versus Efficiency: The Inevitable Trade-Off Policies in the United States designed to reduce income inequality represent a combination of taxes and transfers. Upper-income people are subjected to higher federal income tax rates. Under the Tax Reform Act of 1986, most families with incomes close to or below the poverty line are entirely exempt from federal income taxes. The use of taxes and transfers to alter income distribution can also affect incentives to work, invest, and use resources in the most efficient way. In the preceding section we discussed the impact of programs of assistance to the poor on their incentives. In this section we look at the inevitable trade-off between efficiency and equity that prevails for the economy as a whole when policies redistribute income. Reducing income inequality requires reducing the income of those with the highest earnings and greatest wealth. Such income reduction, say through taxation, can be used to finance increases in the income of the lowest-income groups. Unfortunately, as we have seen, there's no easy way to accomplish this task without reducing the incentive of low-income people to work. There's also another side of the coin: Those who pay the taxes to finance increases in income for low-income groups are also likely to have reduced incentives to work and save. When taxes are increased for upper- and middle-income people, they get to keep less of their earnings. The taxes they pay are therefore likely to distort their work and investment choices in ways that cause losses in the efficiency of resource use. One way to minimize the loss in efficiency is to have only programs of income redistribution that modestly reduce income inequality. This is apparently the course we Americans have chosen. Most studies of the net effect of both taxes and transfers on income redistribution show that the overall impact of U.S. government policies is only a modest inward shift of the Lorenz curve, as you can see in Box 9. Many studies conclude that except for the lowest-income groups, who pay little if any taxes, and some of the richest taxpayers, who pay more than the average percentage of their income in taxes, most taxpayers use the same percentage of their income to pay all federal, state, and local taxes. The combined effect of taxes and all transfer programs is probably a modest inward shift of the Lorenz curve, illustrated in Box 9.