Summary The Economics of the Welfare State (Barr), part 1

Deze samenvatting is gebaseerd op het studiejaar 2013-2014.

Chapter 1: An introduction to the course

The welfare state is not a subject on its own; it fits into the framework of economic analysis. Also, the arguments made in theory do not only support the existence of the welfare state for equity reasons but also in efficiency terms. You might think of the welfare state as:

• A series of intuitions that redistribute income and wealth, provide poverty relief, and seek to reduce social exclusion, which is a ‘Robin Hood’ function.

• A series of intuitions that offer a mechanism for redistribution over the life cycle, which is the ‘piggy bank’ function, and which provides insurance.

There seems to be a general agreement that the major purposes of policy in Western societies embrace efficiency in the use of the resources; their distribution in accordance with equity or justice; and the preservation of individual freedom. However, these purposes might me shaped differently: to a utilitarian, the purpose is to maximize total welfare; to libertarians individual freedom is the most important, to Rawls the aim is social justice, defined in a particular way.

When defining the welfare state, 3 areas of complications stand out:

1. Welfare derives from many sources in addition to state activity. Individual welfare comes at least from the following 4 sources:

   1. The labour market is the most important, first through wage income, but also firms provide occupational welfare in the face of sickness, injury, and retirement.

   2. Private provision includes voluntary private insurance and individual saving.

   3. Voluntary welfare arises within the family and outside, where people give time free or at a below-market price, or make voluntary charitable donations in other forms.

   4. The state provides cash benefits and benefits in kind. It also contributes through tax concessions to the finance of occupational and private provision. Cash benefits have two major components:

      1. Social insurance is awarded without an income or wealth test, generally on the basis of (1) previous contributions and (2) the occurrence of a specified event, such as becoming unemployed or reaching a specific age.

      2. Non- contributory benefits. Universal benefits are awarded on basis of a specified contingency, without either a contribution or and income test. Social assistance is awarded on basis of an income test. It is to help families that are really in poverty.

2. Modes of delivery are also diverse. A service may be financed by the state, but it does not necessarily have to been produced publicly.

3. The boundaries of the welfare state are not well defined.

The term welfare state is used as shorthand for the state’s activities in 4 broad areas:

• Cash benefits

• Health care

• Education

• Food, housing, and other welfare services.

The welfare state exists to enhance the welfare of people that are

• Weak and vulnerable, largely by providing social care;

• Poor, largely through redistributive income transfers;

• Are neither of the above, by organizing cash benefits to provide insurance and consumption smoothing, and by providing medical insurance and school education.

Efficiency has several aspects:

• Macro-efficiency. At any particular time, the efficient fraction of GDP should be devoted to the totality of welfare-state institutions. This is known as static efficiency. Welfare-state institutions should be compatible with other objectives such as economic growth (dynamic efficiency).

• Micro-efficiency. Policy should ensure the efficient division of total welfare-state resources between the different cash benefits, different types of medical treatment, and different kinds of educational activity. The design of policy should choose between market allocation and government intervention in ways that achieve policy objectives better than any other approach.

• Consumption smoothing. This objective contributes to micro-efficiency. Institutions should enable individuals to reallocate consumption over their lifetime.

• Risk sharing. This objective contributes to micro-efficiency. This is a major objective of unemployment benefits and most health-related benefits.

• Incentives. Where institutions are publicly organized, their finance and the structure of benefits should avoid unnecessary adverse effects on labour supply and saving.

Equity also has multiple aspects:

• Relieving poverty. No individual/household should fall below a minimum standard or living.

• Reducing inequality involves both horizontal and vertical equity.

• • Vertical equity. The system should redistribute towards individuals/families with lowe incomes.

  • Horizontal equity. Differences in benefits should take account of age, family size, etc.

• Addressing social exclusion.

• • Social solidarity. Cash benefits and health care should foster social solidarity. Benefits should depend on criteria that are unrelated to socio-economic status.

  • Dignity. E.g. benefits should be delivered in ways that preserve individual dignity and without any unnecessary stigma.

Administrative feasibility has two aspects:

• Intelligibility. The system should be easy to understand, simple, and as cheap to administer as possible.

• Absence of abuse. Benefits should be as little open to abuse as possible.

The following government expenditures are important to distinguish:

• Absorption of goods and services which includes

  • Current spending;

  • Capital spending.

• Transfer payments, which include

  • Current grants to the personal sector;

  • Capital grants to the private sector.

Tax expenditures are implicit public expenditures in the form of tax relief. Cash assistance to help tenants to pay their rent is an explicit transfer; tax relief on mortgage interest payments is an implicit transfer. Tax expenditures can be done in two ways. Tax allowances can subsidize particular activities. Tax credits differ: a person’s tax bill can fall below zero.

Assessing the efficiency and redistributive impacts of the welfare state is a vast undertaking that raises both methodological and measurement problems. Two aspects assume special relevance: the notion of tax incidence (who pays the tax, who benefits, and how much?); and the importance of considering benefits and taxes together. To be sure of the efficiency of any policy or of its redistributive effects, it is necessary also to see how the general equilibrium of its production, consumption, and distribution is affected. The discussion of incidence concentrates on the effect, ceteris paribus, of changes in taxation or expenditure on the relative position of different income groups.

Looking to the future, a number of longer-term trends with major implications for the design of the welfare state recur throughout the book.

• Globalization. The increase of international trade and the result of technological change. Economic activity is increasingly ‘dematerialized’ rather than solid. Globalization reduces the ability of a country to act independently in designing its institutions. Countries with expensive welfare states, will increasingly be at a competitive disadvantage relative to those with more parsimonious ones. At the same time, demands on the welfare state are rising.

• Demographic change. Life expectancy has increased in all industrial countries while birth rates have declined, simultaneously increasing the number of the older people and reducing the number of younger workers.

• Changes in family structure. Families have become more fluid.

• Changes in structure of jobs. The nature of work changes. The demand for unqualified workers is lower than in the past, and, in consequence, their wages are low and their employment often precarious and part-time.

• Rising expenditure on the welfare state. Rising income leads to demands for higher insurance benefits and more extensive consumption smoothing, and to the adoption of a poverty line that rises in real terms. Also, more advanced medical technology extends the range of what is possible. Besides, population ageing will increase spending on age-related benefits, notably pensions, health care, and social care.

• Economic crisis. In the short run there was little change in the structure of benefits, with higher public spending on social protection financed by higher borrowing.

Two challenges stand out. A problem, both for economic and social policy, is the possibility that the strategic design of the welfare state is based, at least in part, on a past social order with stable, two-parent families, with high levels of employments, and where most jobs were full-time and relatively stable. Also, the conflict between economic growth and equality has become sharper of the years.

• The social-democratic approach. Policy was aimed at increasing the demand for labour through active labour-market policies and increased public-sector employment. The problem with this approach was its costs.

• The corporatist approach. Policy tried to reduce the supply of labour, notably through early retirement. The cost in this case is not that of public employment but public pensions.

• The neo-liberal approach. Policy sought to increase the demand for labour by liberalizing labour markets, not least through increased wage flexibility. The advantages of this approach are that it avoids heavy fiscal costs that the other two approaches incurred; and employment growth in those countries that adopted this approach was over the 1980s significantly higher than in the rest of the OECD.

Chapter 2: the state and social justice

A society is cooperative venture for the mutual advantage of its members. In general, it contains both an identity of interests and conflicts of interest between individuals and groups. The purpose of a theory of society is to offer principles that enable us to choose between different social arrangements. You can distinguish broadly three types of theory: libertarian; liberal; and collectivist.

• Libertarian. These are the descendants of 19th-century liberalism, though with important differences between ‘natural-rights’ and ‘empirical’ libertarians. The former (e.g. Nozick) argue that state intervention is morally wrong except In strictly limited circumstances. The latter (e.g. Hayek, & Friedman) are the modern inheritors of the classical liberal tradition. They argue against state intervention not on moral grounds, but because it will reduce welfare.

• Liberal. These theories find their philosophy in utilitarianism and in writers like Rawls. Their policy advocates in Beveridge and Keynes. It assumes societies are analyzed in terms of their individual members. Private property in means of production, distribution and exchange is a contingent matter rather than an essential part of the doctrine – the treatment of private property is explicitly regarded not as an end in itself, but as a means towards the achievement of policy goals. Liberal theories contain ‘a principle of distribution which could, suitably interpreted and with certain factual assumption, have egalitarian implication – in certain circumstances redistribution of income is an appropriate function of the state.

• Collectivism. Marxist theory draws it philosophy from Marx and its policies from writers such as Harold Laski. The theory assumes industrial society as consisting of social classes in terms of their relation to the means of production. Private property only has a limited role, and the allocation and distribution of resources in accordance with individual need is a primary concern of the state. Democratic socialists present an intermediate case. Though sharing to some extent the egalitarian view of Marxists, their analysis has much more in common with liberal thinking.

Laissez faire is a belief in the efficiency and effectiveness of market allocation and derives from two very different philosophical roots. Sometimes on a utilitarian or empirical basis, out of belief that such institutions maximize welfare. In contrast, sometimes by defending private property on moral grounds, as a natural right.

• Natural rights libertarians. Everyone has the right to distribute the rewards of its own labour (= justice in holdings). A person is entitled to a holding if he has acquired it through earnings (= justice in acquisition); or through the inheritance of wealth that was itself justly acquired (= justice in transfer). Holdings that do not apply to neither principle cannot be justified, hence government may redistribute holdings acquired illegally (= the principle of rectification). The propositions support the libertarian predilection for a ‘night watchman’ state with strictly circumscribed powers: the state can provide only one and only one public good – the defense our person and property, including enforcement of contracts, but has no distributional role.

• Empirical libertarians. The primacy of individual freedom; the value of the market mechanism; and the assertion that the pursuit of social justice is not only fruitless (because there is no such thing) but actively harmful. Freedom is defined as the absence of coercion or restraint; it includes political liberty, freedom of speech, and economic freedom, since the pursuit of equality will reduce/destroy liberty. The state has no distributional role, other than for certain public goods and for strictly limited measures to alleviate destitution.

According to the liberals, capitalism is regarded as more efficient than any other system; but it has major costs in terms of poverty and inequality; and government can ameliorate those costs. Therefore, a combination of capitalism and government action jointly maximizes efficiency and equity. This approach derives from utilitarian analysis and philosopher John Rawls.

The utilitarian aim is to redistribute goods (= goods, services, rights, freedoms, and political power) so as to maximize the total utility of the members of society. Goods must be produced and allocated efficiently; and they must be distributed in accordance with equity (though not necessarily equally).

According to Rawls, justice is desirable for its own sake on moral grounds, also, and importantly, institutions will survive only if they are perceived to be just. Rawls argues that there exists a definition of justice that is both general (i.e. not specific to any particular culture) and can be derived by a process that everyone can agree is fair. The original position is Rawls starting point. A contemplate group of rational individuals, all concerned only with their own self-interest, come together to negotiate principles to determine the distribution of goods. They are free agents in the negotiation, but they must abide by the resulting principle. Therefore, rawls uses the convention of a social contract. These negotiations will yield principles of justice that command universal acceptance. Therefore, Rawls abstracts the negotiators from their own society by placing them behind a veil of ignorance. They have general knowledge but each is deprived of all knowledge about himself – i.e. of his characteristics/endowments, his position in society, and the country or historical period into which he is born. The negotiators seek to advance their own interests, but are unable to distinguish them from anyone else’s. The only rational choice is to select principle in terms of the maximin rule – maximize the position of the least well-off individual/group. The original position, together with the veil of ignorance, is an analytical device, which reduces a relatively complex problem, the social choice of the principles of justice, to a more manageable problem, the rational individual choice of principles. Also, Rawls sees the procedure as a moral justification of the resulting principle – they will be seen to be fair, because they are selected in a manner that is both rational and fair; hence his term justice as fairness. Because of the veil of ignorance, the negotiators will choose to maximize liberty for everyone (= the liberty principle). Then, they will turn to the distribution of goods other than liberty. Each will reject any principle of distribution that could leave him disadvantaged or exploit (= the difference principle). Possible conflict between the two principles is ruled out by a priority principle, which gives the first principle absolute priority over the second.

Rawls is an explicit opponent of utilitarianism. He thinks it is illogical (it would be rejected by the negotiators) and unjust. Also, an answer in Paretian terms will not always be a just answer in Rawlsian sense. It has been argued that the negotiators would be unable to make any decisions behind the veil of ignorance. Rawls’s list of liberties may be too narrow, because the principle of toleration (e.g. the diversity of goals) inherent in Rawls’s definition of liberty may reflect class bias, and because some issues are left unresolved. Also, some writers dispute the priority given to liberty: poor people might be willing to trade some liberty for greater social or economic advantage. Besides, an optimal outcome under the maximin rule implies very restrictive assumptions. Some people emphasize that Rawls developed a liberal theory instead of a general theory of justice. According to Miller, social justice has three distinct elements: rights (e.g. political liberty; equality before the law); deserts (i.e. the recognition of each person’s actions and qualities); and needs (i.e. the prerequisites for fulfilling individual plans of life). Conflict may arise between the elements desert and need.

Socialist aims vary widely, but three – equality, freedom and fraternity – are central points. Equality is a variant of vertical equity and fraternity of the social solidarity aim. These aims can clash; and different writers assign different weights to the different terms; but together they make up the social definition of justice. Positive equalizing measures are needed, though not necessarily complete equality of income. The socialist concept embraces freedom of choice, and extends from legal and political relations to economic security. Socialists value cooperation and altruism more important than competition and self-interest. Socialists have criticism of the free market, it starts form the motive attributed to individuals to pursue personal advantage rather than the general good, and denies the libertarian view that the former brings out the latter. They regard the free market as undemocratic, in that some decisions with widespread effects are taken by a small elite, and the others are left to the arbitrary distributional effects of market forces. They say the markets are unjust because it distributes rewards that are unrelated to individual need or merit. Also, they state that the free market is not self-regulating. The market has not been able to abolish poverty, let alone inequality.

Exploitation of labour under capitalism is central in Marxist thought. In conventional economics, individuals are selling their labour services freely in a competitive market; wage is established at the point where labour demand equals its supply, this wage rate is equal to the marginal product of labour. Similarly, capital receives a marginal product, which is equal to the normal rate of profit plus any risk premium. Marx’s argument is in essence that exploitation arose because the capitalist was obliged to pay only a weekly wage sufficient to support the worker and his family at around subsistence, but could then extract as much output as possible by imposing long working hours. The surplus value is the difference between the value of a worker’s output and his wage and is, according to Marx, much greater than that necessary to yield a ‘normal’ rate if profit. Individuals with the only source being the sale of their labour have less power than the (fewer) people who own wealth or have independent access to the means of production. The capitalist mode of production causes conflict between the exploited working class and the small ruling class which derives power from wealth and/or political influence; that conflict is, according to Marx, inevitable. The ruling class dominates government decisions because of its economic power and because members of the economic elite share a common education and social class with the political elite. Accordingly, the government in a capitalist society prefers the ruling social society. Liberty cannot exist where economic and/or political power is distributed unequally; freedom, moreover, includes substantial equality and economic security. Equality to a Marxist does not necessarily imply complete equalization. It can be argued that the Marxist aim is not equality but meeting need.

Chapter 5: measurement and definition problems

Individual wealth broadly arises in three forms which each yields a flow of income.

• Physical wealth consists of consumer durables such as houses, machines and Picassos. It produces non-money income in the form of a flow of services, but can also yield money income.

• Financial wealth includes shares, government bonds, and bank accounts. This kind of wealth yields money income.

• Human capital is wealth embodied in individuals in the form of skills. It is the result of pas investment in education and training, but it also arises from ‘natural talent’. This type of wealth produces income in several forms. When working, human capital yields wages and non-money income like job satisfaction. When not working, he receives non-money income through the enjoyment of leisure, and also in the form of own production.

Full income Y_F = Y_M + Y_N where money comprises wage and non-wage money income and non-money income includes job satisfaction, the flow of services from physical wealth, the value of own production, and the enjoyment of leisure. For given prices, full income thus defined is a measure of an individual’s opportunity set, which measures the individual’s potential consumption, including leisure. Full income is not a complete measure of individual well-being. Non-money income is largely immeasurable.

If Uⁱ, the utility of the ith individual, depends on his income, yⁱ, social welfare, W, can be expressed as W = W (y¹, y², …, yⁿ). Thus, y¹, y², …, yⁿ measures the welfare of each of the n individual members of society. Let social welfare in state A be

W_A = W (y¹, y², …, y^iA, …, y^N),

and, in state B,

W_B = W (y¹, y², …, y^iB, …, y^N).

Appendix 1

Additivity implies that a person’s utility depends only on his own income, independent of anyone else’s income – a strong assumption that rules out the possibility of welfare interdependence and also rests uneasily with the relative definition of poverty. If a social-welfare function is non-decreasing, symmetric, and additive, it has the general form

Appendix 2

In absolute definition, poverty would mean that a person is poor if her money income is too low to keep her alive and healthy. People have different nutritional requirements, so that no universally applicable standard is possible; not is it reasonable to expect people to fill these requirements at minimum cost. Under relative definition, with deceptive simplicity, a person is poor if he feels poor. An absolute poverty line will remain fixed at subsistence; with a relative definition it will rise with living standards generally. As income rises, the demand for inferior goods falls, and they tend to disappear from the market. Formally, an absolute definition of poverty is more appropriate the more the utility of rich and poor depends only on their own incomes, and a relative definition is more appropriate the greater are income externalities.

Appendix 3

Social exclusion

• Embraces multiple sources of disadvantage, including low income, poor health, limited education, and poor housing.

• Is intertemporal, therefore, it embraces the life course. It is also intergenerational.

Multiple dimensions of deprivation characterize social exclusion; people may experience some or all; and the deprivations can have a cumulative effect. Each element of deprivation raises problems of definition and measurement. Also, boiling down different elements into a scalar measure of social exclusion is possible only by applying a vector of weights for the different elements. Such weights inescapably introduce value judgments.

Inequality is concerned with the differences between income groups – therefore, not with the absolute living standard of the poor. It might not be possible to reduce both poverty and inequality. The policy conclusion is not that attacks on inequality will increase absolute poverty, but that they might, making it important to be clear about the relative weights given to the different objectives of relieving poverty and reducing inequality.

The poverty gap considers the total shortfall from the poverty line, divided by (1) the poverty line or (2) total income. Index (1) gives a measure of the average depth of poverty, whereas (2) gives the relative cost of relieving it. Both approaches have been criticized, not least because a transfer from a poor person to a poorer person does not increase measured poverty. Foster (1984) proposed a poverty gap that gives greater weight to larger shortfalls

Appendix 4

Where Y = family income, and P = the poverty line. The value A = 0 gives the headcount; A = 1 gives an unweighted poverty gap; A = 2 gives a higher weight to greater shortfalls.

Individuals are equal if they face identical opportunity sets – that is face the same full income as in figure 5. However, full income cannot be measured, so matters in practice are more complex. An individual’s income depends on his endowments (e.g. of human capital or inherited wealth), his tastes with respect to work and leisure, consumption and savings, risk, etc.; and his luck, since outcomes have a stochastic element. Thus, individuals with identical tastes and opportunity sets may experience very different outcomes. Equality of opportunity exists if Y_F = K for all i = 1, 2, …, N. where Y_F is full income and there is a time dimension. Equality of opportunity implies that people should have an equal change – it is expected value, not an absolute value that should be equal. Equal opportunity can be said to exist id E(Y_F) = K for all i. This equation implies that expected income should be the same for all individuals. This is an adequate definition of equality of opportunity in terms of full income.

Appendix 5

C represent choice characteristics, these include age and any differences in individual choice that are the result of differences in tastes. But, if money income varies systematically with other characteristics (social class, gender, ethnic background, parental money income), we regard society unequal. These are the D (discrimination) characteristics. The equation states that equality of opportunity exists if the expected value of money income is the same for all individuals with given C characteristics, but must be invariant to their D characteristics. However, there are some difficulties involved:

• Using money income as a indicator of welfare raises problems even if we control for age and tastes, since any measure based on material well-being is incomplete.

• There is a problem of distinguishing a C from a D characteristic.

The design of taxes and benefits inescapably affects the behavior of family members; it is not possible to have a policy that does not affect incentives in these and other areas:

• Gender-neutral tax rates generally have different effects on husbands and wives because men and women have different labour supply elasticities.

• Consumption may be different depending on who gets the benefit.

• Policy design can encourage or discourage marriage. Taxes may be higher (lower) on two people if they remain single than if they marry, and similarly with pensions.

• Policy design can encourage or discourage mothers from taking paid work, depending on the design of childcare subsidies and income tax deductions, and additional factors such as the length of school hours.

Different choices can cause differences in money incomes in two ways.

• A and B may have different tastes about money income (i.e. different indifference maps). Suppose A has more money-intensive preferences compared to B, A might choose to work more and B might work fewer hours and/or choose work with more job satisfaction (i.e. higher non-money income). Both A and B maximize their utility: it does not make sense to regard them as unequal.

• There can be differences in acquired skills (hence different budget constraints). Again, there is no reason to suppose there is any inequality provided.

Money income is a misleading indicator of inequality.

Economic well-being, or ‘adjusted’ income, W, is related to gross disposable family income, D, and family size, S, where

Appendix 6

The equivalence elasticity, E, varies between 0 and 1. Atkinson et al. (1995) distinguished 4 approaches to setting a value on E to illustrate that there is no unambiguously ‘correct’ answer

• Statistical scales are developed to count people at or below a given standard of living.

• Programme scales are used for defining social assistance and similar benefits for families of different sizes.

• Consumption scales are based on observed spending patterns.

• Subjective scales attempt to measure the utility associated with different income levels.

The frequency distribution shows the number of income recipients at each level of income and can be represented as a continuous function or histogram. A dramatic way of representing the income distribution is Pen’s parade, in which each person marches past the onlooker. The parade lasts an hour and each person’s height represents his/her pre-tax income, a person with average income having average height. An natural way of trying to capture aggregate inequality is by a summary measure of dispersion like the variance:

Appendix 7

where H is invariant to the absolute level of income and sensitive to income transfers at all income levels, but gives greater weight to transfers to lower incomes. However, its downside is it only considers differences of income from the mean; and it squares those differences. Both procedures are arbitrary. In addition, H may not be concave at higher income levels – H can rise in the face of some transfers from rich to poor.

The Gini coefficient is based on the Lorenz curve; diagrammatically it is the ratio of the shaded area in figure 5.3 to the triangle OAB. The Gini coefficient is defined as half of the arithmetic average of the absolute differences between all pairs of income, the total then being normalized on mean income: appendix 8

The Gini coefficient is independent of the absolute level of income; it avoids the arbitrary squaring procedure of V, C, and H; and it compares each income not with the mean but with every other income. On the other hand, it gives ambiguous results when Lorenz curves cross.

Four sets of criticisms apply to all the descriptive measures:

1. They lack generality. V, C, and H all incorporate the arbitrary procedures of squaring differences from the mean.

2. They all incorporate an implicit and arbitrary social-welfare function with built-in welfare weights. The implied social welfare function for V and C values all reductions in inequality equally, even if redistribution is from a millionaire to a semi-millionaire. For H the implied social welfare function embodies weights derived from the logarithm function. The function underlying the Gini coefficient embraces weights based on rank order.

3. The descriptive measures give only a partial ordering of outcomes.

4. All measurement problems apply equally measures of inequality.

The Atkinson theorem on Lorenz ranking is remarkable for its generality. Assume:

• States A and B have income distributions given by (y^1A, y^2A, …, y^nA) and (y^1B, y^2B, …, y^nB), respectively.

• Total income is the same in states A and B.

• W is a social-welfare function that is non-decreasing, symmetric, additive, and concave.

The Lorenz curve for B lies wholly inside the Lorenz curve for A if and only if W_B > W_A for every social-welfare function with the four properties listed the last assumption.

• Welfare in state B is higher than in state A;

• The income distribution is unambiguously more equal in state B;

• The Gini coefficient compares distributions unambiguously;

• Conventional summary measures (e.g. V, C, and H) all show that inequality is lower in state B;

• If the Lorenz curves cross we cannot say whether inequality is greater in A or B and the Gini coefficient gives an ambiguous comparison. In addition, different inequality measures give different results.

Atkinson drew two major conclusions:

1. Where Lorenz curves cross, it is necessary to compare one income group with another.

2. Only where Lorenz curves do not intersect are explicit welfare weights not needed; in this case all the descriptive measures will agree.

The Atkinson inequality measure considers distributional values explicitly. It is non-decreasing, symmetric, additive, concave, and with constant relative inequality aversion, ε, as an explicit representation of distributional values.

Appendix 9

Chapter 8: relief of poverty

Cash benefits regarding income poverty can be divided into three sorts:

• Benefits awarded on the basis of an income test or wealth test – only where income or wealth falls below a prescribed limit you can get a benefit (e.g. social assistance, housing benefit.

• Benefits based on an income test and additional criteria – e.g. the requirement to be in paid work (e.g. working tax credits).

• So-called universal benefits, awarded without a contributions test or income test, on the basis of other criteria (e.g. child benefit).

From the multiplicity of benefits in different countries it is helpful to distinguish 5 archetypes:

• Social assistance. Social assistance (‘welfare’) in many countries is the final safety net for people whose family income from all other sources falls below a specified minimum. The amount of benefit a household/family is awarded generally depends on an assessment of needs, which will depend on the size of the family and any other factors such as disability; and on the family’s resources, for example earnings or other cash benefits net of any income that is disregarded. The implicit tax rate is a tax that arises when a family in receipt of an income-tested benefit earns extra income, and, as a consequence, loses benefit; if benefit is lost pound for pound with earnings, the implicit tax rate is 1000 percent (see box 8.2);

• Income-tested assistance of pensioners. In some countries anyone is in principle eligible for social assistance. There is a separate system of poverty relief for pensioners. Such systems may offer higher benefits or more generous taper provisions, since encouraging labour supply is less an issue for pensioners than for younger people;

• Income-tested assistance with housing costs. In some countries housing costs are part of social assistance, in others they form a separate programme. Benefits will typically depend on variables such as household / family size, total income, and the level of housing costs. As with social assistance, some incomes may be disregarded, but benefits are withdrawn for income in excess of the disregard;

• Working tax credit / earned income tax credit. This tax credit is aimed at the working poor, with the objectives of relieving poverty and increasing labour-force participation. It is an income-tested poverty relief conditional on the recipient working at least X hours in a week. Benefits may differ between certain types of household (e.g. single parent, families with more children, people with disabilities). The benefit is withdrawn at a rate of x cents per euro of additional earning.

• And child benefit / family allowance. In many countries the child benefit is paid at a flat rate per child, often to the mother, and often without an income test. This allowance is a natural complement to the non-contributory pension. It can also be seen as an element in consumption smoothing, because it contributes to family income at a time when needs are high and income may be reduced by the loss of a second earner.

These benefits cover three broad categories of people:

• Those who contributory social insurance benefits (despite compulsory membership) leave them in poverty.

• Those without social insurance cover because they have exhausted their entitlement or because they never had any (e.g. a school leaver, or a recently divorced woman with no recent contributions).

• Those whose reason for poverty is not covered by contributory benefit (e.g. a low-paid head of a large family, who has to rely on working tax credit and child benefit).

Much poverty is associated with children and/or high housing costs, neither of which is an insurable risk. Private insurance is not possible inmost of these cases; nor is extending social insurance a complete answer. Not helping people that need social assistance (even with ignoring equity arguments) is not an answer since it has a range of efficiency costs, including social unrest/crime among those facing starvation; the death by starvation of dependants including children, who are the future labour force; and the fact that malnutrition causes poor health, thereby raising health-care costs and lowering the capacity of adults to work and of children to absorb education. These costs give efficiency grounds for publicly provided income support.

From the viewpoint of social justice, libertarians incline towards private charity where poverty is caused by a non-insurable risk. Writers such as Friedman and Hayek do not oppose subsistence payments out of public funds, though they favour every inducement to encourage people to work. Socialists, in contrast, argue for generous benefits paid on the basis of need, to advance their egalitarian objectives. Whether benefits should be above subsistence, and if so by how much, has no definite answer.

The following are criteria for assessing redistributive schemes:

• Adequacy. Are benefits large enough to give recipients a socially acceptable standard of living – does it relief poverty?

  • Money benefits. Does the scheme pay enough to allow people to buy an adequate consumption bundle?

  • Stigma. For any field level of money support a person’s living standard is reduced to the extent that he/she feels stigmatized by receiving benefit.

• Coverage involves the following two aspects:

  • Horizontal efficiency is concerned with avoiding gaps – benefits should go to all the poor.

  • Vertical efficiency is concerned with avoiding leakages – benefits should go only to those who need them. This reduces the cost of the scheme, but may involve high implicit tax rates and the poverty trap – a situation in which individuals/families earning an extra one unit of currency lose (at least) one unit of currency of income-tested benefits, and hence make themselves absolutely worse off. Such people have no financial incentive to work longer hours. A distinct from the unemployment trap.

• The cost criterion embraces the benefits themselves and administrative costs.

There are three approaches to targeting:

• Income test, where the amount of benefit is directly related to individual/family income. This involves important costs. It might create major disincentives between work effort and saving. Also, it is intrusive to assess income and hence stigmatizing, particularly if the income unit is the family or extended family rather than the individual, so that the determination of eligibility requires all family members to reveal their income. Besides, measuring income is administratively demanding, because of the necessity to measure the applicant’s income and to keep his/her circumstances under review.

• Indicators of poverty, where benefits are based on easily observable characteristics that are highly correlated with poverty. This method can have significant advantages over income testing. Disincentives for recipients are weaker. Where the indicator is observable, it is less demanding administratively. Finally, it is possible to use an indicator which facilitates self-targeting. Disadvantages of this method are gaps in coverage that arise because of some people with incomes below the poverty line that may not have the relevant characteristics, thus the indicators are not completely horizontally efficient. Also, there may be leakages, because some persons will have the necessary characteristics, but are not poor, so that the indicators are not completely vertically efficient.

• Self-targeting. Sometimes it is possible to improve targeting by creating incentive structure under which the choices of claimants act as a signalling device. The price subsidies approach subsidizes a carefully chosen bundle of goods consumed disproportionally by the poor. Also, the conditional benefits approach might be used which benefits on specific actions by the recipients. It advantage is that it benefits all who come forward and only those who come forward; and the only people who claim are those who genuinely cannot find higher paying work. Two potential disadvantages are that targeting may be imperfect, there might be leakages and gaps, and, additionally, not everyone agrees that this approach contributes to social justice.

Keeping the absolute definition of poverty in mind, social assistance offers generally benefits high enough to relieve poverty in high-income countries, at least in the narrow sense that nobody starves. An important issue is whether benefits are high enough to not just relieve immediate poverty, but to prevent it in the longer term.

In most high-income countries, in principle, everyone is covered; a significant number of eligible recipients do not receive benefit – that is, take up is incomplete. On the supply side, some eligible applicants may not be awarded benefit: an official may take a narrow interpretation of regulations or be unaware of certain entitlements. There also may be demand-side reasons, in that an unknown number of eligible people do not apply for benefit. This might be because of ignorance, inconvenience, and stigma. Inconvenience is concerned with the cost to the applicant of making a claim including time spent filling forms. Some writers argue that such costs may be deliberate, to avoid the worst problems of adverse selection and moral hazard. The underlying argument is that the imposition of costs on claimants assists the operation of self-targeting. Stigma might arise if individuals feel that, if they receive the benefit, they will be labelled as belonging to a socially rejected group. These issues all had to do with horizontal efficiency. Vertical efficiency aims to withhold benefit from those who do not need it. Expenditures on poverty relief have increased over the years because of rising unemployment and other reasons for non-participation.

A range of income-tested benefits helps with housing costs, which raise similar issues to income support: benefits targeted tightly to contain costs conflict with laboratory-supply incentives. The problem can be particularly acute with housing because housing costs are generally large, so that the taper, which creates a labour-supply disincentive, applies over a long range of income, and, besides, because the effect is likely to be strongest in cities, which are the most likely place to find a job but also the place where housing costs tend to be the highest hence the disincentive problem is greatest.

One of the main causes of low income is the lack of a job. Subsidizing employment leads to reduction in the relative earnings of people with low skills, and their labour-force participation rates. By tying benefit to work, people have an incentive to find (or keep) work so as to qualify. See also figure 8.2. At B₁ (maximum benefit) the poverty relief is stronger, and so is the incentive to join the workforce. However, fiscal costs will be high – not only the cost of benefit for people with earnings below E₂, but also because the taper beyond point c takes place at higher levels of earnings; hence more people qualify for at least some benefit. If a is small, the incentive to participate is stronger, but the hours worked might be lower. The slope of c-d represents the rate of taper raises the standard targeting dilemma of costs versus disincentives. A steeper slope makes a corner solution at c more likely; it reduces labour supply, but also reduces fiscal costs.

Having children is highly correlated with poverty. Family income tends to be low precisely at the time when the demands on that income are high; families with children systemically have low income relative to needs. Child benefit is administratively cheap because it generally has a single, once-and-for-all information requirement – a birth certificate.

Most countries have a pre-transfer income distribution heavily skewed towards the lower tail; benefits need to be fairly tightly targeted to contain costs. High marginal tax rates are widespread used in welfare systems. Consequently, low-income families cannot raise their net income significantly; and high tax rates bring about a substitution effect against work effort and so are potentially a major labour-supply disincentive.

Fixed-period awards enable the poor to raise their net income more easily, since benefit need not be lost at the time earnings rise. Also, the tendency for families to be trapped in poverty is less acute than the traditional view suggests. Further, labour-supply incentives may be improved. Temporary changes in earnings will not affect benefits; and even where increases are expected to persist, the tax rate relevant to labour-supply decisions is that perceived by recipients, which will depend on their rate of time preference. This is almost certainly high, because of liquidity constraints, because any increase in earnings may only be temporary. There are two other advantages of fixed-period awards. Firstly, if taxes are fully discounted, the withdrawal of benefit as income rises is analytically equivalent to a lump-sum tax collected at some time in the future, with all the welfare properties of lump-sum taxation. Secondly, they ameliorate the dilemma faced by public policy between the desire to preserve incentives by keeping tax rates low, and the need to reduce costs by targeting benefits tightly on those in needs.

Cash benefits may fail to relieve poverty for three sets of reasons:

1. The absolute level of benefits may be too low;

2. Coverage may be inadequate for certain groups, in the sense that they are poor but not eligible for benefit;

3. Take-up may be incomplete either (on the demand side) because of ignorance about entitlement, or stigma, or (on the supply side) because of maladministration or discrimination.

Because of three mean reasons dependence on means-tested benefits has tended to increase over time:

1. Rising unemployment;

2. Joblessness connected with lone parenthood and disability;

3. Changes in social-security policy.

In assessing the effectiveness of income transfers in relieving poverty there are some methodological issues:

1. There are many problems in defining the poverty line, the unit of receipt, and the distribution of income within that unit;

2. There is the value placed by recipients on the transfers: the value of cash benefits may be reduced by stigma, and that placed on in-kind transfers may be less than their market price;

3. There is the incidence of the transfers. Calculations ignore behavioural effects.

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