Public Finance (MPA405)

Dr. Khurrum S. Mughal

Lecture 18: Government Subsidies and Income Support for the Poor

Public Finance

Subsidizing Food

• Food Stamps are the subsidy that allows the recipient a particular allotment of vouchers to buy food but the recipient may supplement the subsidy with their cash. It is illegal to sell the food stamps though it may be in the recipients interests for them to do so.

• Two different Cases

The Impact of an In-Kind Transfer: Food Stamps

• Person initially at E1• Can use subsidy for food

only so BC is not attainable• Cash grant could enable her

to attain that point• Total food consumption is

grant plus her own spending

• Grant frees some of her income for consumption of other goods

Ex

pe

nd

itu

re o

n O

the

r G

oo

ds

pe

r M

on

th (

Do

llars

)

0 QF

A

B

I

A

U2

U1

A'

M2

M1

QF1 QF2

Food per Month

C

F

E2

E1

The Impact of an In-Kind Transfer: Food Stamps

0

B

B

I

A

U2

U1

A'

M1

QF1

L

U3

QF

Food per Month

Q* 1

QF2

E2

E1

C

• Person initially at E1• Can use subsidy for food

only so BC is not attainable• Moves to pint C on U2• Cash grant could enable her

to attain that point E2 at U3

Implication

• Given that on average recipients would spend more per person than the grant

• So the subsidy can be treated as substitute of cash grant

• Only a situation where the subsidized amount is low enough

International Food Subsidies

• Several nations use a price-reducing subsidy to make food more affordable.– Programs that reduce the price of food benefit

higher-income people as well.

• Some nations only subsidize food that is typically consumed by the poor.

• Some nations distribute food directly.

The Impact of Government Assistance Programs on Incentive to Work

• Grant ensures minimum level of income independent of work

• Larger the grant size, greater is the disincentive to work– Because of income effect that makes work

unfavorable

• Transfers could cause people to work more or less depending on whether leisure is a normal good.

The Impact of Government Assistance Programs on Incentive to Work

• Economic Analysis can be conducted by using indifference curve with leisure and work for pay.

• Leisure is engaging in any activity other than work for pay

• Maximum leisure per day is 24 Hrs

The Impact of Government Assistance Programs on Incentive to Work

• Budget Line: Person’s opportunity for giving up leisure for work

• Nonwage income is Zero– I = w(24-L)– Where I is income per day and L is leisure

per day

The Income Effect of a Transfer

Inco

me

per

Day

Leisure Hours per Day

0 L1 24

F

C

A

L2

D

U3

U2 U1

E1 E2

E3

G

TransferPayment

Implication

• Increase in transfer payments induces individual to increase leisure hours and reduce wok per day.

The Impact of Government Assistance Programs on Incentive to Work

• Another work disincentive– The way benefits are reduced as individual

earns more income

• A subsidy of BD shifts the budget line up– From the point he will be paid Point C in

figure

A Transfer that Declines with Earned Income

• Subsidy shifts Budget Line up to CD and decreases its slope with more leisure

• Meaning: Reduce the person’s real wage as he works less than 24-L*

• Move from E1 to E2 after subsidy

• Substitution as well as income effect

• Work increases work income but reduces transfer income

– An incentive to substitute

• Decreases the opportunity cost of leisure

• Low level of subsidies are desirable L* 24 L2 L1

MaximumDaily

Transfer

Leisure Hours per Day

Inco

me

per

Day

U2

U1

A

D

B

C E1

E2

Empirical Evidence

• A 10% increase in welfare payments to individuals decreases work effort by 2%.– Even if welfare benefits are reduced

substantially– Or rate at which they are phased out with

earnings is reduced– The increase in work would be insufficient to

reduce poverty

A Negative Income Tax

• A Negative Income Tax is a system where there is no status test but there is an income guarantee and a take-back rate.

• A minimum income guarantee for everyone

• People below the floor will receive subsidies, while above that people will pay taxes

• Floor would vary with household size

A Negative Income Tax

• T = IG – tNIE

Where• IG = Income guarantee• tN = take back rate• IE = earned income• T = Transfer

Break-Even Income

0 = IG – tNIB

IB = IG/tN

Negative Income TaxEarned Income IE Transfer T = IG – tNIE Disposable Income ID

0 5,000 5,000

1,000 5,000 – (.5 × 1000) = 4,500 5,500

2,000 5,000 – (.5 × 2000) = 4,000 6,000

3,000 5,000 – (.5 × 3000) = 3,500 6,500

4,000 5,000 – (.5 × 4000) = 3,000 7,000

5,000 5,000 – (.5 × 5000) = 2,500 7,500

6,000 5,000 – (.5 × 6000) = 2,000 8,000

7,000 5,000 – (.5 × 7000) = 1,500 8,500

8,000 5,000 – (.5 × 8000) = 1,000 9,000

9,000 5,000 – (.5 × 9000) = 500 9,500

10,000 5,000 – (.5 × 10000) = 0 10,000

A Negative Income Tax

• Implication:– A very expensive program if IG is set at a reasonable level.

– Assuming IG equal to $20, 000 per year for a family of four and tN = 50%

– All families of four with income less than $40,000 will be eligible, specially in absence of status test

– If tN is set lower to improve work incentive like 20% then the break-even income level would rise to $100,000 per year

– Tax rates and prices of other Govt services would have to increase a lot to finance such activity

A Negative Income Tax Plan

IG

IB

An

nu

al D

isp

os

ab

le In

co

me

(I D

)

45º

Transfers

Taxes

Annual Earned Income

Wage Rate Subsidies

• Wage Rate Subsidies are government additions to wages designed to increase the pay of the working poor.

Wage Rate Subsidies

Wage Paid Subsidy per Hour

Total Wage Received

$2.00 $1.50 $3.50

$2.50 $1.25 $3.75

$3.00 $1.00 $4.00

$3.50 $0.75 $4.25

$4.00 $0.50 $4.50

$4.50 $0.25 $4.75

$5.00 $0.00 $5.00