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 Rupees 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 Rs.15,000.
Any person who would make under Rupees.15,000 by working has no incentive to find and keep a job. For every rupee that the person would earn, the government would reduce the income supplement by a rupee. In effect the government taxes 100 per cent of additional earnings.
The adverse effects of this 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.
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 per cent so that poor families are worse off when they earn more. By trying to help the poor, the government discourages those families from working.
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 rupee it earns, then it faces an effective marginal tax rate of 30 per cent. 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 more the program costs. Thus, policymakers face a trade-off 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 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 the 1996 welfare reform bill which imposed a 5 year lifetime limit on welfare recipients. Welfare should be a second chance, not a way of life.
How has the reform worked? The debate over the bill persists to this day, but there is no doubt that its passage was followed by a large decrease in the welfare rolls and a large increase in employment among those groups traditionally on welfare.
This nation transformed its assistance programs to poor families, with children from cash assistance oriented programs aimed at providing income support, to work assistance programs aimed at encouraging and supporting work. Critics can argue that the changes have left us with an inadequate safety net, in which an increasing number of families will be unable to return for assistance due to time limits, past sanctions, and limited state funds. Meanwhile work requirements force women into unstable, difficult work situations with low wages and inadequate support for child care, health, career and other family needs. Supporters can argue that the system has now worked for seven years. Due to a mix of economic good fortune and well-designed policies, a substantial number of women who should previously have been receiving welfare are now in employment building a record of experience and demonstrating to their children the importance of work preparation. Dire predictions about deep poverty and greatly increased homelessness have not come to pass. Even if the work support system is far from perfect, it may be preferable to the poorly functioning welfare system of the past.