THIRD EDITION. ECONOMICS and. MICROECONOMICS Paul Krugman Robin Wells. Chapter 18. The Economics of the Welfare State

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1 THIRD EDITION ECONOMICS and MICROECONOMICS Paul Krugman Robin Wells Chapter 18 The Economics of the Welfare State

2 WHAT YOU WILL LEARN IN THIS CHAPTER What the welfare state is and the rationale for it What defines poverty, what causes poverty, and the consequences of poverty How income inequality in America has changed over time How programs like Social Security affect poverty and income inequality The special concerns presented by health care insurance Why there are political differences and debate over the size of the welfare state

3 Poverty, Inequality, and Public Policy The welfare state is the collection of government programs designed to alleviate economic hardship. A government transfer is a government payment to an individual or to families that provides financial aid to the poor, assistance to unemployed workers, guaranteed income for the elderly, and assistance in paying medical bills for those with large health care expenses.

4 The Logic of the Welfare State One major rationale for the welfare state is alleviating income inequality. A poverty program is a government program designed to aid the poor. A second major rationale for the welfare state is alleviating economic insecurity. A social insurance program is a government program designed to provide protection against unpredictable financial distress.

5 The Logic of the Welfare State These two rationales for the welfare state are closely related to the ability-to-pay principle (see Chapter 7). The ability-to-pay principle was used to justify progressive taxation.

6 The Logic of the Welfare State The ability-to-pay principle says that people with low incomes (for whom an additional dollar makes a big difference to their economic well-being) should pay a smaller fraction of their income in taxes than people with higher incomes (for whom an additional dollar makes much less difference). The same principle suggests that those with very low incomes should actually get money back from the tax system.

7 FOR INQUIRING MINDS Justice and the Welfare State In 1971 the philosopher John Rawls published A Theory of Justice. It is the most famous attempt to date to develop a theory of economic fairness. Rawls concluded that we should decide economic and social policies behind a veil of ignorance about own identity. It s sort of a generalized version of the Golden Rule: Do unto others as you would have them do unto you if you were in their place. It is an argument for a generous welfare state.

8 FOR INQUIRING MINDS Justice and the Welfare State In 1974, Robert Nozick published the libertarian response, Anarchy, State, and Utopia. Nozick argued that justice is a matter of rights, not results, and that the government has no right to force people with high incomes to support others with lower incomes. He argued for a minimal government that enforces the law and provides security the night watchman state. He argued against the welfare state programs that account for so much government spending.

9 The Problem of Poverty The poverty threshold is the annual income below which a family is officially considered poor. The poverty rate is the percentage of the population with incomes below the poverty threshold. The following graph shows the U.S. poverty rate since 1959.

10 U.S. Poverty Trend

11 FOR INQUIRING MINDS Defining Poverty Who decided how much income an American family needs to escape poverty? Mollie Orshansky, a research analyst at the Social Security Administration, developed initial estimates of the poverty threshold in Orshansky started by estimating the cost of an inexpensive, but nutritionally adequate diet. She then observed that families with children spent about one-third of their income on food. She argued that any family earning less than three times the cost of purchasing an adequate diet did not have adequate income.

12 FOR INQUIRING MINDS Defining Poverty Was Orshansky s the right measure of poverty? Yes, when it was created. This measure of poverty is badly outdated now because the composition of spending by low-income families has changed significantly since the 1960s. On average, the share of income spent on food has fallen to less than 20%, but the share spent on things such as housing, health care, transportation, and child care has risen.

13 Who Are the Poor? In 2009, about 43.6 million Americans were in poverty 14.5% of the population, or about one in seven persons. About one-third of the poor were African-American and a roughly equal number were Hispanic. Within these two groups, poverty rates were well above the national average: 25.8% of African-Americans and 25.3% of Hispanics. But there was also widespread poverty among non-hispanic Whites, who made up more than half the ranks of the poor.

14 Who Are the Poor? Adults who work full-time are very unlikely to be poor: only 2.7% of full-time workers were poor in Adults who worked part-time or not at all during the year made up most of the poor in 2009.

15 Who Are the Poor? Female-headed families with no husband present had a very high poverty rate: 29.9%. Married couples were much less likely to be poor, with a poverty rate of only 5.8%; still, about 40% of poor families were married couples.

16 What Causes Poverty? Lack of education 82% college premium (2007) Lack of proficiency in English Racial and gender discrimination Bad luck

17 Consequences of Poverty The consequences of poverty include: lack of access to health care lack of access to affordable housing learning disabilities Children raised in severe poverty tend to suffer from lifelong learning disabilities.

18 Consequences of Poverty Poverty is self-perpetuating. The children of the poor start at such a disadvantage relative to other Americans that it s very hard for them to achieve a better life.

19 GLOBAL COMPARISON Poor People in Rich Counties Poverty rate 18% 17.0% Relative Absolute % 11.4% % 6.9% 8.3% 7.6% 7.5% 6.5% United States United Kingdom Canada Germany Sweden

20 GLOBAL COMPARISON Poor People in Rich Counties According to the relative definition of poverty (you re poor if you have a low income compared with other people in your country), the United States has a high poverty rate compared with other rich nations. According to absolute poverty (similar to the official U.S. poverty threshold), the U.S. is no longer the country with the highest poverty rate by this measure. The U.S. in second place. By either measure, the U.S. has a high poverty rate compared with other rich countries.

21 Economic Inequality Mean household income is the average income across all households. Median household income is the income of the household lying at the exact middle of the income distribution.

22 Economic Inequality Income in the United States is quite unequally distributed. The average income of the poorest fifth of families is less than 25% of the average income of families in the middle. The richest fifth have an average income more than three times that of families in the middle. The incomes of the richest fifth of the population are, on average, about 15 times as high as those of the poorest fifth. The distribution of income in America has become more unequal since 1980.

23 Economic Inequality The Gini coefficient is a number that summarizes a country s level of income inequality based on how unequally income is distributed across quintiles.

24 Income Inequality Around the World

25 ECONOMICS IN ACTION Trends in U.S. Income Inequality

26 The U.S. Welfare State

27 The U.S. Welfare State A means-tested program is a program available only to individuals or families whose incomes fall below a certain level. Social Security, the largest program in the U.S. welfare state, is a non-means-tested program that provides retirement income for the elderly. It provides a significant share of the income of most elderly Americans. Unemployment insurance is also a key social insurance program.

28 The U.S. Welfare State An in-kind benefit is a benefit given in the form of goods or services. A negative income tax is a program that supplements the income of low-income working families.

29 The Effects of the Welfare State on Poverty and Inequality

30 The Effects of the Welfare State on Poverty and Inequality The American welfare state is redistributive. It increases the share of income going to the poorest 60%, while reducing the share going to the richest 20%.

31 ECONOMICS IN ACTION LULA LESSENS INEQUALITY Brazil was one of the world s most unequal societies in 2002, the year Luiz Inacio Lula da Silva universally known simply as Lula became the nation s president. It was still one of the world s most unequal societies in 2010, when he handed the reins over the Dilma Roussef, his hand-picked successor. But inequality was down, and poverty was sharply lower. And Brazil s fight against poverty and inequality has become something of an international role model.

32 The Economics of Health Care Health insurance satisfies an important need because expensive medical treatment is unaffordable for most families. Under private health insurance, each member of a large pool of individuals pays a fixed amount to a private company that agrees to pay most of the medical expenses of the pool s members.

33 Who Paid for U.S. Health Care in 2009? Private Insurance 34% Out of pocket 13% Other public 7% Medicare 22% Medicaid 16% Other private 8%

34 Who Paid for U.S. Health Care in 2009? The majority of Americans not covered by private insurance are covered by: Medicare, which is non-means-tested and applies only to those aged 65 and older; or Medicaid, which is available based on income.

35 The Economics of Health Care

36 The Consequences of Being Uninsured (a) Barriers to Receiving Health Care, 2009 (b) The Financial Burden of Paying Medical Bills, 2010 No regular source of care 21% 56% Had problem paying medical bills 8% 33% Postponed seeking care because of cost 20% 32% Changed way of life significantly to pay medical bills 5% 27% Needed care but did not get it 13% 26% Contacted by collection agency about medical bills 5% 15% Did not fill a prescription because of cost 13% 27% % % Uninsured Insured

37 Health Care in Other Countries The United States differs from other wealthy countries in its heavy dependence on private health insurance and its high health care spending per person. Compared with other wealthy countries, the U.S. system has much higher costs. The higher costs do not necessarily imply better care.

38 Health Care in Other Countries Some countries, such as Canada, have a single-payer system. A single-payer system is a health care system in which the government is the principal payer of medical bills funded through taxes.

39 Health Care in Other Countries

40 Changes in Health Insurance Status, Change (millions) Population 9.7 Employment-based coverage Medicaid and SCHIP Uninsured

41 Rising Health Care Costs Health care expenditure (percent of GDP) 20% Year

42 The Debate Over the Welfare State The debates over the welfare state include the following questions and concerns: about how large the welfare state should be philosophical concerns about government involvement about the trade-off between efficiency and equity that high marginal tax rates to finance an extensive welfare state can reduce the incentive to work that means-testing programs to reduce the cost of the welfare state also reduce the incentive to work

43 The Debate Over the Welfare State

44 ECONOMICS IN ACTION French Family Values The United States has the smallest welfare state of any major advanced economy. France has one of the largest. As we ve already described, France has much higher social spending than America as a percentage of total national income, and French citizens face much higher tax rates than Americans. One argument against a large welfare state is that it has negative effects on efficiency.

45 ECONOMICS IN ACTION French Family Values Is France less efficient than the United States? Yes, generally the French work less. French GDP per capita is only 80% of the U.S. level. But young people in France don t need to work because college education is generally free, and students receive financial support. Also, French law requires employers to offer at least one month of vacation. Most U.S. workers take less than two weeks off. French retirement system allows workers to collect generous pensions even if they retire very early. This is a big burden on the French welfare state.

46 VIDEO PBS NewsHour with Paul Solman: Do Social Safety Net Programs Shrink Gap in U.S. Economic Inequality? As part of Paul Solman's reporting on Making Sen$e of financial news, NewsHour has been airing a series on economic inequality. The widening wealth gap in America was examined in a past report, but economist Bob Lerman says those data are flawed because they do not include the value of Social Security and health insurance.

47 Summary 1. The welfare state absorbs a large share of government spending in all wealthy countries. Government transfers are the payments made by the government to individuals and families. Poverty programs alleviate income inequality by helping the poor; social insurance programs alleviate economic insecurity.

48 Summary 2. The poverty threshold is adjusted according to the cost of living, but not according to the standard of living. The average American income has risen substantially over those 30 years. However, the poverty rate in the United States the percentage of the population with an income below the poverty threshold is no lower than it was 30 years ago. There are various causes of poverty: lack of education, the legacy of discrimination, and bad luck.

49 Summary 3. Median household income, the income of a family at the center of the income distribution, is a better indicator of the income of the typical household than mean household income because it is not distorted by the inclusion of a small number of very wealthy households. The Gini coefficient, a number that summarizes a country s level of income inequality based on how unequally income is distributed across quintiles, is used to compare income inequality across countries.

50 Summary 4. Both means-tested programs and non-means-tested programs reduce poverty. The major in-kind benefits programs are Medicare and Medicaid, which pay for medical care. Because of concerns about the effects on incentives to work and on family cohesion, aid to poor families has become significantly less generous even as the negative income tax has become more generous. Social Security, the largest U.S. welfare state program, has significantly reduced poverty among the elderly. Unemployment insurance is also a key social insurance program.

51 Summary 5. Health insurance satisfies an important need because most families cannot afford expensive medical treatment. Private health insurance, unless it is employment-based, has the potential to fall into an adverse selection death spiral. Most Americans are covered by employment-based private health insurance; most of the remaining are covered by Medicare (for those 65 and older) or Medicaid (for those with low incomes).

52 Summary 6. Compared with other countries, the United States relies more heavily on private health insurance and has substantially higher health care costs per person without providing better care. Some countries have a single-payer system, a system in which the government pays most medical bills, funded through taxes.

53 Summary 7. Debates over the size of the welfare state are based on philosophical and equity-versus-efficiency considerations. 8. Politicians on the left tend to favor a bigger welfare state and those on the right oppose it. This left-right distinction is central to today s politics. America s two major political parties have become more polarized in recent decades, with a much clearer distinction than in the past about where their members stand on the left-right spectrum.

54 Key Terms Welfare state Government transfer Poverty program Social insurance programs Poverty threshold Poverty rate Mean household income Median household income Gini coefficient Means-tested programs In-kind benefit Negative income tax Private health insurance Single-payer system