Posted by on January 26, 2014

There is some interesting reading in last week’s edition of the Economist magazine. In the Lexington column, the author quotes President Obama scolding Republicans for their obviously retrograde belief that extended unemployment benefits reduce work incentives. Obama said he could not remember ever meeting an American “who would rather have an unemployment check than the pride of having a job”.

Obama clearly needs to get out more. For example, it is pretty clear that he has never met any of the 106 people described in an article on the preceding page of the magazine, entitled “Fishy tales”. These people are under indictment for allegedly receiving over $2 million in disability checks – technically, I guess, not unemployment checks – while their Facebook and Twitter accounts show them playing basketball, using jet skis, flying helicopters and, in the case of one “housebound” claimant, holding a rather sizable marlin caught off the coast of Costa Rica, on a vacation doubtlessly paid for by you and me.

Although Obama can probably be forgiven for not knowing any of these 106, it is much harder to understand how he has missed meeting any of the 4 million new claimants of disability benefits during the period from 1999 to 2014, an increase almost 7 times faster than the increase in the general population. Either there has been an epidemic of clumsiness in America or perhaps there are factors other than “pride” which enter into people’s occupational choices?

Or maybe Obama should go out and meet some of the millions of people who have dropped out of the labor force – or, to be more precise, at least out of the official labor force — in an environment where 39 States, according to economists from the libertarian think tank the Cato Institute, don’t even require claimants to be looking for a job in order to collect more in state and federal benefits than a secretary earns; in 11 States, these benefits are greater than the salary of a starting teacher.

I think that nothing would improve the quality of political discourse more than a general recognition, by all political parties and in references to all strata of society, that mankind has evolved a highly sophisticated talent for gaming the system. I think both parties substantially acknowledges that this talent exists in highly paid bankers, who game the “heads I win, tails you lose” and “too big to fail” incentive systems in their industry, but it would be really refreshing to see the Democratic Party finally acknowledge that it also exists in the welfare stratum.

Now, don’t get me wrong: this talent for gaming the system doesn’t always manifest itself. Internalized (“pride” and “guilt”) and externalized (“shame”) factors sometimes override it. For example, the famously generous welfare states of Scandinavia have survived, I am convinced, because these small and highly cohesive societies produce cultural factors that have largely offset the economic motivations provided by their systems. It should come as a surprise to no one, however, that as cultural cohesiveness has broken down under the impact of immigration and increased mobility, these countries are increasingly questioning the sustainability of their models.

Unfortunately, the anonymity and mobility of American society means that we can count very little on these cultural inhibitors. In addition, it is clear that in all societies, inhibition falls in an atmosphere of generalized cheating: eventually, even the virtuous start to question why they are the only ones playing the game straight. In fact, societies probably reach a “tipping point” where gaming is so prevalent that people start to feel that they have to cheat just to even the odds. Although I can’t prove it, I get a distinct feeling that America has recently reached this tipping point, probably helped by a Presidential bully pulpit that talks a lot more about rights than responsibilities.

So, what would a rational welfare system look like, one that provided a safety net for those truly unable to take care of themselves or suffering a temporary setback, but one that also acknowledged that people must be appropriately incentivized? Or, as the Economist put it in an earlier article, one that “must balance the desire to keep people out of penury with the equally humanitarian desire not to let them drift into lives of indolence and despair”. This is a highly complicated area of specialized economics where I cannot claim to be an expert, but some guiding principles appear to be obvious.

First, the system would be a lot simpler than the one we have. The Cato Institute study cited above counts 126 separate Federal anti-poverty programs; the states add many more. This is madness. Among other things, it means that it is impossible to have an overview of all the benefits actually received by real families: the extent that claimants are single- , double- or even one-twenty-sextuple-dipping the system.

The UK government has recently adopted a holistic approach to welfare payments and has put a cap on the total amount of benefits that a family can receive at roughly £500 a week, which is designed to equal the average pre-tax earnings of an employed family in the UK. The application of the cap showed 33,000 families that were above the limit, with some approaching twice this amount. The Conservative Party is now considering reducing the cap to roughly £400 per week, to reflect the take-home pay of a typical family. It is projected that this reduction will affect up to 1 million claimants.

This policy was vigorously opposed by the Labour Party, of course, which argued that it would unfairly punish large families. But since middle-class employed families must routinely consider their financial means when planning their families, is it really so heinous to impose the same discipline on families receiving benefits? In any event, the electorate has spoken clearly: recent polls suggest that this is one of the most popular government measure ever adopted.

The next characteristic of a rational system would be one that avoids the phenomenon that economists call the “poverty trap”. This is the tendency of the welfare and the tax systems to strongly disincentivize people to take a job and start earning money. When an unemployed person commences work, he or she can cease to qualify for various anti-poverty programs; in addition, like everyone else, the newly employed person becomes subject to the tax system. As one would expect from the ridiculously complicated and incoherent system that we have, the combined impact of the withdrawal of benefits and the imposition of taxes can produce highly irrational results. For example, the Congressional Budget Office has done some analysis for a hypothetical single family mother in the state of Pennsylvania which shows that such a person would, as her earnings rose and she fell out of various benefit programs and into various tax brackets, face an effective marginal tax rate of 17% to 95%! Needless to say, we might be asking a bit too much of “pride” to offset the disincentive of a 95% tax rate.

Finally, the current system, where many of the benefits accrue at the state level, produces huge variances. To quote the same Cato Institute study, a single mother with two children would receive over $49,000 of benefits in Hawaii, the most generous state, versus just shy of $17,000 of benefits in Mississippi, the stingiest. Although in general I am in favor of the supply of government services on a decentralized basis, to increase competition between government entities, this type of glaring disparity can only promote “welfare tourism”, as people move to the high-benefit areas. And since the Federal government supports many of the state programs with revenue sharing, this affects everyone.

In summary, what would be some of the characteristics of a more rational welfare program? At the risk of stepping blindly into a highly specialized area, I would cite the following:

1. The system would be simple, probably centered on a “negative” income tax, such as the existing earned-income tax credit. This negative income tax would supplement the income of the unemployed or low-earners and would, in an ideal world, blend seamlessly into a greatly simplified “positive” income tax table. In addition to this, there could be targeted programs for the essentials of food and shelter, but every effort must be made to avoid the crazy quilt of programs that we currently have.

2. The level of benefits would be calibrated to reflect the differential living costs of different parts of the country, which can be done with far greater precision than is currently used. Private sector companies regularly employ specialized consultants to help them adjust compensation across locations with different living costs and the same type of expertise should be used to set benefit conditions. The unemployed will then be incentivized to move to the areas offering the best employment prospects and not the most generous handouts.

3. The system would probably employ caps, similar to the ones introduced in the UK. Among other things, this would incentivize claimants to utilize the same prudent family planning that applies to the employed. It would also sharply increase the perceived fairness of the system, which alone will have a beneficial impact on reducing the tendency to “game”.

4. The system should be linked to a generous program of life-time support for vocational training. In a world of accelerating change, society needs to support earnest efforts for people to re-tool themselves. Needless to say, these programs need to be directly linked to employment needs and should not, unlike the existing student loan programs, be available for the pursuit of frivolous subjects that have little prospect of improving employment prospects and are really a form of consumption.

5. Finally, with a simplified and unified “negative” and “positive” income tax system, it will be easy to avoid the “poverty trap” and produce very strong incentives to start earning. Giving the tremendous social benefits that arise from working, we should target extremely low, or zero, marginal tax rates for low earners. Nothing would encourage work better than allowing the newly employed to enjoy the full fruits of their labors.

Doubtlessly, there is more that needs to be done than this, but these principles would at least constitute a good start.

Unfortunately, given that President Obama and most of the rest of the Democratic Party, in the face of overwhelming evidence to the contrary, seem to believe that “pride” is the only aspect of human nature, I don’t think that we can expect this start anytime soon.

Roger Barris, London

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Posted in: Economics, Policy

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