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Incentives and the Welfare
State
James Mirrlees
University of Melbourne and Chinese
University of Hong Kong
Trevor Swan Lecture
ANU
13 March 2008
The welfare state as a tax schedule
• The welfare state provides unemployment
and disability insurance, school education,
health care, some pension, for (almost)
everyone.
• It may provide basic income, low-cost
housing, subsidised food, transportation,
etc. for people with low incomes.
• Real income is higher than earned and
capital income when low, though less at
higher income.
UK as an example
• Income tax and national insurance: at an
increasing rate, starting at incomes well
below median income.
• Working tax credit, for lower-income
workers, depending on family size.
• Substantial commodity taxes, averaging
maybe 14% (ignored in following figures)
• Health care and school education of value
at least 15% of median income (also not in
the graph).
UK Budget Constraint, 2006
30K
Disposable
income
20K
from: Mike Brewer,
Emmanuel Saez, and
Andrew Shephard
10K
0
0
5K
10K
15K
20K
25K
30K
Annual Gross Earnings (1 earner, 2 children)
35K
40K
Marginal tax rates and incentives
• The marginal tax rate at low incomes is
100%. For most, it is over 70%
• Economists believe that creates poor work
incentives.
• Someone with low earning ability would be
expected not to work at all.
• Someone with moderate earning ability
would settle for a job with productivity
around £10,000 per year.
Impact on GDP
• The orthodox claim is that countries that
give large welfare benefits independent of
income, and that redistribute income
strongly from rich to poor will have a lower
GDP, since people will work less and
produce less.
• Prescott has argued that is why Americans
work more than Europeans, and have a
higher average income.
Charging for services
• Another implication drawn is that people
should pay for medical care, and for
education.
• Because then extra income is more
valuable… improving work incentives.
• A change in the system that would
increase work incentives would, however,
reduce the real (after tax and subsidy)
income of people with the least earning
capacity.
Qualitative and quantitative arguments
• In principle,
– More pay for more work encourages work.
– And having less encourages work.
• Are these quantitatively large effects?
• If that UK budget constraint did reduce
most people’s annual earnings to
£10,000, it would be a large effect.
• It has not yet done so.
• Why? A wrong assumption (I claim).
Is working all bad?
• Standard assumption: work is painful.
• But:
– People like to be doing something (maybe
vicariously, and not all the time). Natural
selection must have made us that way.
– People like to be useful.
– Studies show that unemployment makes
people more unhappy than lower income.
– Statistical estimates of labour preferences
yield U-shaped indifference curves.
– People rarely work for very short periods.
• I do not claim that more work is always
better: we want leisure too.
• And maybe some kinds of work are
unpleasant even for an hour or two.
• And some people may not be able to do
work that is both enjoyable and useful.
• And there are people who seem not to like
working at all, at least when old, or young.
• But, as a simplified model of the world, we
should assume that (most) people prefer
working up to a point.
Optimal budget constraints
• We imagine an economy in which people
choose how much to work, expecting
particular (lifetime) consumption for each
possible (lifetime) work plan.
• The total consumption available is what
can be produced from the total amount of
work they do.
• How can we maximize their total utility?
How the model works
• The answer depends on the way we
measure people’s utility. But not as much
as you might think.
• It also depends on the distribution of
working skills in the population: how many
can do unskilled, skilled, and professional
jobs, for example.
• I assume that a household’s consumption
cannot fall when earnings increase.
Results
• I find that there is a range of incomes,
from zero to some positive level, for which
the marginal tax rate should be 100% (as
for many in the UK).
• This holds provided the distribution of
skills within the population is realistic.
• It holds whether preference for
redistribution is strong or weak.
Proof
• It is harder to prove than you might think.
• Essentially:
– (1) The least skilled people are going to do
some work even if not rewarded for it.
– (2) Introducing net pay for work increases
work done, and therefore GDP, but only
proportionately, so not very much.
– (3) And it forces a reduction in minimum net
income, so not worth it (unless very few at the
bottom).
Provisos
• The conclusion is too extreme. The labour
market does not work well for jobs with
wage rates in the 100%-marginal-tax
range.
• So the marginal tax rate should be less
than 100%. Then employers can attract
workers by increasing the wages for lowwage jobs.
Implementation
• Can use means-tested welfare benefits, or
employment subsidies.
• With employment subsidies, employers
might report lower wage rates than they
pay.
• In reality, e.g. because of minimum wages,
they pay too much. I presume
unemployment is the result.
• Not a minimum-wage proposal: more a
minimum-take-home-pay proposal.
Unemployment
• The model used implies that people are
unemployed only if they are unable to get
jobs, e.g. because of wage-stickiness or
efficiency wages.
• It does not tell us how high the income of
the unemployed should be.
• An alternative view: Emmanuel Saez
assumes there is substantial disutility from
having a job, and deduces the m.t.r at zero
income should not be high.