How Our Welfare System Discourages Work

There was a fascinating article in The Economist the other day about how our benefits system works to keep people stuck on welfare. Specifically, it cuts off benefits at such a quick rate that only a fool would take a job. Let’s discuss.

The Economist began by acknowledging the massive success of welfare reform in 1996. The Republican-led Congress, with grudging agreement from Clinton, put limits on cash benefits and tightened the requirement for able-bodied claimants to seek work. The Democrats screamed that poor people would end up starving in the streets... never happened. Instead, the result was “impressive,” according to The Economist: people receiving cash benefits fell sharply from 12.3 million people to 4.1 million people and employment skyrocketed among single mothers. Everyone was better off.

Now people are talking reform again for ideological reasons, but there is little creative thinking. Conservatives want to cut or destroy these programs, Democrats want to expand them and eliminate requirements. That’s about as creative as it gets. No one is talking about simplifying the system or killing the bad incentives. Other countries are: Britain is trying to put all of its benefits in one place and put a cap on them and Germany combined its benefit centers with job centers and brought down its unemployment rate. We aren’t talking about any of that.

We should.

The first problem with our system is that it is so complex that it’s not even clear what everyone gets. For example, CATO just did a study which claimed that a single mother would get paid more benefits in 39 states than a secretary would be paid and, in 11 states, the single mother would get more than a first year teacher. Clearly, that would discourage working, right?

Yeah, but CATO didn’t account for the fact that not everyone gets all the benefits. For example, only 15% of those who receive cash benefits (TANF) also get a housing benefit (what CATO counted as the largest benefit). CATO also failed to consider that some benefits (like food stamps and Medicaid) continue even after you get a job. In fact, most people receiving Medicaid and food stamps have jobs.

So the obvious question is that if we don’t know much about how the system actually works, then how can we know there is a problem? Well, the confusion itself is a problem. This confusion makes it hard to determine what works and what doesn’t, and whether or not the system actually discourages employment. Clearing up that confusion would go a long way toward (1) diagnosing the problems, (2) monitoring that people are getting what they need but aren’t taking advantage of the right hand not knowing what the left hand is doing, and (3) making reform more effective.

Further, the system does discourage work, and the Congressional Budget Office has proved it. The CBO examined the Pennsylvania scheme to see what happens as the benefits phase out. TANF vanishes once a person earns $4,900 a year. The Earned Income Tax Credit (given to 9.4 million people), gives a single mother a credit that rises to $3,250 per year if she makes between $9,600 and $17,500 in income each year, but then phases out fast. At $23,000 in income, the single mother loses food stamps and federal housing assistance.

The CBO then viewed these reductions as “taxes” for the sake of comparison. In other words, because these benefits declined as income rose, the CBO counted the loss of the benefits as a tax on the new income. This is actually a great way to look at the reduction of benefits because it shows exactly what the value of working is worth. And what the CBO found was that as the typical single mother earned more income, her effective marginal rate rose from 17% to 95%! Said differently, when you factored in the benefits lost by the single mother as she earns more income, she effectively keeps only 5% of what she earns from her new job.

This is solid proof that our system discourages people from working: would you work if you only kept 5% of what you earned? That needs to change. We need to reform the system to reduce benefits more smoothly, and to keep the effective taxation rate lower. In fact, I would suggest that the system should be designed to make sure the effective tax rate never rises above 20% if you want people to have an incentive to work.

Thoughts?