Is welfare dependence optimal for whom – part 2: the labour supply effects of welfare benefit abatement rate changes

Figure 1 shows that the introduction of a welfare benefit has both income and substitution effects. The welfare benefit abates at rate t so the take-home pay of workers is less than the full wage until the benefit cut out point shown by the arrow in Figure 1. After this cut-out point, no benefits are payable and the work receives a full wage of w times the hours worked.

Figure 1: the labour supply effects of the introduction of a welfare benefit

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The income effect increases the consumption of all goods including leisure. The substitution effect increases the attractiveness of not-working relative to work because prior to the cut-out point, take-home pay is less.

· Some workers will choose to not work at all as indicated by arrow 1 in figure 1 because this makes them better off. They have more leisure time and more income.

· Other workers working at a relative low wage will work less hours than before as indicated by arrow 2 in Figure 1 because of the revised rewards of working. Working fewer hours for slightly less is a better labour-leisure trade-off for them. They earn less, but have more leisure time.

Figure 1 illustrates several of the ambiguities of welfare reform. A welfare benefit induces some workers to work fewer hours and others to stop working altogether. In addition, the abatement rate of less than 100 per cent increases the region in which workers working full-time or semi-full-time might find working less hours attractive. Some workers move from full-time work to part-time work on lower income but with more leisure time.

If the benefit abatement rate was 100 per cent, there is a larger gap between working full-time and not working at all. This large take-home pay gap makes jumps from not working to full-time work much more rewarding.

Several jurisdictions increased benefit abatement rates to 100 per cent to make full-time work more rewarding and part-time work less rewarding. Higher benefit abatement rates on earned income of welfare beneficiaries may actually increase net labour supply because fewer workers enter the benefit, more leave for full-time jobs, but fewer work part-time.

These intended and unintended consequences of welfare reform for abatement rate reforms are illustrated further in Figure 2.

Figure 2: Benefit abatement rate reductions and labour supply

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Benefit abatement rates are reduced in Figure 2, which increases the cut-out point at which workers cease to be eligible for any welfare benefits.

· Arrow 1 shows the decision of those currently not working to start working part-time, which is a common motive for and the desired outcome behind reduced benefit abatement rates. These beneficiaries are working but are taking-home a higher income. Their labour leisure trade-off now favours more work and less leisure.

· Arrow 2 shows those currently working part-time reducing their hours because this clearly increases both their take-home pay and their leisure time.

· Arrow 3 shows the full-time workers working at a relative low wage have an incentive to reduce to part-time because this is a better labour-leisure trade-off for them. Their take-home pay is less, but they enjoy more leisure time.

The net labour supply effects of lower abatement rates are ambiguous because the reduced hours of those who are already in work offsets the labour force participation of those previously not working.

A key point to remember from this reduction in welfare abatement rates is no welfare recipients leaves the welfare system but some join the welfare rolls because of the reduction in the benefit abatement rate.

Whether labour supply on net actually increases or decreases depends on the relative numbers of individuals at different points on the budget constraint working full-time, not working and working part-time and on the magnitudes of their responses.

Some will stay as they are working full-time, not working and working part-time. Others will reduce their hours of work. The dictates of team production and co-ordinated working times may prevent this happening immediately. At the next job changes, those currently working full and part-time can take full advantage of lower benefits abatement rates as shown in Figure 2.

The objective of reducing welfare dependency and poverty by encouraging part-time work with lower benefit abatement rates has unintended consequences.

People focus on those who start working part-time as a conduit to eventual full-time work and self-sufficiency if welfare abatement rates are lowered to make part-time work more attractive.

What is forgotten is those who are currently working full-time, or part-time, who because of the increase in income from part-time work plus continued for partial benefit receipt find that part-time welfare dependency is optimal for them. They drop out of full-time work.

An additional reason for this entry of new people onto the welfare rolls is that welfare benefits come with a range of second tier benefits. In addition to housing supplements to pay the rent, there are special grants that can be applied for to pay for unexpected expenses such as medical and dental work or damaged around the house.

As alluded to previously, one of the welfare reforms introduced in the United States in the early 1980s was to increase the welfare abatement rate on earned income to 100% from 67% which it applied since the 1960s. This increase in welfare benefit abatement rates to 100% on earned income increased the gap between welfare dependency and working full time. The idea was to make full-time work a more attractive option relative to welfare benefit receipt.

The blogs so far

part-one-the-labour-leisure-trade-off-and-the-rewards-for-working

part-two-the-labour-supply-effects-of-welfare-benefit-abatement-rate-changes

part-3-abatement-free-income-thresholds-and-labour-supply

part-4-in-work-tax-credits-and-labour-supply

part-5-higher-abatement-rates-and-labour-supply

part-6-mandatory-work-requirements-and-labour-supply

part-7-the-role-of-tagging-in-welfare-benefits-system

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