Public Finance (MPA405)

Dr. Khurrum S. Mughal

Lecture 16: Government Subsidies and Income Support for the Poor

Public Finance

Economic Analysis of the Effects of Government Transfers

• Effect on Resource allocation• Consumer may consume where MSB is less

that MSC• Loss of willingness to work if after work

income is less• Analysis highlights the equity-

efficiency trade-off

Price Distorting Subsidies

• Price Distorting Subsidies lower the price of the particular good relative to others for eligible people.

Price Distorting Subsidies

• Example of Housing subsidy– Hiring apartment at below the market rent– Govt pays the difference

• Subsidized Mortgage loans

A Price Distorting SubsidyE

xpen

dit

ure

on

Oth

er G

oo

ds

per

Mo

nth

(D

oll

ars)

Housing Services per Month 0 L' H1 H2 H3

N3 N1 N2

S

I

B A

L

E1 E3

U2 U3 U1

E2

Subsidy

Price Distorting Subsidies

• Implications:– Induces to purchase a larger amount of housing

that he/she would normally do– Higher level of utility in presence of cash grant

equal to the subsidy– Spending on other goods can also be increased– Dead weight loss

• Difference between E2 and E3

Price Distorting Subsidies and Market Effects

• Example of Housing Market• Operates on constant cost• Long run supply curve is perfectly elastic• Government agrees to pay half the rent

Excess Burden of a Subsidy: Market Effects

B E

Q1

F

A

E’S’

D = MSB

400

200

Number of Apartments Rented

Q20

C

Ren

t (D

oll

ars

per

Mo

nth

)

S = MSC

Excess Burden of Subsidy

Dead Weight Loss or

Excess Burden

• Dead Weight Loss (sometimes called Excess Burden ) is the measure of the dollar value of the distortion that exceeds the amount transferred to the recipient.

Implications• Induces low-income people to increase

their consumption – increased demand• More resources are allocated for

building more houses– But value exceeds the benefits

• Important to compare costs to tax payers and the benefits accruing to low income tenants

Implications• Cost of Subsidy to tax payers

– $200 multiplied by increase in apartments rented after subsidy Area BAE`C

Excess Burden of a Subsidy: Market Effects

B E

Q1

F

A

E’S’

D = MSB

400

200

Number of Apartments Rented

Q20

C

Ren

t (D

oll

ars

per

Mo

nth

)

S = MSC

Excess Burden of Subsidy

Implications• Benefits to Low Income Tenants

– Those who would rent one bedroom apartment even without the subsidy.

• $200 multiplied by Q1 (Area BEFC)

– Those who would rent after the subsidy. Net benefit would be the difference between MB they assign to housing and $200 (Area EE`F)

Excess Burden of a Subsidy: Market Effects

B E

Q1

F

A

E’S’

D = MSB

400

200

Number of Apartments Rented

Q20

C

Ren

t (D

oll

ars

per

Mo

nth

)

S = MSC

Excess Burden of Subsidy

Implications• Total Benefit: Area BEFC + EE`F• Total Cost: Area BAE`C

• So the cost is greater than the benefit and there is excess burden

Price Distorting Subsidies that Lowers the Price to Zero

• Medicaid – Largest program of assistance to Poor in USA

• Reduced the cost of medical services to “zero”• Assuming annual quantity of medical care

consumed can be measured by number of hospital visits

• Supplied by perfectly competitive industry• MSC doesn’t increase when more is made

available

Full Subsidization of Medical Services

Medical Office Visits per Year0 Q*

E1

QG

25 = P*

E2

MBL

B

A

Pri

ce (

Do

llar

s p

er M

on

th)

Excess Burden

Implications

• Increase in Consumer Surplus• Part of increase is already what would have

been acquired anyway• Excess burden is the due to subsidy in kind• Medicaid recipients would be better off with

cash subsidy

Additional Effects of Subsidies: The Case of Increasing Costs

• Medicaid not only costs taxpayers money to pay for the program, it also increases the amount they pay for medical services by increasing demand for those services.

The Impact of The Medicaid Program on Price: The Case of Increasing Cost

Pri

ce

(D

olla

rs)

Medical Office Visits per Year

0 QI O

Q'

E1

QL

140

Q2 QG QO

E2

100

S = MSC

DO DM = MSB

DL

D' M

Implications

• Increase in Prices of Medical Services• Tax payers finance the program• Tax payers face the higher medical service

prices for themselves• Overall decrease in real incomes of tax

payers• Losses in efficiency as well as changes in

income distribution

Subsidizing Housing

• Providing an Apartment: This subsidy allocates a standard apartment to an eligible recipient. With this type of subsidy the recipient cannot supplement the subsidy with their cash. It is a “take it or leave it” option.

• Housing Vouchers: This subsidy allows the recipient a particular allotment of vouchers to rent housing but the recipient may supplement the subsidy with their cash.

• Cash: This subsidy is not restricted to spending on housing.

Public Housing

• Government constructed low cost housing for low income families

• Rented at well below market rates• Public Housing are expected to increase recipient's

housing consumption• Might reduce housing consumption due to lack of

freedom of choice• Suppose Government offers housing at $30 per

room where the rent for 3 bedroom apartment is 90 $– The same goes for rent in the market for $300

Eligibility for Public Housing and the Effect on Housing Consumption

Ex

pe

nd

itu

re o

n O

the

r G

oo

ds

pe

r M

on

th (

Do

llars

)

Housing per Month (Number of Rooms Rented) 0

800 = I

M

H

400= F J

B A

210

210

4

E1

U1 U2 U3

I'

1 3 2 5 6 7

90 G

E2

Refusing a Public-Housing SubsidyE

xp

en

dit

ure

on

Oth

er

Go

od

s p

er

Mo

nth

(D

olla

rs)

Housing per Month (Number of Rooms Rented)0

U3

E1 U2

I

M G

J

A 1 2 3 4 5 6 7

Subsidizing Food

• Food Stamps are the subsidy that allows the recipient a particular allotment of vouchers to buy food but the recipient may supplement the subsidy with their cash. It is illegal to sell the food stamps though it may be in the recipients interests for them to do so.

The Impact of an In-Kind Transfer: Food Stamps

0

B

B

I

A

U2

U1

A'

M1

QF1

L

U3

QF

Ex

pe

nd

itu

re o

n O

the

r G

oo

ds

pe

r M

on

th (

Do

llars

)

0 QF

A

B

I

A

U2

U1

A'

M2

M1

QF1 QF2

Food per Month

C

Q* 1

F

QF2

E1

E1

CE2

E1

The Impact of Government Assistance Programs on Work

• Transfers could cause people to work more or less depending on whether leisure is a normal good.

International Food Subsidies

• Several nations use a price-reducing subsidy to make food more affordable.– Programs that reduce the price of food benefit

higher-income people as well.

• Some nations only subsidize food that is typically consumed by the poor.

• Some nations distribute food directly.

The Income Effect of a Transfer

Inco

me

per

Day

Leisure Hours per Day

0 L1 24

F

C

A

L2

D

U3

U2 U1

E1 E2

E3

G

TransferPayment

A Transfer that Declines with Earned Incomee.g. T=$300-.7IE

L* 24 L2 L1

MaximumDaily

Transfer

Leisure Hours per Day

Inco

me

per

Day

U2

U1

A

D

B

C E1

E2

Empirical Evidence

• A 10% increase in welfare payments to individuals decreases work effort by 2%.

A Negative Income Tax • A Negative Income Tax is a system where there is no

status test but there is an income guarantee and a take-back rate.

• T = IG – tNIE

Where• IG = Income guarantee• tN = take back rate• IE = earned income• T = Transfer

Break-Even Income

0 = IG – tNIB

IB = IG/tN

Negative Income TaxEarned Income IE Transfer T = IG – tNIE Disposable Income ID

0 5,000 5,000

1,000 5,000 – (.5 × 1000) = 4,500 5,500

2,000 5,000 – (.5 × 2000) = 4,000 6,000

3,000 5,000 – (.5 × 3000) = 3,500 6,500

4,000 5,000 – (.5 × 4000) = 3,000 7,000

5,000 5,000 – (.5 × 5000) = 2,500 7,500

6,000 5,000 – (.5 × 6000) = 2,000 8,000

7,000 5,000 – (.5 × 7000) = 1,500 8,500

8,000 5,000 – (.5 × 8000) = 1,000 9,000

9,000 5,000 – (.5 × 9000) = 500 9,500

10,000 5,000 – (.5 × 10000) = 0 10,000

Wage Rate Subsidies

• Wage Rate Subsidies are government additions to wages designed to increase the pay of the working poor.

Wage Rate Subsidies

Wage Paid Subsidy per Hour

Total Wage Received

$2.00 $1.50 $3.50

$2.50 $1.25 $3.75

$3.00 $1.00 $4.00

$3.50 $0.75 $4.25

$4.00 $0.50 $4.50

$4.50 $0.25 $4.75

$5.00 $0.00 $5.00