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Means-Tested Welfare and the Disincentive to Work

I have been writing a series of posts on indefensible government policies. My previous post involved employee fringe benefit laws. This post discusses means-tested government programs.

The welfare state consists of government programs that distribute significant funds to private individuals. This money is allocated in two types of programs: means-tested programs and universal benefit programs. Means-tested programs are restricted to people of limited income, whereas universal benefit programs are conferred on all people who satisfy the conditions for the program. For example, Medicaid is a means-tested program that provides health care to low income persons, whereas Medicare is a universal benefit program that provides health care to all persons who are over 65.

Both of these types of programs have serious difficulties. Here I discuss the problems with means-tested programs.

At first glance, means-tested programs seem to make a lot of sense. They restrict benefits to people who need them. It does not make sense to provide welfare to people who have significant income. Thus, one might conclude that the same is true for other benefits.

But there are significant problems with means-tested benefits. One problem is that such programs require a significant amount of administrative effort and associated cost to ensure that the persons are actually eligible. For example, it may be a problem if people work off the books and still receive the benefits. Some means-tested programs have a work requirement built into them. But such work requirements are probably not effective and they can significantly raise administrative costs.

But to my mind the truly problematic part of such programs is that they often make it unattractive for people to work. As people earn more money from a job, their benefits are reduced or eliminated. Depending on a person’s circumstances, their earnings might reduce their benefits by 50 to over 100 percent. These high implicit marginal tax rates are an enormous problem.

If a person will lose $75 in benefits if they earn an additional $100 in wages, then it is quite likely that they will not take that work. And this is awful. It is not merely a substantial inefficiency, depriving the economy of a worker’s input (and requiring the rest of us to pay taxes to support him). It is also the effect on the recipient of the benefits. Work provides important social connections, self-esteem, and purpose to people. If our system makes it unattractive for someone to work, it causes him to lose out on these very important goods.

There are means of reducing these effects. First, one can keep the overall means-tested benefits at a low amount, but this of course means a reduction in means-tested benefits. Second, one can slow the decline in the benefits as income rises so that one needs to earn a greater amount before the benefits are eliminated. But this has the disadvantage of reducing the extent to which the program is focused on the poor. Third, one can use a work requirement, but that requirement has the disadvantages I mentioned above.

Perhaps, then, there is some room for some legitimate use of means-tested benefits. But the significant use of such benefits under our existing system, with high implicit marginal tax rates, is extremely problematic. We can only tolerate a limited number of means-tested benefit programs before the negative effects outweigh their limited benefits.

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