Extra Note: Transfers
This note will discuss transfers, denoted "Tr" in our model, which are defined as the giving of money (or
consumption goods) to individuals by the government.
What are some examples of large transfer programs in the US?
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Welfare programs like TANF (food stamps) and EITC (earned income tax credit)
Social Security payments
SSID (disability payments)
Medicare and Medicaid payments (transfers of health care income)
Housing vouchers
Note, Medicare and Medicaid are directed at a specific component of consumption (health expenditures) while
housing vouchers are directed at another component of consumption (housing).
In both cases, these types of
expenditures can be considered like “cash”. Why? Because individuals can reduce the spending they allocate on
these goods out of their own income and reallocate that money to other consumption goods. The rationale is that
when the government gives an individual a housing voucher, he can spend less of his income on housing (because
the government is paying for it) and more on other consumption goods such as satellite TV.
Recently, economists are interested in studying the labor force effects of a transfer program called Unemployment
Insurance (U.I.) which provides payments to unemployed workers.
Economists think of transfers as directly affecting the household budget constraint.
transfers directly increases PVLR (the present value of lifetime resources).
Why? A large increase in
Note: Let’s revisit our Topic 1 slides. In that lecture, I defined disposable income as gross income less taxes plus
transfers:
Yd = Y – T + Tr
(1)
As you can see from the above identity, an increase in transfers will increase household disposable income.
Throughout class, we have proven that increasing household PVLR:
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Increases consumption (C) as PVLR increases
Decreases labor supply (NS) as PVLR increases – after accounting for substitution effects
Note: Transfers are different than government spending. Government spending (G) is the purchasing of goods
and services by the government for government uses (building roads, providing school services to the
community, buying missiles, paying for the President’s salary). These are the direct purchase of goods and
services by the government. . In the case of transfers, the government gives individuals (consumers) money and
consumers decide how to spend it.
Often, we tend to think of transfers as a negative tax. This intuition comes from the disposable income equation
(1). Taxes reduce household income while transfers increase household income. A large permanent decline in
labor income taxes will increase PVLR. A large permanent increase in transfers will also increase PVLR.Now,
let’s think about different types of transfer programs:
1. Transfer programs with direct substitution effects on labor supply:
Some transfer programs affect the value of leisure directly like unemployment insurance and welfare benefits. In
this case, the transfers generate substitution and income effects on labor supply. Earlier in this chapter, we
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discussed the income effects of cash-like transfer programs. Now, I want to call your attention to the substitution
effects.
Note: With transfers, the income and substitution effects shift the labor supply curve in the same direction.
Why? Let’s look at an example. Suppose the government gives us money for not working. For concreteness, let’s
call this unemployment insurance. These payments are targeted to people only when they are not working. In this
case, there will be a substitution effect. The substitution effect says I should work less when there are generous
welfare payments or unemployment benefits. The reason is that the price of taking leisure decreases when the
government pays me not to work. An increase in the value of leisure will shift the labor supply curve to the left.
We will work less when there is an increase in unemployment benefits and welfare payments.
These kinds of transfers (whose payments are tied directly to whether you work) induce a substitution effect such
that an increase in transfers will cause households to work less. This is because the transfers reduce the relative
price of leisure relative to working.
Some questions that may come up with respect to my discussion above:
Why does the net price of leisure go down?
The price of leisure is the difference between resources you get if you work an extra hour and the resources you get
if you do not work an extra hour. If the government pays you not to work, then that the resources you get if you do
not work will increase. This reduces the net benefits from working.
Let me offer an example: Suppose wages are $15/hour and there are no transfer payments. The opportunity cost of
your time (the price of leisure) is $15/hour. Suppose the government pays us $6/hour in unemployment benefits
(unemployment benefits are usually per week – not per hour – but, you can just take the weekly payment and divide
by the usual hours worked per week (40) and get an approximate hourly wage). In a world where the government
pays you $6/hour not to work, the opportunity cost of your time (the price of leisure) will fall to $9/hour ($15 - $6).
This is the reason certain welfare benefits will also induce a substitution effect.
How is this case different from taxes?
Cutting taxes creates a substitution effect that increases the resources that you get if you work an extra hour.
Giving unemployment benefits increases the resources that you get if you do not work an extra hour. They both
have substitution effects, but they go in opposite directions. One makes you work more, the other makes you work
less. However, I want to stress that the income effect in both these examples goes in the SAME direction. In both
cases (a large permanent cut in taxes and a large permanent increase in transfers) will increase PVLR making us
richer. In both cases, the income effect will say that we should work less. The fact that the transfers affect the
price of leisure (directly) and that taxes affect the price of work (directly) means they have substitution effects in
opposite directions. But, the income effect goes in the same direction. This is why permanent changes in taxes
have an ambiguous effect on how much we will work (depending on the strength of the income and substitution
effects).
There is no such ambiguity with transfers. A large permanent increase in welfare payments/unemployment
insurance means that we will work less because of substitution effect (they are paying us not to work) and because
of an income effect (because PVLR increases). Both of these effects will shift the labor supply curve to the left.
Bottom line:
A large permanent increase in transfers that are tied to working status (such as unemployment
insurance) have a substitution effect that reduces the price of leisure (that makes us work less) and
have an income effect (PVLR increases) that says that we should work less. Both will shift the
labor supply curve left.
As a result, transfers such as unemployment insurance will:
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Shift the labor supply curve left.
Have no effect on labor demand
Lower N*
Shift the Long run aggregate supply curve left (as N* falls)
Shift the IS curve right (as PVLR increases).
2. Transfer programs without direct substitution effects on labor supply:
Transfer programs such as Medicare have essentially the same effect as transfer programs that are tied to work
status. No matter what, Americans over 65 are able to access government health insurance (Medicare) under some
conditions. In the case of Medicare payments, the amount you work while you are young does not affect your
Medicare benefits. Given that, the price of leisure does not change directly from the implementation of the
Medicare program. However, even if there are no direct effects on the price of leisure, there is still an income effect.
The income effects are the same as we discussed above. An increase in PVLR (from the expected future Medicare
transfers) makes me richer today, reducing my incentive to work.
In this case, the effect of transfers will be EXACTLY the same as we discussed above.
Bottom line: Transfers such as Medicare will:
Shift the labor supply curve left (because PVLR increases).
Have no effect on labor demand
Lower N*
Shift the Long run aggregate supply curve left (as N* falls)
Shift the IS curve right (as PVLR increases).
The reason is that the income and substitution effects go in the same direction. Even if there are no direct
substitution effects, the labor supply curve will still shift left because of the income effect.
Summary/Discussion
Large transfers could reduce Y* relative to what it would be without the transfers through their effect on the labor
market. The decline in Y* (relative to trend) that resulting from a large increase in transfers depends on the strength
of the income and substitution effects. If both are small, the effect on Y* would be small. If one is big, the effect
on Y* will be big. Given that they both go in the same direction, it doesn’t matter which one is big.
This argument (the effect of transfers on Y*) is one of the main reasons economists believe that Europe is less
productive than the U.S. Transfers are much higher in Europe and Y* growth tends to be lower. This is the
rationale for why transfers could affect productivity growth within a country.
I was at a panel discussion with Gary Becker and Kevin Murphy in which we discussed how transfers could also
affect A (TFP) in our model. Subsidizing leisure (paying people not to work) through high transfers reduces the
benefits of schooling. Why would this be? There is less incentive to spend time going to school to receive a high
wage when I could get a pretty good life by not working given high transfers. Lower schooling could reduce
productivity which would further reduce Y*. I think these effects are actually much more important than the direct
effect on N* (discussed above).
Note: In our models, we will ignore this second effect unless I tell you otherwise. TFP is held fixed with all other
changes in exogenous variables unless I tell you otherwise. This just makes our life easier.
Main Take Away:
Large permanent increases in transfers can reduce Y* and shift the IS curve right (as C
increases due to the increase in PVLR).
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