Welfare trap
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The welfare trap is a theory which says that taxation and welfare systems can jointly contribute to keep people on social insurance. This is also known as the unemployment trap or poverty trap in the UK.
In the UK, there is a distinction between two concepts:
- the unemployment trap occurs when the net income difference between low-paid work and worklessness benefits is less than work related costs, discouraging movement into work;
- the poverty trap refers to the position when in-work income-tested benefit payments are reduced as income rises, combined with income tax and other deductions, with the effect of discouraging higher paid work whether that involves working longer hours or acquiring skills.
Mechanism and examples
An example of how the welfare trap works is as follows: A person on welfare finds a part time job that will pay her a minimum wage of five dollars per hour, eight hours per week. The forty dollars she earns will be deducted from her welfare payments leaving her with no net gain. Frequently, in fact, she will recover a net loss as the government will also levy a tax on her forty dollars. There may also be extra child-care and commuting costs, now that she is no longer able to remain at home all day. Therefore, despite performing eight hours of work productive to society (and, theoretically, herself) she is now worse off than before she landed a job.
The principles underlying the welfare trap ultimately stem from the way people make decisions in light of personal valuation of their time and effort. Consider this next example: a man is receiving welfare from the government to the tune of 15,000 dollars per year. He does, essentially, nothing to earn that money and spends his days doing whatever he pleases (within the limits of what he can afford, given the money he is receiving).
Eventually, he is offered a job paying 25,000 dollars per year. Should he take the job?
At first, the answer might seem to be a simple "yes", due to the obvious material gains: an extra 10,000 dollars, which represents an increase of 66% in his revenue. However, he would have to pay taxes from his new salary, which might reduce his new income from 25,000 dollars to, say, 22,000, and therefore reduce his net gain accordingly from 10,000 to 7,000 dollars. This is still an improvement in his material situation, but it comes at the expense of a lot more work: the man would likely have to work 40 hours per week at his new job, at an effective wage increase of $3.50 per hour, which is below minimum wage. Also, he will incur additional ancillary costs such as time and money spent commuting, and increased stress. As such, he will weigh the benefits of the extra money against the "cost" he incurs from working. If he decides, as he likely will given the above circumstances, that the extra money is not worth the effort, he has been "caught" in the welfare trap.
In short, the welfare trap demonstrates the way that social welfare systems can create a perverse incentive. Although such systems are intended to provide a buffer for unemployed citizens and thereby raise the standard of living, they may create a situation whereby the welfare recipient has an incentive to avoid raising his own productivity because his net income gain after benefits and taxes is not enough to compensate for the effort he must expend at work. This has a negative effect on society by reducing overall productivity, economic efficiency, resource allocation and morale and therefore ultimately reducing the standard of living.
Proposed solutions
The existence of a welfare trap depends on the difference between welfare income and the typical income one would receive from a low-paying job. A welfare trap can exist when this difference is too small. Thus, the general solution to the welfare trap is to make the difference larger, either by increasing the revenue of people in low-end jobs or by reducing welfare payments (or both).
In Europe, Canada and the UK, proposed solutions typically involve lowering taxes on the poor, and/or not deducting small wages from welfare checks, thus allowing a person on welfare who finds a part-time minimum wage job to make a net gain. Another method is to subsidize the employer for hiring a low-wage worker.
However, in the US, Japan and Australia, other, more radical, solutions are gaining popularity. These solutions generally involve dramatically cutting welfare payments or eliminating them entirely. Opponents of these solutions argue that they might leave the very poor without protection from starvation and death, which could create a bigger problem than it solves. On the other hand, supporters rejoinder that eliminating government welfare would have no effect on private charities, religious charities, family support structures and individual donations, which, they argue, are more than capable of preventing (to the degree humanly possible) starvation and death for the destitute. Additionally, those in favor of curtailing or ending welfare argue that lowering welfare benefits from the government provides added incentive to work, or at least removes the disincentive to do so.
Some other suggested schemes to solve the problem are the guaranteed minimum income and a negative income tax, which are based on the concept of giving everyone, whether working or not working, a constant amount of welfare payments (for most people, other than the unemployed or those on low-paying jobs, this would be essentially equivalent to a partial tax refund). Thus, the unemployed would not lose all welfare benefits at once when they find a job; rather, their benefits would decrease gradually as their job income increases. This would give them far greater incentives to find employment.
One well-known counterforce to the welfare trap is simple pride. Being on welfare carries with it a social stigma that, sometimes, can hurt an individual's pride enough to cause him to break the cycle on his own. That is, despite a net loss in a monetary sense, it becomes worth it in the subjective valuation sense for the individual to get a job and get off "the dole."
Criticism
A crucial link in the chain that creates a welfare trap are the personal preferences and state of mind of people on welfare. It is a question of personal preference whether a certain amount of money is worth expending a certain amount of effort at work. Thus, critics argue that the welfare trap is more of a psychological problem than an economic one.
References
This free download of the Free Institure for Economic Research analyses wellfare in the Western social models and investigates a tax structure coping with the wellfare trap.