THIRD EDITION

ECONOMICS
and
MICROECONOMICS
Paul Krugman | Robin Wells

Chapter 18
The Economics of the Welfare State
 • What the welfare state is and the
rationale for it
• What defines poverty, what causes
poverty, and the consequences of
WHAT YOU poverty
WILL LEARN • How income inequality in America has
changed over time
IN THIS
• How programs like Social Security affect
CHAPTER poverty and income inequality
• The special concerns presented by
health care insurance
• Why there are political differences and
debate over the size of the welfare state
Poverty, Inequality, and Public Policy
• The welfare state is the collection of government programs
designed to alleviate economic hardship.

• A government transfer is a government payment to an

individual or to families that provides financial aid to the
poor, assistance to unemployed workers, guaranteed
income for the elderly, and assistance in paying medical bills
for those with large health care expenses.
The Logic of the Welfare State
• One major rationale for the welfare state is alleviating
income inequality.

• A poverty program is a government program designed to

aid the poor.

• A second major rationale for the welfare state is alleviating

economic insecurity.

• A social insurance program is a government program

designed to provide protection against unpredictable
financial distress.
The Logic of the Welfare State
• These two rationales for the welfare state are closely related
to the ability-to-pay principle (see Chapter 7).

• The ability-to-pay principle was used to justify progressive

taxation.
The Logic of the Welfare State
• The ability-to-pay principle says that people with low
incomes (for whom an additional dollar makes a big
difference to their economic well-being) should pay a
smaller fraction of their income in taxes than people with
higher incomes (for whom an additional dollar makes much
less difference).

• The same principle suggests that those with very low

incomes should actually get money back from the tax
system.
FOR INQUIRING MINDS
Justice and the Welfare State

• In 1971 the philosopher John Rawls published A Theory of

Justice. It is the most famous attempt to date to develop a
theory of economic fairness.

• Rawls concluded that we should decide economic and

social policies behind a “veil of ignorance” about own
identity.

• It’s sort of a generalized version of the Golden Rule: Do

unto others as you would have them do unto you if you
were in their place.

• It is an argument for a generous welfare state.

FOR INQUIRING MINDS
Justice and the Welfare State

• In 1974, Robert Nozick published the libertarian response,

Anarchy, State, and Utopia.

• Nozick argued that justice is a matter of rights, not results,

and that the government has no right to force people with
high incomes to support others with lower incomes.

• He argued for a minimal government that enforces the law

and provides security—the “night watchman state.”

• He argued against the welfare state programs that account

for so much government spending.
The Problem of Poverty
• The poverty threshold is the annual income below which a
family is officially considered poor.

• The poverty rate is the percentage of the population with

incomes below the poverty threshold.

• The following graph shows the U.S. poverty rate since 1959.
U.S. Poverty Trend
FOR INQUIRING MINDS
Defining Poverty
• Who decided how much income an American family needs
to escape poverty?
• Mollie Orshansky, a research analyst at the Social Security
Administration, developed initial estimates of the poverty
threshold in 1963–1964.
• Orshansky started by estimating the cost of an inexpensive,
but nutritionally adequate diet. She then observed that
families with children spent about one-third of their income
on food.
• She argued that any family earning less than three times the
cost of purchasing an adequate diet did not have adequate
income.
FOR INQUIRING MINDS
Defining Poverty

• Was Orshansky’s the right measure of poverty? Yes, when it

was created.

• This measure of poverty is badly outdated now because the

composition of spending by low-income families has
changed significantly since the 1960s.

• On average, the share of income spent on food has fallen to

less than 20%, but the share spent on things such as
housing, health care, transportation, and child care has
risen.
Who Are the Poor?
• In 2009, about 43.6 million Americans were in poverty—
14.5% of the population, or about one in seven persons.

• About one-third of the poor were African-American and a

roughly equal number were Hispanic. Within these two
groups, poverty rates were well above the national average:
25.8% of African-Americans and 25.3% of Hispanics.

• But there was also widespread poverty among non-Hispanic

Whites, who made up more than half the ranks of the poor.
Who Are the Poor?
• Adults who work full-time are very unlikely to be poor: only
2.7% of full-time workers were poor in 2009.

• Adults who worked part-time or not at all during the year

made up most of the poor in 2009.
Who Are the Poor?
• Female-headed families with no husband present had a very
high poverty rate: 29.9%.

• Married couples were much less likely to be poor, with a

poverty rate of only 5.8%; still, about 40% of poor families
were married couples.
What Causes Poverty?
• Lack of education
 82% “college premium” (2007)

• Lack of proficiency in English

• Racial and gender discrimination

• Bad luck
Consequences of Poverty

The consequences of poverty include:

• lack of access to health care
• lack of access to affordable housing
• learning disabilities
 Children raised in severe poverty tend to suffer from lifelong
learning disabilities.
Consequences of Poverty
• Poverty is self-perpetuating.

• The children of the poor start at such a disadvantage

relative to other Americans that it’s very hard for them to
achieve a better life.
GLOBAL COMPARISON
Poor People in Rich Counties
Poverty
rate 18% Relative Absolute
17.0%

16

14
12.4%
12 11.4%

10
8.7% 8.3%
8 7.6% 7.5%
6.9% 6.5%
6

0
United United Canada Germany Sweden
States Kingdom
GLOBAL COMPARISON
Poor People in Rich Counties

• According to the relative definition of poverty (you’re poor

if you have a low income compared with other people in
your country), the United States has a high poverty rate
compared with other rich nations.

• According to absolute poverty (similar to the official U.S.

poverty threshold), the U.S. is no longer the country with
the highest poverty rate by this measure. The U.S. in second
place.

• By either measure, the U.S. has a high poverty rate

compared with other rich countries.
Economic Inequality

 Mean household income is the average income across all

households.

 Median household income is the income of the household

lying at the exact middle of the income distribution.
Economic Inequality
• Income in the United States is quite unequally distributed.
 The average income of the poorest fifth of families is less than
25% of the average income of families in the middle.
 The richest fifth have an average income more than three
times that of families in the middle.
 The incomes of the richest fifth of the population are, on
average, about 15 times as high as those of the poorest fifth.

• The distribution of income in America has become more

unequal since 1980.
Economic Inequality

• The Gini coefficient is a number that summarizes a country’s

level of income inequality based on how unequally income is
distributed across quintiles.
Income Inequality Around the World
ECONOMICS IN ACTION
Trends in U.S. Income Inequality
The U.S. Welfare State
The U.S. Welfare State
• A means-tested program is a program available only to
individuals or families whose incomes fall below a certain
level.

• Social Security, the largest program in the U.S. welfare state,

is a non-means-tested program that provides retirement
income for the elderly. It provides a significant share of the
income of most elderly Americans.

• Unemployment insurance is also a key social insurance

program.
The U.S. Welfare State
• An in-kind benefit is a benefit given in the form of goods or
services.

• A negative income tax is a program that supplements the

income of low-income working families.
The Effects of the Welfare State on Poverty and Inequality
The Effects of the Welfare State on Poverty and Inequality

 The American welfare state is redistributive.

 It increases the share of income going to the poorest 60%,

while reducing the share going to the richest 20%.
ECONOMICS IN ACTION
LULA LESSENS INEQUALITY
• Brazil was one of the world’s
most unequal societies in
2002, the year Luiz Inacio Lula
da Silva – universally known
simply as Lula – became the
nation’s president.
• It was still one of the world’s
most unequal societies in
2010, when he handed the
reins over the Dilma Roussef,
his hand-picked successor.
• But inequality was down, and
poverty was sharply lower.
• And Brazil’s fight against
poverty and inequality has
become something of an
international role model.
The Economics of Health Care
• Health insurance satisfies an important need because
expensive medical treatment is unaffordable for most
families.

• Under private health insurance, each member of a large

pool of individuals pays a fixed amount to a private
company that agrees to pay most of the medical expenses
of the pool’s members.
Who Paid for U.S. Health Care in 2009?

Private Insurance Out of pocket

34% 13%

Other public

7%

Medicare
22%

Medicaid
Other private
16%
8%
Who Paid for U.S. Health Care in 2009?
The majority of Americans not covered by private insurance
are covered by:
 Medicare, which is non-means-tested and applies only
to those aged 65 and older; or
 Medicaid, which is available based on income.
The Economics of Health Care
The Consequences of Being Uninsured
(a) Barriers to Receiving Health Care, (b) The Financial Burden of Paying Medical Bills,
2009 2010

No regular 56% Had problem 33%

source of paying 8%
21%
care medical bills

Changed way
Postponed 32% of life 27%
seeking care significantly to
20% 5%
because of pay medical
cost bills

Needed care 26% Contacted by 15%

but did not collection
13% 5%
get it agency about
medical bills

Did not fill a 27% 0 10 20 30 40 50%

prescription
13%
because of
cost

0 10 20 30 40 50% Uninsured Insured

Health Care in Other Countries
• The United States differs from other wealthy countries in its
heavy dependence on private health insurance and its high
health care spending per person.

• Compared with other wealthy countries, the U.S. system has

much higher costs.

• The higher costs do not necessarily imply better care.

Health Care in Other Countries
• Some countries, such as Canada, have a single-payer
system.

• A single-payer system is a health care system in which the

government is the principal payer of medical bills funded
through taxes.
Health Care in Other Countries
Changes in Health Insurance Status, 2000–2009
Change (millions)

20
24.8

15

10 18.2 12.2

–9.7
–5
Population Employment-based Medicaid and Uninsured
coverage SCHIP
Rising Health Care Costs
Health care expenditure
(percent of GDP)

20%

15

10

1960 1970 1980 1990 2000 2009

Year
The Debate Over the Welfare State
The debates over the welfare state include the
following questions and concerns:

• about how large the welfare state should be

• philosophical concerns about government involvement
• about the trade-off between efficiency and equity
• that high marginal tax rates to finance an extensive welfare
state can reduce the incentive to work
• that means-testing programs to reduce the cost of the
welfare state also reduce the incentive to work
The Debate Over the Welfare State
ECONOMICS IN ACTION
French Family Values

• The United States has the smallest welfare state of any

major advanced economy.

• France has one of the largest. As we’ve already described,

France has much higher social spending than America as a
percentage of total national income, and French citizens face
much higher tax rates than Americans.

• One argument against a large welfare state is that it has

negative effects on efficiency.
 ECONOMICS IN ACTION
French Family Values
• Is France less efficient than the United States? Yes, generally
the French work less.
 French GDP per capita is only 80% of the U.S. level.
• But young people in France don’t need to work because
college education is generally free, and students receive
financial support.
• Also, French law requires employers to offer at least one
month of vacation. Most U.S. workers take less than two
weeks off.
• French retirement system allows workers to collect generous
pensions even if they retire very early. This is a big burden on
the French welfare state.
VIDEO
 PBS NewsHour with Paul Solman: Do Social Safety Net
Programs Shrink Gap in U.S. Economic Inequality?

 As part of Paul Solman's reporting on Making Sen$e of

financial news, NewsHour has been airing a series on
economic inequality.
 The widening wealth gap in America was examined in a past
report, but economist Bob Lerman says those data are flawed
because they do not include the value of Social Security and
health insurance.

 http://www.pbs.org/newshour/bb/business/july-
dec11/inequality_09-21.html
Summary
1. The welfare state absorbs a large share of government
spending in all wealthy countries.

Government transfers are the payments made by the

government to individuals and families.

Poverty programs alleviate income inequality by helping

the poor; social insurance programs alleviate economic
insecurity.
Summary
2. The poverty threshold is adjusted according to the cost of
living, but not according to the standard of living. The
average American income has risen substantially over
those 30 years.

However, the poverty rate in the United States — the

percentage of the population with an income below the
poverty threshold—is no lower than it was 30 years ago.

There are various causes of poverty: lack of education, the

legacy of discrimination, and bad luck.
Summary
3. Median household income, the income of a family at the
center of the income distribution, is a better indicator of
the income of the typical household than mean household
income because it is not distorted by the inclusion of a
small number of very wealthy households.

The Gini coefficient, a number that summarizes a country’s

level of income inequality based on how unequally income
is distributed across quintiles, is used to compare income
inequality across countries.
Summary
4. Both means-tested programs and non-means-tested
programs reduce poverty. The major in-kind benefits
programs are Medicare and Medicaid, which pay for
medical care.

Because of concerns about the effects on incentives to

work and on family cohesion, aid to poor families has
become significantly less generous even as the negative
income tax has become more generous.

Social Security, the largest U.S. welfare state program, has

significantly reduced poverty among the elderly.

Unemployment insurance is also a key social insurance

program.
Summary
5. Health insurance satisfies an important need because most
families cannot afford expensive medical treatment.

Private health insurance, unless it is employment-based,

has the potential to fall into an adverse selection death
spiral.

Most Americans are covered by employment-based private

health insurance; most of the remaining are covered by
Medicare (for those 65 and older) or Medicaid (for those
with low incomes).
Summary
6. Compared with other countries, the United States relies
more heavily on private health insurance and has
substantially higher health care costs per person without
providing better care.

Some countries have a single-payer system, a system in

which the government pays most medical bills, funded
through taxes.
Summary
7. Debates over the size of the welfare state are based on
philosophical and equity-versus-efficiency considerations.

8. Politicians on the left tend to favor a bigger welfare state

and those on the right oppose it. This left-right distinction
is central to today’s politics. America’s two major political
parties have become more polarized in recent decades,
with a much clearer distinction than in the past about
where their members stand on the left-right spectrum.
Key Terms

• Welfare state • Private health insurance

• Government transfer • Single-payer system
• Poverty program
• Social insurance programs
• Poverty threshold
• Poverty rate
• Mean household income
• Median household income
• Gini coefficient
• Means-tested programs
• In-kind benefit
• Negative income tax