CAREER: The Welfare Consequences of Social Insurance and Redistributive Taxation: Evidence and Policy Implications

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

The United States spent approximately $1 trillion on income security and redistributive tax programs in 2004. Is this social safety net desirable from the perspective of maximizing social welfare? Can the structure of the social safety net be improved to provide the same level of benefits while reducing costs in terms of aggregate economic efficiency? This project aims to identify ways to improve the design of large-scale government programs. The project is organized around three broad ideas: I. Liquidity. Existing studies have assumed that behavioral responses to government policies -- such as the increase in unemployment durations caused by unemployment benefits -- are caused by moral hazard (a substitution effect), rather than a liquidity (income) effect. However, when individuals have limited savings, as do many agents experiencing shocks such as job loss or illness, they may change their behavior simply because they have more cash-on-hand (liquidity). This project develops methods to estimate the importance of liquidity vs. moral hazard. These estimates are used to quantify the value of various government programs. For example, the method is applied to calculate the value of providing health insurance by diagnostic condition, in order to precisely characterize which types of health insurance coverage should be prioritized in government programs such as Medicare and Medicaid. II. Commitments. Many households have "consumption commitments" such as housing that are difficult to adjust when shocks occur. Existing analyses of optimal policy neglect such commitments by assuming that households can adjust consumption of all goods when shocks occur. This project shows that commitments amplify risk aversion over moderate-sized risks. Commitments therefore increase the value of programs that insure temporary shocks relative to programs that provide long-term redistribution through taxation or welfare support. Hence, the optimal design of the social safety net may have very different characteristics when commitments are taken into account. III. Salience. Another benchmark assumption in economic models of government policy is that all agents are fully informed of and optimize with respect to the incentives created by government policies. This project develops methods to test this important assumption. In collaboration with H&R Block, we study the effects of providing simple information on the Earned Income Tax Credit (EITC) to tax filers in 2007. We conduct an experiment involving 40,000 H&R Block clients and track the amount they earn over two years. The goal of the EITC is to encourage individuals to work more; our objective is to test whether making the incentives provided by the EITC clear to individuals (e.g. $4 for every extra $10 earned) helps achieve this objective. The research has direct applicability to a broad range of policy issues. The project assists policy makers in assessing the implications of policy changes such as social security privatization, consumption tax reforms, or the introduction of unemployment and health insurance savings accounts. The project also helps identify new ways to implement policies that maximize economic welfare. For example, incorporating the EITC directly into weekly paychecks may make the incentives more salient while providing more liquidity. The project could also shed light on the best methods to simplify the tax code, an issue emphasized as a priority by the President's Tax Reform Panel.