THIRD EDITION

ECONOMICS
and
MICROECONO
MICS
Paul Krugman | Robin
Wells

Chapter 18
The Economics of the Welfare State

WHAT
YOU
WILL
LEARN
IN THIS
CHAPTER

What the welfare state is and

the rationale for it
What defines poverty, what
causes poverty, and the
consequences of poverty
How income inequality in
America has changed over time
How programs like Social
Security affect 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 wellbeing) 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.
Its 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 securitythe
night watchman state.
He argued against the welfare state programs

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 Orshanskys the right measure of poverty?
Yes, when it was created.
This measure of poverty is badly outdated now
because the composition of spending by lowincome 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
poverty14.5% of the population, or about one
in seven persons.
About one-third of the poor were AfricanAmerican 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
its very hard for them to achieve a better life.

GLOBAL COMPARISON
Poor People in Rich Counties
Poverty
rate 18%

Relative

17.0%

Absolute

16
14

12.4%

12
10

11.4%

8.7%

6.9%

8.3%
7.6%

7.5%
6.5%

6
4
2
0
United
States

United
Kingdom

Canada

Germany

Sweden

GLOBAL COMPARISON
Poor People in Rich Counties
According to the relative definition of poverty
(youre 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

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 countrys 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
Brazil was one of the
LULA
LESSENS
worlds
most
unequal
INEQUALITY
societies in 2002, the
year Luiz Inacio Lula da
Silva universally known
simply as Lula became
the nations president.
It was still one of the
worlds 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 Brazils fight against
poverty and inequality
has become something
of an international role

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
pools members.

Who Paid for U.S. Health Care in

2009?

Private Insurance

Out of pocket

34%

13%

Other public
7%
Medicare
22%
Medicaid
16%

Other private
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, 2009

(b) The Financial Burden of Paying Medical Bills,

2010
56%

No regular
source of
care

21%

32%

Postponed
seeking care
because of
cost

20%

26%

Needed care
but did not
get it

13%

27%

Did not fill a

prescription
because of
cost

33%

Had
problem
paying
medical
Changed
bills
way of life
significantly
to pay
medical bills
Contacted
by collection
agency
about
medical bills

8%

27%
5%

15%
5%

10

20

30

40 50%

13%

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 singlepayer 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,

20002009
Change
(millions)
20

24.8

15
10

18.2

12.2

Medicaid and
SCHIP

Uninsured

5
0
9.7

5
Population

Employment-based
coverage

Rising Health Care Costs

Health care expenditure
(percent of GDP)

20%

15

10
5

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 weve 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 dont 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-dec
11/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 thresholdis 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 countrys 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 nonmeans-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

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 employmentbased 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-versusefficiency 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 todays
politics. Americas 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
Government transfer
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
Private health insurance