By Dwight R. Lee
The federal government has increasingly assumed responsibility for reducing poverty in America. Its primary approach is to expand programs that transfer wealth, supposedly from the better off to the poor. In 1962, federal transfers to individuals (not counting payments for goods and services provided or interest for money loaned) amounted to 5.2 percent of gross domestic product, or 27 percent of federal spending (Stein and Foss 1995, p. 212). By 2000, federal transfers had increased to 10.9 percent of GDP, or approximately 60 percent of federal spending; GDP was $9.82 trillion and federal spending was $1.79 trillion. These transfers are commonly referred to as government redistribution programs, presumably from the wealthy to the poor. The unstated implication is that income was originally distributed by someone. But no one distributes income. Rather, incomes are determined in the marketplace by millions of people providing and purchasing services through voluntary exchanges, and government transfers necessarily limit these exchanges. That explains the quotation marks around the term “redistribution.”
Almost without exception, academic studies and journalistic accounts of government’s effect on the well-being of the poor focus exclusively on the effectiveness of programs that actually transfer income to the poor. What does this leave out? It leaves out all the programs that transfer income away from the poor. To know the net amount the poor receive after considering transfers to and transfers from them, we need to consider all government transfer programs.
Such an examination yields a striking fact: most government transfers are not from the rich to the poor. Instead, government takes from the relatively unorganized (e.g., consumers and general taxpayers) and gives to the relatively organized (groups politically organized around common interests, such as the elderly, sugar farmers, and steel producers). The most important factor in determining the pattern of redistribution appears to be political influence, not poverty. Of the $1.07 trillion in federal transfers in 2000, only about 29 percent, or $312 billion, was means tested (earmarked for the poor) (Rector 2001, p. 2). The other 71 percent—about $758 billion in 2000—was distributed with little attention to need.
Take Social Security, for example. The net worth per family of the elderly is about twice that of families in general. Yet, Social Security payments transferred $406 billion in 2003 to the elderly, regardless of their wealth. Also, qualifying for Medicare requires only that one be sixty-five or older. Because this age group’s poverty rate is quite low (only 10.4 percent in 2002), most of the more than $280 billion in annual Medicare benefits go to the nonpoor.
What is more, the direct transfer of cash and services is only one way that government transfers income. Another way is by restricting competition among producers. The inevitable consequence—indeed, the intended consequence—of these restrictions is to enrich organized groups of producers at the expense of consumers. Here, the transfers are more perverse than with Medicare and Social Security. They help relatively wealthy producers at the expense of relatively poor (and, in some cases, absolutely poor) consumers. Many government restrictions on agricultural production, for example, allow farmers to capture billions of consumer dollars through higher food prices (see agricultural subsidy programs). Most of these dollars go to relatively few large farms, whose owners are far wealthier than the average taxpayer and consumer (or the average farmer). Also, wealthy farmers receive most of the government’s direct agricultural subsidies.
Restrictions on imports also transfer wealth from consumers to domestic producers of the products. Again, those who receive these transfers are typically wealthier than those who pay for them. Consider, for example, the tariffs imposed on steel imports in 2002 to save steelworkers’ jobs. A study done for the Consuming Industries Trade Action Coalition in 2003 found that the steel tariffs eliminated the jobs of about 200,000 U.S. workers in industries that, because of the tariffs, had to pay more for the steel needed in their production processes. This is far more jobs than were saved, because the entire American steel industry employs only 187,500 workers, only a fairly small fraction of whom would have lost their jobs without the steel tariffs. Also, consumers had to pay more for products containing steel. Since unionized steelworkers earn more than the average worker and consumer, the steel tariffs transferred wealth to a few well-paid and politically organized workers at the expense of many less-well-paid workers and consumers.
Not only do the poor receive a smaller percentage of income transfers than most people realize, but also the transfers they do get are worth less to them, dollar for dollar, than transfers going to the nonpoor. The reason is that subsidies to the poor tend to be in kind rather than in cash. Slightly over half of all the transfers targeted to the poor are in the form of medical care. In addition to medical care, the poor receive a significant proportion of their assistance for such things as housing, energy, and job training. This means that well over half of the transfers going to the poor are in-kind transfers. However, transfers that are not means tested are more likely to be in the form of cash. For example, in 2000, Social Security retirement payments were $353 billion, more than 46 percent of non-means-tested government transfers during that year. Many other non-means-tested transfers are also in the form of cash payments. Consider just a few of the farm subsidy programs. From 1995 through 2002, corn farmers received $34.5 billion in government subsidies, wheat farmers received $17.2 billion, soybean growers received almost $11 billion, and cotton farmers received $10.7 billion. When all non-means-tested cash transfers are added up, they come to more than 50 percent of all non-means-tested transfers. While in-kind transfers are worth having, economists who study poverty point out that the poor, like the rest of us, value cash more than in-kind transfers because with cash they can choose what to buy. So a higher percentage of the transfer dollars going to the nonpoor is actually worth a dollar to the recipients than is the case with the transfer dollars going to the poor.
The most important question, of course, is whether the poor have benefited from the large increase in the percentage of national income that has been channeled through government in the name of reducing poverty. The answer, surprising though it may seem, is that we really do not know. To determine the effect of government transfer programs on the poor, we would have to know how the poor would have fared had these programs never existed, and that is difficult to estimate with much confidence.
Most attempts to measure the benefit to the poor from government transfers compare the income of the recipients with what their incomes would be if all transfer income were eliminated. The assumption is that the entire transfer is an increase in the income of the recipients. Such studies conclude that government programs have significantly reduced the poverty rate.
But such studies overstate the benefits to the poor because they fail to account for the negative effect of the benefit programs on the income-earning actions of the beneficiaries. When, for example, transfers are means tested, recipients who work lose a large part of their transfer payment. This penalty on working has the same effect as a high marginal income tax and creates a disincentive for the poor to work their way out of poverty, trapping the most vulnerable poor into permanent dependency. Ending the transfer payment, therefore, would motivate the former recipient to earn more income. Failing to account for this higher earning in the absence of welfare payments causes analysts to overstate welfare programs’ positive effect on recipients’ income. In fact, ending the welfare trap was part of the motivation for the welfare reform of 1996 (the Personal Responsibility and Work Opportunity Reconciliation Act of 1996), which limits the time an individual can remain on welfare.
The Earned Income Tax Credit program (EITC), which was expanded in the 1980s and 1990s, is an attempt to transfer income to the poor without significantly reducing their incentive to work. The EITC is a federal income tax credit that low-income workers receive through lower (in some cases negative) taxes, and which they can take as a cash refund. There is evidence that the program has increased the incentive for people on welfare to enter the workforce. But it also reduces the incentive for those already working to work as many hours as before: the more income a worker earns, the smaller the tax credit received. A clear advantage of the EITC is that it transfers income in the form of cash, with this transfer coming to about $33 billion in 2002. Workers covered by the EITC, though, receive less than this $33 billion. The reason is that the net effect of the EITC is an increase in the supply of workers, which causes wages to fall. This downward pressure on wages is not negated by the minimum wage, because more than 60 percent of the workers receiving EITC make more than the minimum. And even those at minimum wage can have their wages reduced through the loss of fringe benefits.
Although there is controversy over the magnitude, all economists agree that means-tested programs, even the EITC, create disincentives. The late Arthur Okun, President Lyndon B. Johnson’s chief economist and a strong advocate of government transfers to the poor, compared transfer programs to a leaky bucket to illustrate the fact that the increase in recipient income is less than the amount transferred. Okun’s bucket leaks from both ends. The higher taxes needed to pay for transfers to the poor also create disincentives for those with higher incomes to work as hard, earn as much, and invest in businesses, which can reduce not only the money available for transfers, but also economic activity and job opportunities for the poor.
Probably the best reason for believing that government transfers have done less to help the poor than most people think follows from recognizing that competition for political favor determines transfer decisions, as it does most government decisions. People are poor because they do not have the skills, drive, and connections to compete effectively in the marketplace. For those same reasons, they are unlikely to compete very effectively politically. The result is that the best-organized, and generally the wealthiest, groups consistently outcompete the poor for government transfers. For example, according to the Environmental Working Group Farm Subsidy Database (easily found through Google), “Nationwide, ten percent of the biggest (and often most profitable) subsidized crop producers collected 71 percent of all subsidies, averaging $34,800 in annual payments between 1995 and 2002. The bottom 80 percent of the recipients saw only $846 on average per year.” The same pattern occurs with contract set-asides, that is, contracts to perform services for the federal government that are set aside from the normal bidding process for particular types of business. Thomas Sowell (2004, p. 120) reports on a study that found that more than two-thirds of a random sample of minority recipients of contract set-asides by the Small Business Administration were millionaires. These are only some of many examples.
This discussion has been entirely about the effect of federal taxes and transfers on the poor, even though state and local government policies also affect income inequality. State and local programs are more difficult to discuss because there are so many of them and they differ in details, but there is little reason to believe that they are any more effective at transferring income from the wealthy to the poor than are federal programs. First, those with the skills and connections to compete best for federal programs that serve their interests are also more effective competing at the state and local levels. The best public schools, for example, are in wealthy suburbs, not inner cities. Second, state and local taxes are regressive; that is, they take a larger percentage of income from those with less income. Finally, even if they wanted to, state and local policymakers have less ability to reduce income inequality than the federal authorities because states must compete with each other for residents.
Despite the significant increase in the percentage of national income transferred through government programs since the 1960s, there is no evidence that the distribution of income (again, after taxes and transfers at all levels of government) has shifted in favor of the poor. We can never know for certain what would have happened if government transfers had not increased. But even if transfer programs have somewhat increased the share of national income going to the poor, their disincentive effects have made national income smaller than otherwise. A slightly higher share of a smaller pie could be a smaller slice.