Welfare trap: Encyclopedia - Welfare trap

Welfare trap

The welfare trap is a name for the phenomenon by which taxation and welfare systems 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 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.

Welfare trap - 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. Eventually, he is offered a job paying 25,000 dollars per year. Should he take the job? He will likely reason as follows: Once the government has extracted its taxes from his salary, the man is left with a net total of, say, 20,000 dollars a year. A total difference of 5,000 dollars per year from his original 15,000. Yet, in order to obtain this extra 5,000 dollars, the man must abandon a life of indolence and wake up every day, day after day, and labor for his living. Thus, the man would very likely choose to remain on welfare, living how he pleases. There would need to be a job with a certain threshold salary in order to make it "worth it" for the man to go off welfare. While this threshold would be different for each person (based on his subjective valuation process), it is clear that it would have to be rather higher than most of the basic jobs for which most people receiving welfare are qualified.

In short, the welfare trap is an example of a perverse incentive - although intended to reduce unemployment and poverty, it creates a situation whereby the individual has an incentive to avoid raising his own productivity due to its adverse effect on net income after benefits and taxes. This has a negative effect on society by reducing overall productivity, economic efficiency, resource allocation and morale.

Welfare trap - Proposed solutions

There have been a number of solutions proposed to this problem. In Europe, Canada and the UK, these 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.

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.

The only other 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."

Category: Welfare

Adapted from the Wikipedia article "Welfare trap", under the G.N U Free Docmentation License. Please also see http://en.wikipedia.org/wiki