Work Incentives in the AFDC System: An Analysis of the 1981 Reforms
Abstract
The road to welfare reform increasingly appears to be one of the rockier paths the United States has traversed. Indeed, by all outward appearances it is not even clear whether the current path runs uphill or downhill. As far as work incentives in the welfare system are concerned, economists of all political persuasions, from Milton Friedman to James Tobin, have agreed that the uphill direction is that which leads to lower tax rates (i.e., lower benefit-reduction rates). However, as with free trade, the near unanimity of opinion among economists has, strangely, only occasionally persuaded a majority of the nation's representatives to vote to go uphill. The legislative history so illustrates. From 1935, when the Aid to Families with Dependent Children (AFDC) program was enacted, to the 1967 Social Security Amendments, the tax rate in the program was 100 percent-that is, benefits were reduced by one dollar for every extra dollar earned. With the 1967 Amendments, Congress lowered the tax rate to 67 percent, and, in the heady atmosphere of the 1960's, it was expected that further progress in this direction would be made and that the tax rate would be lowered further. Indeed, the Family Assistance Plan subsequently proposed by President Nixon would have lowered tax rates; however, the legislation passed the House but not the Senate. The Ford Administration considered welfare reform proposals internally but never proposed legislation, while the Carter Administration proposed a massive welfare reform plan that met with no legislative success. Welfare reform was finally achieved in 1981 when the Omnibus Budget Reconciliation Act (OBRA) was enacted. But OBRA increased the tax rate back to 100 percent, the level prevailing prior to 1967. In retrospect, it appears that 1967 marked the end, not the beginning, of legislative progress on work incentives in the welfare system. In this paper I shall report the results of recent research that complicates the issue considerably by questioning whether lower tax rates do in fact provide work incentives. The findings themselves seesaw not unlike the path of welfare reform itself. First, on a theoretical basis, it appears that lower tax rates in a welfare program do not necessarily increase labor supply in the low-income population as a whole, contrary to the conventional wisdom. In fact, it also appears that members of the Reagan Administration were aware of this all along, well in advance of the economics profession. This theoretical ambiguity has fairly fundamental implications for the work-incentive issue in welfare reform. Second, nevertheless, the empirical resolution of the ambiguity provided by existing econometric estimates in the labor supply literature and by estimates of the effect of AFDC on labor supply indicates that a lower tax rate would indeed increase labor supply in the low-income population as a whole, and that a higher tax rate would decrease it. Thus the conventional wisdom is correct even though based upon an incorrect tDiscussants: Henry Aaron, The Brookings Institution and University of Maryland; Harold Watts, Columbia University; Edward Gramlich, University of Michigan.
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