(This essay was published in Hong Kong Economic Journal on 29 January 2014)
The centerpiece of the Chief Executive’s 2014 Policy Address is the “Low-income Working Family Allowance” to provide an income supplement for low income working families below (or nearly below) the newly defined poverty line. According to the Address, the annual expenditure involved is estimated to be around $3 billion. More than 200,000 low-income families with 710,000 members, including 180,000 eligible children and young people, will benefit from the allowance.
The proposed income redistribution program is quite similar to the earned income tax credit scheme in the U.S., which is a refinement of Professor Milton Friedman’s negative income tax proposal (see his Capitalism and Freedom, 1962, pp.190-195). The government proposal tries to mitigate the disincentive effects of income redistribution on work incentives by setting the amount of subsidies to be contingent upon hours worked. Whether it will succeed depends on the details of the program that have not yet been announced. I certainly hope the government had consulted some trained labor economists when designing the scheme.
Tackling poverty is a very difficult problem. There are at least two broad levels at which it could be tackled. First is the question of how to tackle the direct effects of poverty. A poor person has a low level of income and can only afford a low level of consumption. Giving him an allowance allows him to spend more and to alleviate the direct effects of poverty, i.e., low consumption levels. This can be accomplished most efficiently through a cash-based income redistribution policy rather than cumbersome subsidies-in-kind. Income supplements should only be conditioned on the level of income, hours of work, and number of members in the household, and nothing else.
The second question is how to tackle the causes of low income. The answer to this question is usually very complex, but it boils down to one issue – low productivity. And this has to do with encouraging economic growth. In this essay, I shall deal primarily with the first problem and leave the second problem to next week’s essay.
Charity Originates in Sympathy
Milton Friedman also considered it wise to tackle the first problem. For him poverty was an externality. At a conference for conservative scholars organized in the 1950s by the Earhart Foundation, Friedman first made the argument that the poor generated a negative externality by making the non-poor unhappy. He asked the audience, a group of conservative scholars, if they would be happy to see somebody starve to death in front of their house.
At that time, the welfare state was greatly admired as a solution for almost every social problem. It was literally unthinkable that a solution other than government could be contemplated. The predominant intellectual position favored using income redistribution to help the poor. Unfortunately half a century of social welfarism has not only failed to alleviate poverty, but many other social problems. However, at that time the disappointing failures of the social welfare state were still largely unknown. It is only today after half a century of experience and research that we have become much more aware that many social problems were actually worsened by the social welfare state and the policies it adopted.
Friedman’s view can of course be traced directly back to Adam Smith’s concept of human sympathy developed in his The Theory of Moral Sentiments. Charity is a human trait that encourages one to be generous in dealing with those less fortunate than ourselves. There are limits, however, and only saints would give away all their own money to help others; there are very few saints in the world. Still all of us are willing to part to some degree with some of our resources to help others who are less fortunate.
Discriminating Sympathy
Income redistribution through the effort of government is justified, according to Milton Friedman, because relying solely on voluntary private charity is not sufficient due to the free rider problem in alleviating poverty. If someone else gives charity to help the poor, I am benefited because the negative externality I experience is reduced. This leads to too little charity.
In practice, government income redistribution efforts through taxation appear to be primarily concerned with the domestic poor rather than those in foreign places, even if they are in extreme poverty. And the amount of redistribution that takes place in many rich countries appears to have far exceeded the levels that would normally be necessary to correct the effects of the negative externality on our feelings of sympathy.
Moreover, what is the moral justification for lavishing so much money on helping those who are poor in our own community and so little on those elsewhere, who are often much more poor? Most of my liberal friends, I observe, are silent on this point. They are less enthusiastic about helping the extreme poor in foreign places and seem more excited about redistributing tax income generously to help those who are only modestly poor in our own relatively prosperous community. They are also sometimes hostile towards immigrants.
Politics obviously plays an important role in being overzealous with redistributing income, especially in populist democratic politics. Politics always starts with dividing the world into insiders and outsiders, and giving political rights to the former and denying them to the latter. Democratic politics allows citizens to vote, but not non-citizens. In so doing, it naturally breeds an inward looking orientation that is absent from economic exchanges in the market place. Hong Kong’s growing interest in income redistribution is a natural extension of its development as a political entity with a growing inward looking self-identity.
Natural Propensity to Shirk
For Friedman, income redistribution is justified but should be conducted in modesty to help those who cannot help themselves through no fault of their own. Income redistribution through a “Low-income Working Family Allowance” should be aimed at avoiding the development of a social welfare state. There are two relevant considerations.
First, income redistribution provides two kinds of negative work incentive effects. The person whose income is taxed now has a reduced incentive to work because he does not get the full fruits of his labor. The person who receives the cash subsidy also has a reduced incentive to work because he is now paid to enjoy leisure and consumption. Both effects reduce work and negatively impact growth and the economy, and are especially of great concern for reducing the work incentives of the poor. Moreover, they impact tax revenues that have to be paid for income redistribution spending. History has shown again and again that income redistribution pushed to excess is bad for economic growth, and ultimately makes poverty even more difficult to alleviate.
The work disincentive problem is particularly significant in rich societies because labor force participation typically declines among the relatively more affluent as leisure is increasingly valued. In addition, population ageing is another important factor that is reducing total work and labor supply. Both factors are in effect in Hong Kong.
It is, therefore, important for the “Low-income Working Family Allowance” not to exacerbate this problem too much. One should avoid funding an overly generous program. Poverty as a negative externality should certainly be alleviated, but I find the logic propounded by those who insist that welfare should be an entitlement to be wholly outrageous and singularly oblivious to the findings of the new science of empirical labor economics.
Charts 1 and 2 below show that beginning from 2001, the percentage of the population in Hong Kong that was not in the labor force increased dramatically from around 0.5-1.5% in the period 1986-1996 to 2.0-4.5% in 2001-2011. This has occurred among both men and women with only slight differences. These individuals are not working for no compelling reason. And they are present across all age groups.
Chart 1: Percentage of Men not in the Labor Force for No Compelling Reason by Age Group
Source: Sample datasets of Population Census/By-Census
Chart 2: Percentage of Women not in the Labor Force for No Compelling Reason by Age Group
Source: Sample datasets of Population Census/By-Census
“For no compelling reason” means that they are not looking for a job, not at school, not sick, not in prison, and not homemakers. They have just decided not to work. Some of them will most likely be classified among poor families according to the government’s recently defined poverty-line. But then they have chosen not to work without any compelling reason not to!
Abuses of Welfare
In an earlier essay (see HKEJ 16 January 2013), I had simulated the amount of money required to compensate a minimum wage worker, who is paid $30 an hour and working 40 hours, earning $1200 a week, to voluntarily drop out of the labor force. It turned out the amount of compensation required is quite modest. It ranged from $313 for someone with a strong preference for leisure to $671 for someone with a strong preference for working. A mid-range estimate was about $429 per week.
The Comprehensive Social Security Assistance scheme pays eligible individuals (single able-bodied elderly persons and adults suffering from ill-health or who are 50% disabled) a standard rate of $2820 a month. This is worth approximately $700 a week and would be sufficient compensation to induce a minimum wage worker with a strong preference for work to withdraw from the labor force.
The means tested Old Age Living Allowance of $2200 a month provides approximately $500 per week and is sufficient compensation for a minimum wage worker with a mid-range balanced preference for work and leisure to drop out of the labor force voluntarily. These estimates of mine provide a benchmark to appreciate the value of leisure and how people make choices in response to cash income supplements.
In the US, the fraction of young men who are not at work for no compelling reason is much larger. Some one-eighth of white men and one-third of black men in their mid-twenties to early thirties fall into this category. Part of the reason is that the low earnings of young men without much education or other skills discourage them from looking for work. Another reason is government welfare in the form of food stamps, unemployment compensation, government medical coverage, and rent subsidies when they do not work regularly.
In particular, generous disability payments have encouraged large percentages of the population to withdraw from the labor force. In 1982, the US unemployment rate hit its postwar high of 10.8%, but individuals out of the labor force on disability payments were only 2.5%. In 2012, individuals out of the labor force on disability payments were 5.9% of the labor force, while the unemployment rate was 7.7%. This means the total share of workers who are either unemployed or receiving disability payments from the government totals 13.6%. The disabled are among the large number of Americans who have left the labor force and who are unlikely to be returning back.
Why have claims for disability risen in the US? Medicine has improved substantially. Fewer workers labor in dangerous industrial jobs. The rate of deaths due to injuries has plummeted. Behavior that can cause disability, such as alcohol use and smoking, has declined substantially. American age-adjusted mortality rates are far lower than in the past. The aging of the baby-boom generation can explain just 15.5% of the growth in disability claims. Two primary reasons for the rise in disability claims in the US are that either work has become less attractive or that disability insurance has become more attractive and available. People are rational after all.
An important reason why Friedman supported cash income supplements for alleviating poverty was that it provided a more efficient alternative to the “present rag bag of measures directed at the same end.” Friedman showed that for the US in 1961 a total of $33 billion was spent on direct welfare payments and programs of all kinds. At that time there were approximately 57 million households. The $33 billion spent on welfare expenditures would have been sufficient to provide the lowest 20% of these households each with $3,000 when the median household income was $5,700.
For him the cash income supplements for low income families were intended to replace the existing rag bag of measures that were likely to be not cost effective and hugely wasteful of resources in the goal of alleviating poverty, but succeeded to keep large bodies of administrators and service providers employed. Will the proposed “Low-income Working Family Allowance” be a replacement for existing welfare programs or just another addition to the present rag bag? Experience from elsewhere tells us the latter case is highly likely. Let us hope that it would at least succeed in holding down the upward trend of committing more resources to the rag bag for a long time.
Friedman pointed out that the transparency of redistributive cash income supplements has a potential downside. He writes, “There is always the danger that instead of being an arrangement under which the great majority tax themselves willingly to help an unfortunate minority, it will be converted into one under which a majority imposes taxes for its own benefit on an unwilling minority. …. I see no solution to this problem except to rely on the self-restraint and good will of the electorate.”
Growth as Alternative to Income Redistribution
History has shown that Friedman’s concern is not without basis. Table 1 below shows the percentage of government expenditure on subsidies and transfers in Western economies in the period 1870-95. On average they have increased from 1.1% of GDP around 1870 to 4.5% in 1937. Starting from 9.9% in 1960 it continued to increase to 23.2% in 1995.
Natural Propensity to Shirk
For Friedman, income redistribution is justified but should be conducted in modesty to help those who cannot help themselves through no fault of their own. Income redistribution through a “Low-income Working Family Allowance” should be aimed at avoiding the development of a social welfare state. There are two relevant considerations.
First, income redistribution provides two kinds of negative work incentive effects. The person whose income is taxed now has a reduced incentive to work because he does not get the full fruits of his labor. The person who receives the cash subsidy also has a reduced incentive to work because he is now paid to enjoy leisure and consumption. Both effects reduce work and negatively impact growth and the economy, and are especially of great concern for reducing the work incentives of the poor. Moreover, they impact tax revenues that have to be paid for income redistribution spending. History has shown again and again that income redistribution pushed to excess is bad for economic growth, and ultimately makes poverty even more difficult to alleviate.
The work disincentive problem is particularly significant in rich societies because labor force participation typically declines among the relatively more affluent as leisure is increasingly valued. In addition, population ageing is another important factor that is reducing total work and labor supply. Both factors are in effect in Hong Kong.
It is, therefore, important for the “Low-income Working Family Allowance” not to exacerbate this problem too much. One should avoid funding an overly generous program. Poverty as a negative externality should certainly be alleviated, but I find the logic propounded by those who insist that welfare should be an entitlement to be wholly outrageous and singularly oblivious to the findings of the new science of empirical labor economics.
Charts 1 and 2 below show that beginning from 2001, the percentage of the population in Hong Kong that was not in the labor force increased dramatically from around 0.5-1.5% in the period 1986-1996 to 2.0-4.5% in 2001-2011. This has occurred among both men and women with only slight differences. These individuals are not working for no compelling reason. And they are present across all age groups.
Table 1: Growth of Government Expenditures on Subsidies and Transfers, 1870-1995 –– Percentage on GDP
| Percentage on GDP | ||||||
| About 1870 | 1937 | 1960 | 1970 | 1980 | 1995 | |
| Canada | 0.5 | 1.6 | 9.0 | 12.4 | 13.2 | 14.9 |
| France | 1.1 | 7.2 | 11.4 | 21.0 | 24.6 | 29.9 |
| Germany | 0.5 | 7.0 | 13.5 | 12.7 | 16.8 | 19.4 |
| Japan | 1.1 | 1.4 | 5.5 | 6.1 | 12.0 | 13.5 |
| Norway | 1.1 | 4.3 | 12.1 | 24.4 | 27.0 | 27.0 |
| Spain | – | 2.5 | 1.0 | 6.7 | 12.9 | 25.7 |
| U.K. | 2.2 | 10.3 | 9.2 | 15.3 | 20.2 | 23.6 |
| U.S. | 0.3 | 2.1 | 6.2 | 9.8 | 12.2 | 13.1 |
| Australia | – | – | 6.6 | 10.5 | 16.7 | 19.0 |
| Austria | – | – | 17.0 | 16.6 | 22.4 | 24.5 |
| Belgium | 0.2 | – | 12.7 | 20.7 | 30.0 | 28.8 |
| Ireland | – | – | – | 18.8 | 26.9 | 24.8 |
| Italy | – | – | 14.1 | 17.9 | 26.0 | 29.3 |
| Netherlands | 0.3 | – | 11.5 | 29.0 | 38.5 | 35.9 |
| New Zealand | 0.2 | – | – | 11.5 | 20.8 | 12.9 |
| Sweden | 0.7 | – | 9.3 | 16.2 | 30.4 | 35.7 |
| Switzerland | – | – | 6.8 | 7.5 | 12.8 | 16.8 |
| Average | 1.1 | 4.5 | 9.7 | 15.1 | 21.4 | 23.2 |
Source：Vito Tanzi and Ludger Schuknecht, Public Spending in the 20th Century: A Global Perspective, Cambridge University Press, 2000
When over one-fourth of GDP is redistributed to a rag bag of measures one should expect poverty to have been considerably alleviated in these societies if not totally eliminated. But this is not the case. Income inequality in the West has not improved and in fact has fallen backwards in more recent decades. Sociologists, economists, and political scientists agree that an underclass exists in all these societies. For decades these problems were believed to affect mostly “minorities”, but recent evidence shows that many in the mainstream middle class are descending into the underclass. So why did the welfare state with one-fourth of GDP at its disposal still fail to prevent that?
Most likely the ability of income redistribution in alleviating poverty has its limits; and like everything else is subject to diminishing returns. Poverty alleviation has to be tackled through another front – economic growth. This is the subject of next week’s essay.
References:
Milton Friedman, Capitalism and Freedom, University of Chicago Press, 1962.
Yue Chim Richard Wong, “The Value of Not Working and Its Policy Implications,” Hong Kong Economic Journal, 16 January 2013
Seventh essay in the series on Rekindling Hong Kong’s Magic
