Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS1

EXPENDITURE PROGRAMS AND SOCIAL INSURANCE

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS2

Even if the individual does not work, there is an upper limit to the amount of leisure she can consume, because there is a “time endowment”.

Assuming no welfare is available if the ind. Works 1 hr. Each week, her consumption of leisure equals her time endowment minus 1 hr (with $w as income).

Assume that welfare program is announced and that this individual is eligible for $ 338 monthly. How does the budget constraint change?

I. EFFECTS OF EXPENDITURE PROGRAMS

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS3

Do receipt of welfare payments create a “welfare mentality” that reduceS the chances the recipient would ever become self-supporting. This question is “whether the receipt of welfare changes the slopes of an individual’s leisure/income indifference curves”. So far, no empirical studies have succeeded in finding evidence for this question.

Welfare payments may also create dependence through its effects on family structure. Fathers may be induced to leave their families.

An alternative scheme is “workfare”. Able-bodied individuals receive transfer payments onlf if they agree to participate in a work related activity and accept employment if offered.

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS4

Proponents of workfare point to several advantages:

1) requiring welfare recipients to work may make the program more popular politically and hence lead to more generous benefits.

2) By making it harder to collect welfare, it reduces caseloads and lowers the cost of welfare.

3) It gives people the opportunity to gain work experience and skills, allowing them ultimately to escape from poverty.

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS5

Government programs that replace income losses that are consequences of events at least partly outside personal control are referred to as social insurance, under which social security and unemployment insurance can be analyzed.

Although the various programs serve different functions, several share these characteristics:

1) participation is compulsory2) eligibility and benefit levels depend, in part, on past

contributions made by the worker.3) Benefit payments begin with some identifiable occurence such

as unemployment, illness or retirement.4) The programs are not means –tested; financial distress need

not be established to receive benefits.

II. SOCIAL SECURITY AND UNEMPLOYMENT INSURANCE

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS6

1) Adverse Selection:

Private insurance companies sell policies that provide a fixed annual income in event of disablement. Such policies –annuities- are sold only to fairly large groups of people.

Employers with many workers can make collective purchases for their employees. Individuals and small groups can buy annuities but they are expensive and rare.

We can expect an individual who knows he is especially likely to collect benefits to have an especially high demand for insurance, known as adverse selection.

Even if the insurance company requires a physical exam, chances are that the individual knows more about his health status than the company.

WHY SOCIAL INSURANCE?

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS7

These higher premiums exacerbate the adverse selection problem. Only individuals who know they are in great risk will pay the high prices. This requires a further increase in premiums and the pattern continues.

Many people who are not part of some large group find the cost of insurance so high that they choose not to insure. The market fails to provide an efficient amount of insurance. Mandatory social insurance solves this problem by forcing everyone into one big group.

2) Paternalism: Individuals lack the forsight to buy sufficient insurance for

their own good and therefore the gov. must force them to. Individuals who can opt out of a social insurance program may believe that if they put themselves in a sufficiently desperate situation, gov. will feel obliged to come to their aid (moral hazard). Compulsory system eliminates this kind of moral hazard.

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS8

3) Economize on Decision-making Costs:

Insurance and annuity markets are complicated, it is likely to involve a lot of time or effort to choose the right policy.

If public decision-makers can choose an appropriate program for everybody, individuals do not have to waste resources on making their own decisions.

4) Income Distribution

To an extent, social insurance programs are also income distribution programs, that’s why they are compulsory.

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS9

During their working lives, members of system and their employers make contributions via a tax on payrolls. On retirement, members are eligible for payments based in part on their contributions.

By providing a fixed annual benefit for as long as one lives, ss (social security) provides insurance against the possibility that one will live longer than expected and use up all the assets one has accumulated for retirement.

Financing of ss is by payroll tax which is a flat % of an employee’s annual gross wages up to a certain amount.

SS is more than insurance, because if insurance were the only objective, each individual would receive an actuarially fair return on average, the benefits received would equal premiums paid.

STRUCTURE OF SOCIAL SECURITY

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS10

Some economists argue that ss distorts people’s behavior and impairs economic efficiency.

Saving behavior: Life cycle theory of saving: individuals’ consumption

and saving decisions are based on lifetime consideration. During their working lives, individuals save some portion of their incomes to accumulate wealth from which they can finance consumption during retirement. Such funds increase society’s capital stock.

EFFECTS ON ECONOMIC BEHAVIOUR

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS11

Effects of a SS system on life time savings:

1) Wealth-substitution Effect: Workers realize that in exchange for their ss contributions, they’ll receive a guaranteed retirement income. If they view ss taxes as a means of saving for these future benefits, they’ll tend to save less on their own.

2) Retirement Effect: ss may induce people to retire earlier than they would have because to receive benefits, they have to reduce participation in labor force. If the length of retirement increases, the ind. Has more nonworking years during which consumption must be financed but fewer working years to accumulate funds.

3) Bequest Effect: people want to leave inheritances for their children. Parents would save more to increase bequests so as to offset the distributional effect of ss.

Evidence shows that (1) > (2) + (3) (saving falls) Although ss distorts economic decisions by depressing both

work effort and savings, this does not mean it is a bad system.

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS12

Nb* B = t * Nw * w Nb : total number of retirees , B: benefit per retiree , T: tax rate Nw: number of workers, w: wage per worker

Social security system is financially unstable: t = (Nb / Nw)/ (B / w)

D.R = dependency ratio: Nb / NwR.R = replacement ratio: B / w

Long term problems with social security arise from the fact that D.R is increasing over time.

LONG TERM STRESSES ON SOCIAL SECURITY

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS13

1) Maintain the current system:

The current system could be maintained by an increase in taxes only by 1-2 % points. Alternatively R.R could be lowered.

2) Privatize the system:

The argument is that if social security taxes were invested in the private market, these substantial rates of return would allow retirees to enjoy large benefits without imposing huge taxes on the current workforce.

SOCIAL SECURITY REFORM

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS14

Privatization can help finance future retirees’ consumption only to the extent that it allows future output to increase. The only way it can increase future output is by increasing the capital stock in the present.

There is no reason to believe that privatization by itself would raise national saving. The government has to finance its deficits one way or another. If ss surpluses are not held in government bonds, the government must sell its bonds to private investors.

In order to induce private investors to accept government bonds that would have been bought by the trust fund, their yield has to go up or yield on stocks must fall or both. At the end, all that takes place is a swap of public and private securities between trust fund and private markets.

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS15

One possible drawback of privatization is that it would expose individuals to more financial risk – if stock market turned down, their consumption during retirement suffers.

Administrative costs of privatization may be an important issue.

Social security has two goals: 1) force individuals to insure themselves by reallocating

income from their working years to retirement, 2 ) distribute income to elderly citizens who would

otherwise lack a “socially adequate” level of support.

These goals may not be maintained with privatization.

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS16

Private markets fail to provide adequate amounts of insurance in situations where adverse selection and moral hazard are important. Unemployment satisfies these conditions:

Adverse Selection: Those workers who have the highest probability of becoming unemployed have the highest demand for unemployment insurance.

Moral Hazard: Those workers who managed to obtain insurance might experience more unemployment than otherwise would have been the case.

It is hard to imagine that providing unemployment insurance would be a profitable venture for private insurance companies. A compulsory government program avoids the adverse selection problem. Government provision of UI may increase efficiency. But it doesn’t eliminate moral hazard.

UNEMPLOYMENT INSURANCE

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS17

UI is financed by a payroll tax, paid by employers only.

UI may increase unemployment due to:

1) imperfect experience rating: it may be mutually beneficial to lay the worker off temporarily.

2) workers may accept employment in industries where the probability of future layoffs is great.

3) Unemployed people may spend more time looking for work than they would otherwise.

If workers spend more time to search, they may find jobs that are more appropriate for their skill, which increases efficiency.

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS18

Reasons:

1) Poor Information:When you are ill, you may not have a very good sense of what medical procedures are appropriate. The person on whom you are likely to rely for advice, (doctor) is the person who is selling you the commodity.

2) Adverse Selection and Moral Hazard: Adverse selection: When a health insurance company sets a price for a policy for

individuals in a given class, the policy tends to be purchased by those individuals within the class who have the highest risk.

III. HEALTH CARE

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS19

This adverse selection problem causes the average buyer of insurance to have a high risk than the average person in his or her class. Company must raise premium to break even. With higher premiums, relatively low-risk individuals leave the market. The market may underprovide health insurance.

Moral Hazard :

If people know that they have insurance, they may take less care to avoid risks.

People with insurance may adopt more unhealthy lifestyles because insurance reduces the negative results of doing so.

People also have incentives to overconsume health care, as insurance pays all or most of the cost.

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS20

Should Government’s Role in Health Care Increase?

1) Single Payer System: funded by taxes and provides all citizens, regardless of income or health status, with a determined set of health care services, at no direct cost to the insured. Forcing everyone into the system solves the adverse selection problem.

Proponents believe that it is unethical to force sick people to have to make cost-benefit decisions about receiving health care and admire the universal access feature of the program. However, because patients pay little or nothing for care, critics note that there are no incentives to reduce costs in the system.

In single-payer countries, rationing is done by imposing constraints on the supply side of the system.

Prof. Dr. Y.Kuştepeli ECO 2006 PUBLIC ECONOMICS21

2) Managed Competition:

It is a combination of government regulation and market competition. The idea is to have “sponsors” to purchase health insurance on people’s behalf.

Sponsors could be large employers or they could be cooperatives formed by banding together groups of small businesses. The sponsors would require health care providers and insurance companies to compete on price and quality to obtain their business.

The sponsors would offer consumers a variety of insurance plans and let them choose the one that suited them best. Unemployed individuals could also purchase insurance through sponsors; their premiums would be publicly subsidized.