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A new idea for welfare reform

April 1, 1995


Michael Keane Visiting Scholar, Institute
A new idea for welfare reform

At the heart of the current welfare reform debate is the future of Aid to Families with Dependent Children (AFDC), the program that provides income support for single mothers and their children. AFDC is widely unpopular because AFDC recipients rarely work. This makes AFDC an attractive political target - and the consensus in both parties is that the system should be changed so that recipients are encouraged or required to work. It is clear that AFDC will be changed. The question is, how?

The problem with AFDC is that it creates a framework in which work is not a rational economic choice for most single mothers. The "typical" single mother is a poorly educated white woman with two children who has experienced a divorce or separation, and who can only get low-wage jobs. If she does not work, then AFDC provides a basic level of income support, albeit well below the poverty line. But, if she gets a job, everything she earns (beyond her child care and other work-related expenses) is subtracted from her AFDC benefits, dollar for dollar. Thus, under the current system, there is little to no incentive for a low-wage single mother to work.

One of the most basic economic principles states: If you want less of something, tax it, if you want more of something, subsidize it. The AFDC system heavily taxes work. The obvious way to get AFDC recipients into the labor market is to start subsidizing work. Recently I completed a study with Robert Moffitt of Brown University in which we assess the impact of providing a work subsidy to single mothers. According to our analysis, provision of a modest work subsidy would lead to a substantial reduction in the AFDC caseload, and a substantial increase in the number of single mothers who work. Strikingly, we also find that a modest subsidy would be roughly cost neutral.

Consider the following analysis that is representative of our results. We examine the effect of creating a modest work subsidy of at most $32 per week ($1,660 per year), paid to any single mother who works at least 20 hours per week. To limit the subsidy to low-income women, we reduce the basic $32 per week subsidy by 7 cents for each dollar earned. We find that this modest work subsidy would reduce the AFDC caseload by 17 percent and reduce by 20 percent (or approximately 850,000 people) the number of non-working single mothers. It would also reduce total government welfare costs by 3 percent, while increasing the net after tax earnings of the typical low-income single mother by 2 percent.

It may be surprising that a modest work subsidy of less than $32 per week would induce 850,000 non-working single mothers to enter the labor market. But consider a woman with an opportunity to work 20 hours per week at $5 per hour. For her, the subsidy would come to $25 per week. This would raise her effective wage rate to $6.25 per hour--a substantial increase.

It may also be surprising that the work subsidy is cost neutral. The subsidy saves the government money when it induces single mothers to work and get off welfare, for the cost of the subsidy is less than the benefits paid to non-working mothers. The subsidy costs money when it is paid to mothers who would have worked regardless. For the specific subsidy formula used in the above example, the costs of the subsidy are roughly offset by the savings. More generous work subsidies would cause greater numbers of AFDC recipients to start working, while leading to modest overall increases in welfare costs.

A key aspect of the subsidy proposal is that it targets part-time work. There are two reasons for this. First, from a social perspective, it may be undesirable to have single mothers spend 40 hours per week away from their children. From an economic perspective, it is also not cost efficient. The welfare benefits of a typical single mother are reduced by approximately 70 percent if she shifts from non-work to part-time work. Correspondingly, the most substantial reductions in government welfare costs come from encouraging single mothers to work part time (rather than full time). Hence, targeting the work subsidy to encourage part-time work leads to the greatest possible AFDC cost reduction for each work subsidy dollar spent.

Another key aspect of the work subsidy is that it is provided to any single mother who works at least part time, regardless of whether or not she is on AFDC. This differentiates it from many other welfare reform proposals, which involve building work incentives into the AFDC program itself. For example, one idea is to provide free day care to AFDC recipients who work, and to allow them to keep a fraction of any income they earn in excess of work expenses. But providing work incentives to AFDC recipients alone (rather than to all single mothers) would have the perverse effect of making AFDC participation more attractive--thus increasing the AFDC caseload.

In summary, our results indicate that a work subsidy program for single mothers would encourage work and reduce welfare caseloads without increasing total welfare costs. Furthermore, the provision of a work subsidy would actually make single mothers and their children better off. Alternative proposals to get AFDC recipients into the labor market should be judged by whether they can achieve these same objectives.

Unfortunately, the welfare reform proposals of both the House Republicans and the Clinton administration fail to meet this standard. In particular, both proposals would be extremely expensive. Consider the welfare reform legislation recently passed by the House. Its centerpiece is a two-year time limit on collecting AFDC benefits. This would certainly force single mothers off AFDC. But many single mothers on AFDC have wages too low to support a family by work alone. The House legislation begs the question: "What will happen to the 9.5 million children of the 4.5 million single mothers currently on AFDC if their mothers fail to find good jobs in two years?"

Despite its problems, the current AFDC program provides support for these children in a remarkably cost-efficient way. In 1990 it cost only $20.4 billion, or 0.33 percent of gross domestic product, and it provided support for 9.5 million children at a cost of only $2,250 per child annually. If AFDC were simply cut off after two years, many of these children would be left without adequate support. If society refuses to tolerate such a situation, then alternative means to support these children, such as publicly provided foster care, would be vastly more expensive than AFDC.

Consider next the Clinton administration plan. It also calls for a two-year limit on AFDC receipt, but with guaranteed public works jobs for women who cannot find work after two years. The creation of such jobs is notoriously expensive (about $15,000 per job per year). In addition, the administration plan includes an incentive for low- income people to work through expansion of the earned income tax credit (EITC). The EITC is a type of work subsidy, but our results indicate that most EITC dollars go to full-time workers who would have worked full time regardless. Thus, the EITC is an extremely cost- inefficient way to encourage work. In fact, our research indicates that the increase in the EITC proposed by the administration would substantially increase government welfare costs.

In conclusion, our research indicates that a universal work subsidy is the most promising strategy for welfare reform. Among the proposals currently being debated, only a universal work subsidy can encourage work and reduce welfare caseloads, without simultaneously increasing program costs or hurting single mothers and their children.

Michael Keane is an associate professor at the University of Minnesota, in the Department of Economics and the Department of Industrial Relations, Carlson School of Management. He is also a consultant to the Federal Reserve Bank of Minneapolis. The study described here was commissioned by the Food and Nutrition Service of the U.S. Department of Agriculture, and the research was supported by the Federal Reserve Bank of Minneapolis. It will be published in the bank's Quarterly Review (Spring 1995).