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Speaking of the Economy
Speaking of the Economy - Claudia Macaluso
Speaking of the Economy
March 19, 2021

The U.S. Welfare System: Does it Do the Job?

Audiences: Community Advocates, Economists, General Public, Policymakers

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Claudia Macaluso describes why the United States has a welfare system, how it was designed, and how effective it is at combating poverty, especially during recessions and the downturn caused by the COVID-19 pandemic. Macaluso is an economist at the Federal Reserve Bank of Richmond.


headshot of Claudia Macaluso
Federal Reserve Bank of Richmond


Charles Gerena: My name is Charles Gerena, online editor for the Research Department at the Federal Reserve Bank of Richmond.

Today, I'm having a conversation about the U.S. welfare system with Claudia Macaluso. Claudia joined the Richmond Fed as an economist in 2019 after working at the University of Illinois at Urbana-Champaign as an assistant professor of economics. Her research centers on labor market dynamics and mismatch, occupational and spatial mobility of workers, and human capital.

Thanks for speaking with me today, Claudia.

Claudia Macaluso: It's great to be here. Thank you.

Gerena: Let's start by taking a step back. What interested you in taking a deep dive into the welfare system?

Macaluso: That's a great question. I normally think about the mobility of workers across jobs, and what facilities and hampers that mobility.

Because of my interest in labor economics, in mid-June 2020, when the first wave of the pandemic was in full swing, I was invited to offer opening statements at an event that was held by the Fed of Richmond and the Fed of Atlanta on benefits cliffs. This was an all-day workshop, so it sounded pretty interesting and I accepted. I have to admit that I knew quite little about the topic, but I was interested in learning more.

It was perfect timing because, at the time, Congress had just finished debating the merits and drawbacks of offering financial assistance to American families — this is the now infamous $600. Now, it seems quite quaint, doesn't it? There was some resistance to such provisions among legislators, among some of the employers we regularly survey at the Fed, and, in fact, a good part of the media and civil society.

I quickly realized how the discussion around welfare can be really polarizing. In addition to this opposition there is also, just as loud sometimes, the cheering of progress by the other half of society and the media and legislators. Some of them see the welfare state as progress, a significant achievement in human development. Some others, instead, see the term "welfare state" as pretty much an abomination, a distortion of the founding values of the country.

When I got into this debate, I was approaching it from a technical point of view. I'm a labor macroeconomist, so the first thing I thought about is the parallel with employment insurance benefits, or UI. At the time, we were discussing the UI extensions, that was in spring 2020. I saw that as an extraordinary measure for extraordinary times. We were in the midst of the pandemic recession and unemployment had skyrocketed above like 10 percent, and so that measure was meant to alleviate poverty at a time when poverty was extraordinarily large.

When I came to the realization that my view was already positive on the UI benefits, here I was, scarcely two minutes into research on the welfare system and benefits cliffs and I was already taking, to some extent, a stand. And that made me intrigued because this is a topic that really triggers discussion and important conversations.

Gerena: Definitely.

Certainly, over the years, the welfare system has made headlines whenever proposals are made to reform it. For those of our listeners who haven't had direct experience with it, what is this system exactly?

Macaluso: That's a great question. Let me take a step back further and reflect on why do we even have a welfare system.

Ever since the Industrial Revolution, society has recognized that the gains of economic growth and progress do not really accrue equally to all citizens. We recognize that there are haves and have-nots.

In the 1800s, poverty shrunk dramatically both in the whole world and in the U.S. specifically. But it's fair to say that poverty has not been eliminated. In fact, currently, one out of six Americans is poor, and the definition of poverty is that an individual earns less than $12,880 per year. The welfare system wants to address exactly this — poverty.

Why do we care about fighting poverty? Well, poverty obviously affects those who experience it in a negative way. In addition, there is good evidence that it affects all of us in a negative way. There is especially robust evidence of harm to children. Even when they undergo a relatively short and temporary stint in poverty, the damage is long lasting.

And, of course as we all know, poverty has other side effects that we regard negatively. Drug abuse and mental health issues come to mind. Involvement in the criminal justice system is correlated with poverty [as well as] increased incidence of divorce, pregnancy out of wedlock, and teen pregnancies. The key is these phenomena affect the poor directly, but they also affect society as a whole indirectly.

Let me throw out a little jargon here. This is what economists call externalities. We have an externality when the behavior of an individual ends up affecting other people's outcomes. Because of these externalities – the fact that the preference of someone who is poor affects everyone else — and perhaps also because of some empathy and moral considerations, all advanced economies have a welfare system.

This is called a safety net. The idea is that we want to ensure basic standards of living for everyone. I sometimes try to think about it as putting a floor on how low the consumption and well-being of poor individuals can be.

Gerena: Well, you have certainly laid out a logical case for having a welfare system in the United States. So why does it generate so much controversy?

Macaluso: If we think about the origin of the welfare system, it was created as a mix of transfers and taxation benefits to provide this consumption floor for the poor. But how do we provide this extra consumption to those who don't have it? Well, we redistribute resources from rich to poor citizens. But this redistribution, I think, is perhaps the main reason why people pay attention every time the welfare system changes. It's going to change the way the money is moved from rich to poor citizens.

I think we all want the transfer of resources that the welfare system implements to be efficient. We want it to be equitable. And this is true in all countries. I think in the United States there is special attention [paid] to the welfare system because the welfare system is special. The United States is rather unique among other industrialized nations because the safety net is rather small, and it's also available to a smaller number of people than in other countries. Perhaps the most famous example is the fact that the U.S. is the only advanced country that doesn't have universal healthcare.

In a uniquely American way, the debate over welfare is not just a debate over how to move resources from individual A to individual B. It's almost a moral debate about who is worthy, what's fair, and what do we think of the work ethics of the poor.

For a long time, this was guided by the idea that the United Stated is the land of opportunity, and these opportunities are there to be grabbed by anyone who works hard enough. The welfare system contradicts this perception. The fact that we need a safety net, the fact that we need anti-poverty programs, recognizes that some of us may not be able to gain access to opportunities, and that's no matter how hard we try. And so we may need extra help from the government in order to do get access to those opportunities.

So, the very need for a welfare system forces us all to interrogate our value, both political values and moral values. I think conversations about the welfare system are really deep conversations about who we are and who we want to be as a society.

Gerena: You make some great points and I appreciate you providing that important background. Can you give us a bit more detail on the main components of the welfare system?

Macaluso: Of course!

The current system is actually quite complex, as I discovered in my research. Let's try to break it down a little bit. There are two main types of programs: benefits for poor households and tax credits. The benefits are typically in the form of either cash assistance or in-kind transfers — perhaps the most famous in-kind transfer is healthcare assistance.

So let's start with the benefits programs. The main benefits programs are TANF, the Temporary Assistance for Needy Families — that's the closest thing to a welfare check — SNAP, the Supplemental Nutrition Assistance Program — that's the food stamps — subsidized housing programs which are meant to defray housing costs for needy families; and Medicaid and CHIP that provide healthcare assistance.

The healthcare programs are by far the largest. This may be shocking to listeners — it was shocking to me definitely. Of every dollar spent by the federal government, 25 cents are for healthcare programs. In fact, healthcare programs accounted for 5 percent of the total GDP of the United States.

Benefits programs, including healthcare, are mostly in-kind. There is only one part of TANF that's not in-kind — about a third is cash transfers. The distinction is relevant because when someone is sent a check, they have freedom on how they spend it. On the other hand, a food stamp is what it is — you can't buy anything else but food.

I also want to mention that most of these programs have stringent work requirements. That means that if you do not work, you cannot get help. In addition, they are targeted to parents, so typically a family without children or a single individual would not be able to get access to welfare programs, or would get access to a vastly reduce amount.

Gerena: So, it sounds like there's a lot of focus on the in-kind transfers. But what about the tax credit side of the equation?

Macaluso: The other large part of the welfare system are the tax credits. In fact, this part has been growing over time and features prominently in the new act that Congress just passed, the American Rescue Plan Act.

[With] tax credits, there is pretty much two types. The ETIC, the Earned Income Tax Credit, and the Child Tax Credit, the CTC. Both of them consist of what you think they do: an annual refund on a family's tax obligations. Because it is a refund from your tax obligations, then obviously it's only available if you have tax obligations — no income, no taxes, no credit. So, in that sense, even though there are not stringent work requirements, it only accrues to you if you are working.

Also, this tax credit program has some kind of family bias. It's much more generous to parents than non-parents or parents whose children do not live with them. Just to give you a ballpark number, in 2018 the average EITC credit was a little over $3,000 for a family with children, compared with a little below $300 for a family without children.

Gerena: It certainly sounds like there is lots of different requirements and lines that are drawn in terms of eligibility. Given all of that, what parts of the welfare system work the best in keeping people out of poverty?

Macaluso: That's a great question. I think the complexity of the welfare system is certainly something that we need to take into account when we judge whether it is working or not.

Now, does it actually keep people out of poverty? That's a hard question because it depends on what we mean by "keep people out of poverty."

The tax credits historically have been very successful at lifting parents and their children above the poverty line. That's one of the reasons why they are so popular as well.

Why are they so successful? Well, they encourage parents to work more because the more you earn, the more you get back in tax credits. They also directly provide cash. Going back to that point we were making before, when you get cash, you can spend however you like. It's not restricted. That seems to be helpful in lifting people above the poverty line.

When I say it has been very successful, what do I mean? When you look at the percentage of people in the United States that are poor — below the federal poverty line — in the 1970s it was about 25 percent. It's about 15 percent currently. By the way, most of that change actually happened before the 1990s, so before the Clinton reforms.

So, do we take from these numbers that the welfare system is working as intended? Umm, I would say yes and no. It is true that the system has been successful in supplementing the incomes of the poor and lifting them above the poverty line. If I take the baseline income and add the transfers, that goes above that $12K number.

On the one hand, the poverty rate after the transfer has gone down, but the poverty rate before the transfer has not gone down. So what do we make of that? Well, what we make of that is the innate ability of the poor among us to sustain a high level of income, that has not changed. So, the welfare system has not been successful in lifting people out of poverty in a permanent way.

Sometimes I like to think of this as the system works to bring people out of poverty, but not quite up the income distribution.

Gerena: Why is that?

Macaluso: Well, part of this is a function of how the welfare system was designed.

The benefits are relatively small, typically a small fraction of a state's median income. In Mississippi, for example, my single mother with two children would get $170. She would get about $1,000 in New Hampshire. These are the poorest and the richest states, by the way, in the U.S. If you want to put that into perspective, $170 in Mississippi is 0.4 percent of the state's median income. In New Hampshire, it's 1.3 percent, so even when the benefits are so-called "generous," we're talking about 1 percent of the state's median income. That's not a whole lot.

I think it's not hard to see how quality childcare or affordable education is not quite affordable under such income. Perhaps it's not a surprise that, even though a family would be lifted above the poverty line, we wouldn't see the multiplier effect, a lifting up effect, for welfare recipients.

There is also another aspect of this difficulty to lift people up the income distribution, not just out of poverty. This is what we economists refer to as benefits cliffs.

Gerena: You used the term "benefits cliff" a couple of times. This is a topic of interest to the Richmond Fed lately. We've done several webinars on this subject. Tell us briefly what you mean by this.

Macaluso: Well, a benefits cliff is a situation in which, as individuals improve their income levels, the benefit programs reduce the amount of assistance that's available to them, until eventually this amount abruptly becomes equal to zero after a pre-specified income threshold. At that point, an extra dollar earned on your job is more than compensated by the loss of the benefits. That results in your net income actually decreasing even as labor income increases. Needless to say, what tends to happen is that, for the people that are facing a benefits cliff, they tend turn down a better-paying job so that they can keep their income and their benefits.

Gerena: Thank you for that additional definition. We have done a previous podcast on this topic with some members of our Community Development team. I encourage our listeners to take a listen back to that.

Going back, what happens during a recession? How well does the welfare system work?

Macaluso: This question is, unfortunately, extremely relevant right now.

To make a long story short, the welfare system doesn't very well during recessions. The main reason is that, as I described before, most programs have work requirements, so people who are out of work are not eligible for help. But recessions are precisely the times when people become poor because they just lost their job. So, that limits the ability of the welfare system to address poverty because of unemployment.

I should say that one partial exception is SNAP, the food stamps program. But even through that program, assistance to individuals who do not have children is very limited. That cuts out a sizable part of those who may need assistance in recessions.

Gerena: That would suggest that the system didn't help much during the recent, what people are calling the "coronavirus recession."

Macaluso: I would agree with that. I think the pandemic made us all painfully aware of how inadequate the U.S. safety net is. This is true especially for the most vulnerable: children.

The pandemic has affected a large number of individuals and families, not just children. It has swelled the poverty rate — some estimates even put it back at the 1970s level of 25 percent.

There is, perhaps, a silver lining. The incidence of poverty during the recession has made poverty more visible to many Americans who were previously unaware of it. It has amplified how poverty and racial inequality interact. It has underlined how the current system doesn't really address the interplay between poverty and racial inequality. Nor does it address the root causes of poverty, which I think we can agree is institutional racism.

Of course, for those affected, this has a negative impact, now and in the future. That illustrates a point that we didn't really realize as a society, which is the dynamic effect of poverty. Poverty is not just something that hits you now and then disappears and all is well if you start working and create your income.

So, I think the COVID pandemic has made us aware that even those of us who think may not be at risk of poverty, we may be. And that single dip into the poverty pool can have long lasting consequences.

Gerena: So, we're in a situation now where Congress has passed this American Rescue Plan Act to help people in need. How does it address these unique circumstances?

Macaluso: In my view, the bill has two main components. First, it deals with the effects of the pandemic and the severe economic downturn that COVID has brought about. It does that through direct payments to individuals. That's the check that almost all Americans will receive. Second, it takes a bit more of a long term approach and it reforms the safety net as we know it.

The best way to think about it is, perhaps, how the American Rescue Plan Act shifts the paradigm to better support working families with children. This is done by expanding, quite significantly, the size and scope of the tax credits by allowing these tax credits not to diminish with the number of children in the houses. In most other welfare programs there is a cap, so adding a child doesn't increase the amount of benefits one is eligible for.

Honestly, these provisions are nothing short of revolutionary. They really change the way we think about the welfare system, the way we understand the safety net. They recognize that we have a vested interest in healthy, thriving children. In fact, I think it also recognizes that investing in children is a really good idea. It has high returns — there is very robust evidence in economics of the returns to early childhood interventions. And this is not just for the child but also for society as a whole.

So, I think this idea that investment in children has really ROI makes it a worthy cause to spend public money on.

One last thing is these provisions are slated to expire after one year. But my understanding is that there is clear political will to make them permanent. Both the policymakers and the public opinion have come to view a safety net more in the European style, as less of an abomination and more of an opportunity.

Gerena: Well, I guess we'll see what happens. Thank you so much for sharing your insights about the welfare system to our listeners.

Macaluso: Thank you.