EC1420 READINGS STUDY GUIDE – post-midterm
Thanks for the hard work, everyone!
DO NOT DISTRIBUTE
Snezhana Zlatinova (zlatinov@fas) (p..541—560)
Freeman, Richard B. and Katz, Lawrence F. Rising Wage Inequality:
The United States vs. other Advanced Countries
 There was a large increase in income inequality in the U.S. in the 1980’s: 1989
real incomes for the bottom 40% of families were the same as in 1979, whereas
for the top 20% they had risen 20%.
 There has been a shift in labor market opportunities in favor of the more educated,
more skilled: but has this been part of a general pattern for advanced countries?
 4 key aspects of the wage inequality issue are looked at in the paper:
o In the 1980s only in the U.S. did low wage workers actually have large
DECLINES in real incomes
o There was a shift in demand for labor (due to international trade and skillbiased technological change), but these were similar across countries and
hence do not explain cross-country differences in the rise of inequality
o Slower growth in the supply of educated workers (due to slower growth of
college graduates, influx of uneducated immigrants) in the U.S. was a
factor in the rising wage differentials by education
o Differences in wage-setting institutions (such as the steep decline in
unionization in the U.S.) and training programs also contributed to the
cross-country differences.
The Changes in the U.S.in the 1980s:
The finding that inequality increased is not sensitive to dataset used. There are 4 key facts:
1)--in the 1980s wage dispersion increased to levels greater than any since 1940
2)--Pay differentials by both education and age increased (older workers and more
educated workers were paid significantly more)
3)--wage dispersion increased within demographic and skill groups
4)--the real earnings of the lass educated and lower paid actually fell compared to
earnings of analogous individuals a decade earlier.
 Most of these changes were not the continuation of trends that had begun before
the 80s (only within-group wage dispersion for men had begun earlier)
 The rise in the education premium has induced some offsetting forces (increased
enrollment in college)
Changes in other advanced countries:
There are a number of measurement differences between different countries, but
differences that are constant over time shouldn’t distort trends in inequality comparisons.
 In the late 60s-late 70s, all the advanced countries shared a pattern of narrowing
occupational and educational wage differentials.
 In the 80s, overall inequality and education differentials stayed the same in
several countries or grew modestly in most others, but only in the U.K. and U.S.
were there double-digit increases in inequality (and of these two, the real pay of
the poorest in the U.K. still grew, unlike in the U.S.)
Explaining the changes:
The authors offer a 3-part explanation ( which they term Supply-Demand-Institutional,
SDI) for why wage inequality and education differentials increased more in the U.S. than
in other countries:
1. changes in the supply and demand for labor skills do substantially alter wages and
employment of different groups.
2. wage setting institutions: the stronger the role of institutions in wage
determination, the smaller the effect of shifts in demand and supply on relative
wages. Different training and education institutions also yield different outcomes.
3. Institutional changes (i.e. changes in unionization, product market deregulation)
 The SDI explanation fits the U.S., where
i. the internationalization of the economy and immigration raised
supply of uneducated workers, and
ii. technological change such as computers increased relative
demand for the skilled.
iii. At the same time, there was a decline in unionization, which also
contributed to greater wage inequality. (the other institutional
changes, such as the fall in the value of the minimum wage and the
reduced generosity of welfare, these probably had more marginal
effects.)
 With regards to the difference between the rise in inequality in the U.S. and in other
countries, the labor demand part of the SDI explanation are unlikely to be the cause of
differences across countries.
i. In terms of supply, on the other hand, the growth of college
graduates decelerated sharply in the 80s only in the U.S.
ii. In terms of institutions, the U.S. ranks low on the role of wagesetting institutions, and the evidence from the effect of institutions
overseas shows that they can dampen the pressure for greater wage
inequality, but only to a limited extent (labor market forces
eventually affect and limit the effect of institutions)
Conclusion: the rise in inequality in the U.S. is unlikely to be undone simply by
increasing the supply of college graduates. Based on the analysis of overseas approaches,
“ an economic policy that involves policies to augment the skills of the less educated, and
develops institutions to protect workers’ interests in the labor market, and that encourages
market responses in the form of greater investments in higher education” could provide a
solution.
Feldstein, Martin. Reducing Poverty, not Inequality (first 2 pages)
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Feldstein claims that what policy should address is poverty rather than inequality.
In this paper he deals only with the evaluation of changes that increase the income
of the high-income individuals without decreasing the income of others—
according to the Pareto principle, such a change is desirable.
Since there is no way to compare 2 different individuals’ utility from extra
income, redistributive policies are not necessarily justifiable as increasing the
social value of incremental income in the economy.
To claim that all increases in inequality (which a rise in the Gini coefficient
reflects) are bad implies an assumption that the social value of extra income to the
rich is actually negative.
Ec 1420 Review: Pages 561-579
Reducing Poverty, not inequality By Martin Feldstein  Pages 559-567
Thesis: “I disagree…[with the] common reaction in the popular press, in political
debate, and in academic discussions [that] regard the increased inequality as a problem
that demands new redistributive policies…I believe that inequality as such is not a
problem and that it would be wrong to design policies to reduce it. What policy would
address is not inequality but poverty.”
Main Points:
 Increasing income is not necessarily a bad thing, Pareto improvement
 Redistributive policies can still be good because the value of marginal
income is less as income gets higher
 Gini Coefficient
o Measure of income inequality
o Measures the concentration of incomes in the nation, with a
high value implying more concentration
o However, an increase in income concentration among the rich
without a decrease among the poor causes it to go up.
Feldstein says this is bad.
 “There is nothing wrong with an increase in the well-being of the
wealthy or with an increase in inequality that results from a rise in
high incomes.
 4 reasons for increase in higher incomes
o more educated people, higher value placed on education
o entrepreneurial activities are more popular and more profitable
o high-wage people work increasingly long hours
o decline in cost of capital – reflects improved fiscal outlook
 3 sources of poverty: unemployment, a lack of earnings stability,
individual choice
o ways of overcome these problems
 individual choice – “tough love”
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lack of earning ability – improved public schools,
improved on-the-job training, “low cognitive abilities
of some need to be recognized”, dysfunctional lifestyles need to change (ie drug treatment)
American Inequality and Its Consequences By Gary Burtless and Christopher
Jencks  Pages 568-579
Thesis: Paradox: Americans think inequality is an issue “While most Americans
think income inequality is too high, most also distrust the government and attribute
American’s economic success to the fact that its economy is lightly regulated.”
Nice Summary of the Article:
“We being by describing how distribution of income has changed in the US since
the 1970s, why it has changed, and why it is more unequal than the distribution in other
rich democracies. We then assess the evidence on whether changes in economic
inequality affect four other things that Americans care about – economic growth, equality
of opportunity for children, longevity, and the distribution of political influence. We
conclude that inequality probably does not have a consistent effect, either positive or
negative, on economic growth in rich democracies. We show that college attendance
became more related to parental income as economic inequality increased in the US.
Nonetheless, evidence does not show that a father’s economic status has more influence
on his children’s economic prospects in the US than in other rich countries where
incomes are more equal. Increases in economic inequality probably slow the rate of
improvement in longevity, but the effect is very small, probably only a few moths. We
also consider the impact of economic inequality on the distribution of political power.
We argue that increases in economic inequality tend to increase the political power of the
rich, at least in the United States. Overall, we conclude that the effects of inequality on
economic growth, health, and equality of opportunity are modest and uncertain in rich
countries. Accordingly, citizens of these countries should decide how much economic
inequality they are willing to tolerate largely on the basis is what they think is just, not on
the basis of alleged beneficial or adverse effects.”
From: “Inequality and Its Consequences”
Gary Burtless and Christopher Jencks
P580 - 598
Main Points:
US has very high income inequality, which has been rising since the 1980’s
especially. While immigration confounds these numbers (low income workers being
added to the economy at an increasing rate skews numbers), there is still clearly income
disparity vs. the rest of the world. However, this disparity may also be offset by the
social transfer programs that we have (healthcare, food, housing) and also by the fact the
US has very low unemployment. The article goes on to describe 3 theories of the
connection between Income Inequality and Economic Growth.
Most Important (I think):
I believe the most important points (based on our lectures) are the fact that the US
has very high and increasing inequality, but that US has lower unemployment / different
transfer systems than other countries, and that there is no absolute certainty on which is
better, simply that there are tradeoffs.
Inequality and its Consequences
 Some Causes of income inequality:
o Tax cuts for high income families (1981 and 1986)
o Immigration
 “Immigration raises fundamental questions about how to interpret
statistics on poverty” [ because many immigrants come from countries
where they were living below the world poverty line.]
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How does the US Income Inequality compare with other rich countries?
 Inequality tables for rich countries invariably show that the US ranks at/near the TOP.
o This is slightly offset by the social benefit programs in the US, which cause
high-income families to subsidize healthcare/housing/food/etc.
o Thus, income disparity *may* be overstated because of these programs
 2 Ways to compare: Gini Coefficient, Income Ratios
o Gini Coefficient: Rating of Inequality 0 (equal) – 1(unequal).
o Income Ratio: [Income at 90th percentile / Income at 10th percentile]
 Easier to understand
 5.6:1 in US vs 2.6:1 in Sweden or 3.5:1 in France, point being that the
US has a very large income gap.
The US has different Systems than other countries.
 Unemployment Benefits are lower in the US than in Europe.
o Hard for firms in EU to cut wages. This is implicitly subsidized by higher
income workers and tightens the income gap.
o Lower Unemployment in US
 Once the comparison statistics are recomputed taking into account the
$0 earnings of unemployed, the US Gini Coeff/Ratio are similar to the
rest of the world.
How Does Inequality Affect Economic Growth?
 3 Major Themes
o Kuznet Model:
 Agricultural Society -> Industrial (Rise in Inequality)
 Industrial becomes dominant (Decline in Inequality)
 Urbanization, Political Reform (Decline in Inequality)
 Doesn’t fit the US!
o Okun (1975) argues that artificially changing income disparity will reduce
efficiency and slow down economic growth. However, programs like
disability insurance are seen as benefits that outweigh the costs.
 Seems to fit with our comparison of countries with high and low
unemployment benefits.
o Theory that inequality can reduce growth through political system.
 Poor voters will vote to raise taxes, basically.
 Social Unrest, Riots? Chaos? Etc.
A Final Warning from the Author:
 First, it is very dangerous to make strong causal inferences from cross-national
correlations. Second, it is often even more dangerous to make strong causal
inferences from studies of individual differences within a given country or from
studies that focus on the short-term impact of either a specific policy change or
the overall level of economic inequality.
o = It’s hard to distinguish cause/effect in data gathered, and to sort out the
various confounding factors, which makes it even harder to try to solve
this problem (if we want to).
Gary Burtless and Christopher Jencks
“American Inequality and its Consequences,” pp. 599-617
-Connection between income and life expectancy is probably weak not all casual
-low-income white males die 10 years younger than high-income counterparts;
low-income white women die 4.3 years younger than high income counterparts
-Value of additional income is far greater for poor so shifting income from top to bottom
would increase life expectancy
-But other characteristics of the poor affect life expectancies too (alcoholism, obesity, etc.)
-Big redistribution changes would have political/social consequences
-Debate over economic inequality and health should be redirected to measuring how large
the effect is and if it is significant; authors think it is not significant compared to more
direct and controllable effects on longevity and health
-US lacks centralized wage bargaining, makes unionization hard, sets low minimum
wage, mandates few fringe benefits, not generous to the needy compared to other rich
democracies
-Americans tolerate more income inequality because more hostile to gov’t intervention
-Authors most worried about inequality’s effect on political influence because if the rich
can buy more influence, policies that are yielded only allow rich to further increase
income
-Those who oppose egalitarian proposals argue the market distributes income more justly
than gov’t and that economy rewards people for doing valuable things
-Neither the market nor the political process is going to help so the best response is ad
hoc compromises
-Evaluate policies of income redistribution by asking if they are just
-Growing inequality increases family influence on kid’s opportunities, may reduce life
expectancy
CONCLUSION: Within range of rich democracies, measured inequality does not have
large/obvious effect on growth, mobility and longevity. If you care about those issues,
redistribution is not best strategy because it is a hard sell politically. One should focus on
more direct determinants of the outcome of health (e.g. program to reduce smoking).
“American Inequality and its Consequences” (Burtless and Jencks)
Political Influence:
The main reasons that income inequality is more unequal in some rich economies than
others are political. The US does not have centralized bargaining, high minimum wages,
or generous unemployment benefits and thus has a very unequal distribution of income.
Support for egalitarian economic policies is not too widespread in ht US compared with
other countries. Americans are more tolerant to income inequality, partly because they
are more hostile to government intervention in the economy .A problem arises from the
fact that the rich can buy more political influence and thus have reduced political support
for redistributive policies.
Inequality and Justice:
Both egalitarians and their opponents argue on moral grounds whether inequality is a
desirable market result or an unfortunate and immoral result.
However, policies aimed at changing the distribution of income should not be evaluated
on these justice grounds. The authors fear that changes in the distribution of income can
change the distribution of political power and undermine the legitimacy of the political
system. Growing economic inequality is unlikely to affect economic growth, equal
opportunity, and life expectancy. Rich countries have relatively similar living standards,
life expectancies, and mobility. What distinguishes them is the relative political influence
of different political groups, which explain why some rich countries are more equal than
others.
The authors conclude that changing the income distribution is not the best way to affect
growth, health, or equal opportunity, as it is hard politically. Better ways are increasing
innovation and early education. Secondly, legislators should choose policies their
constituent regard as just.
“The 1996 Welfare Reform”- Rebecca Blank
AFDC has been changing over the past 25 years and has been increasingly tied to
work requirements. The 1996 Welfare Reform (which established TANF) continued
these trends as it limited cash support and mandated even higher work requirements.
TANF (the new program) is a block program and it gives states complete control over the
design of their public assistance programs. Under TANF, states will receive a fixed
nominal amount and the federal government no longer will match increased payments, as
was the case under AFDC. States face mandatory time limits on support they can provide
and are required to encourage work effort as a contingency for welfare eligibility.
How will states respond to the new TANF block grants?
In the short-run, no major changes are expected. In the long run, states might
divert funds from cash assistance to dealing with other problems such as teen pregnancy.
The author argues that the new program will not save many of the problems of the
old program. Undoubtedly, states can decrease the use of public assistance by means of
time limits and eligibility limits and induce public assistance recipients to work more, yet
it is not velar if poor women and their children will end up economically and socially
better as a result. If the jobs available to these women are unstable and low wage, they
will not be able to replace fully their public assistance with new earnings. The impact of
increased parental work on children is also unknown. The expansion of the EITC should
alleviate these problems.
Also, the 1996 Welfare Reform is probably too optimistic about job availability,
especially for low-skilled individuals. Thus, policymakers need to find ways to increase
job opportunities via temporary public sector jobs or wage subsidy schemes.
Moreover, the TANF grants will provide a windfall to new states because recently
caseloads have fallen. This extra financing is expected to be applied to other areas of the
state budget.
Another issue to be considered is the fixed nature of the block grants over the business
cycle. The need for public assistance is countercyclical and it rises when the economy
weakens. The new legislation establishes a contingency fund, to be allocated to states if
their funding needs rise during recessions
Keller Rinaudo
Summary 637-655
1. The impact of the phaseout of the EITC on hours of work
a. Because of the way the EITC is structured, with beneficiaries receiving the
payment as part of their annual tax refund, individuals may not respond to
it as they do to other tax incentives.
b. In general, people just don’t understand the details of the EITC and so are
not actively calculating their marginal wage rates.
c. This is substantially different than payroll taxes where even weekly
changes are very obvious to individuals, who may adjust their behaviors
accordingly.
d. A contentious issue with the EITC is how to set the phaseout rate; many
legislators want to raise the rate to decrease the overall cost of the program.
e. The most important effect of the EITC marriage tax is to discourage
married couples from reporting their true marital status to the IRS
2. Using the tax system to transfer income to the poor
a. EITC take –up rates – Using a tax system to redistribute income is highly
effective because high-participation rates in these programs are common
b. Administrative costs – The EITC is much more administratively efficient
than the AFDC (4x as efficient).
3. The EITC compliance problem
a. Who are the ineligible EITC recipients? – Improper claiming of children is
by far the largest eligibility problem associated with the EITC. Most
people who file have qualifying incomes.
b. Taxpayer error or taxpayer fraud? Liebman 1995A shows that the problem
is about 50-50, based upon the idea that people filing in error won’t
respond to increased value for the EITC.
c. Is noncompliance declining?- The nature of noncompliance is changinf as
the support test has been eliminated and the EITC has been expanded to
higher income tax-payers. The overall effect of new reforms if unclear.
4. Implications for the design of transfer problems
a. The EITC is an inefficient redistribution mechanism because if gives
money to people at or above the poverty line.
b. It is critical to make the right choice between a tax system and a more
traditional AFDC-administered system. Each has distinct advadtages and
disadvantages
5. Brief Overview of Social Security
a. Who receives benefits? – Children, spouses, widows, and parents of
deceased or disabled workers, 90% of those over 65 receive SS
i. For 2/3 of beneficiaries, SS is more than 50% of income
ii. It represents 90% of income for 1/3, and 100% for 20%
iii. These benefits not meant to provide a comfortable retirement, but
to be a safe income foundation.
iv. SS benefits are progressive, and this progressivity is meant to be a
form of social insurance.
b. How are retirement benefits determined?
i. Benefits are progressive and are based upon previous earnings.
ii. Calculations for SS payments are made based upon average
earnings, primary insurance amount, monthly benefit amount, and
indexation for inflation.
iii.
c. How Social Security is financed.
i. The SS payroll tax creates a system that is pay-as-you-go. The tax
is imposed on a bse of earnings up to a maximum taxable earnings
base.
6. Restoring Solvency to Social Security
a. The most straightforward way to characterize the financial imbalance in
entitlement programs is to consider their long-range annual budgets.
b. Reform for SS should include moderation of the growth of benefits and a
new system of personal retirements accounts
c. The rationale for Social Security
i. SS requires people who would not otherwise save for retiement
pay for insurance against old-age poverty.
ii. Well-being in retirement is dependent subject to the risks that
someone might have low income during working years or that an
individual might live a very long time and not have enough money
at the end of life
d. Understanding the financial crisis
i. A pay-as-you-go system is balanced when the cost rate equals the
income rate. The annual balance is the difference between the two.
The cost rate is rising very fast relative to the income rate because
people are living longer and having fewer children.
ii. The dependency ration in the US is increasingly dramatically due
to demographic changes, most especially the baby-boomers.
iii. If SS is not reformed soon, the payroll tax will have to rise from
12% to 19% to continue distributing benefits on the same scale as
the system is currently doing.
Summary, Ec 1420, pp. 660-674
Some Economics of Global Warming
By Thomas Schelling
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Magnitude of global warming in this century is in dispute.
How much of global warming is from human contribution?
Upper and lower bounds on projected temperature change are far apart.
Climate change will be gradual, but will have big economic impact.
Costs of reducing carbon emissions is higher than that of other pollutants, like
CFCs.
Climate change would have probably mattered even more to economies in the
past, which were largely agricultural. Manufacturing or service provision is not
especially sensitive to climate.
So the economic impact on developed countries would be fairly negligible; issues
of comfort from warmer summers might be compensated by advantages gained
from warmer winters.
For developing countries, however, it might be quite large: agriculture might
suffer; disease may spread; food supply might be diminished. This is a strong
argument for trying to slow climate change.
Should developing countries make sacrifices in their development to minimize
emission of gases? We need to consider environment and economic growth
together.
Also, climate change might be discontinuous, and involve sudden shocks or
environmental catastrophes that we cannot predict.
It might cost up to 2 percent of GDP to postpone the doubling of carbon in the
atmosphere by two decades; as much as 100 billion dollars. Cost of reducing in
the developing world might be even more uncertain.
What can be done: reducing emissions directly, reducing deforestation, even
putting objects in orbit to deflect some of the incoming sunlight.
To reduce emissions: switching to lower-carbon fuels in Africa and Asia. The
right incentives might not be in place, however—China can claim that reducing
the number of coal-burning plants is not in their interest.
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A uniform universal carbon tax is probably not a good idea: it would require the
US, for example, to impose taxes equivalent to a dollar on each gallon of gas. No
international organ exists to control the collection of that kind of money.
Tradable permits: how to distribute? By current level of pollution? By pollution
per capita? Schelling proposes a system similar to how money was distributed in
the Marshall Plan—a peer review system of submitting projections of emissions,
and having them reviewed by other countries. “Reduce emissions to level below
that of some year” not particularly productive—doesn’t actually specify what
needs to be done or what can be done.
Send technologies for reducing emissions to where they would be most effective:
Another possibility: rich countries tax themselves on pollution, and contribute tax
revenues to a global fund for emissions reduction.
Mark Hariz
Ec 1420
Rethinking Social Insurance
By Martin Feldstein
Main Idea: Social insurance programs (e.g. Unemployment Insurance, Social Security,
and Medicare) have become the most important, the most expensive, and often the most
controversial aspect of government spending in the US and in many other countries. In
this paper, Feldstein discusses how the major forms of social insurance could be
improved by shifting to a system that combines government insurance with individual
investment-based accounts: unemployment insurance savings accounts (UISAs) backed
up by a government line of credit, personal retirement accounts (PRAs) that supplement
ordinary pay-as-you-go Social Security Benefits, and personal retirement health accounts
(PRHAs) that finance a range of Medicare choices. Feldstein argues that such reforms
would raise economics well-being and are also appealing on broader philosophical
grounds.
1. What is social insurance?
a. Different from private insurance because participation in social insurance
programs is mandatory or is induced by substantial fiscal subsidies.
b. Welfare programs are means-tested (i.e. you have to have low income to
be eligible), while social insurance is event conditioned (i.e. benefits are
paid in the event that something occurs: losing one’s job, retiring, etc.)
c. Unlike welfare programs, social insurance programs are NOT designed to
be vehicles of income redistribution.
d. Main social insurance programs in the US are Unemployment Insurance
(UI), Social Security (SS), and Medicare.
2. Why should there be social insurance?
a. “social solidarity” view
i. the sense that all the individuals in the nation are, in effect, viewed
as a single family and treated equally
ii. claims that individuals are incapable of making the complex
decisions required to pan for retirement income or to choose health
insurance or health care
iii. leads to things like uniform health care for all (at least in principle)
iv. embraced mainly by Europe and NOT by the US
b. “individual liberty view”
i. the provision of health care or retirement income is not a legitimate
role for government because it forces individuals to participate in a
common program rather than taking personal responsibility and
making decisions that reflect their own preferences
ii. claims that individuals differ in their tastes and are better able than
governments to judge what is in their own best interest
iii. this is Milton Friedman’s view
c. Marty accepts Friedman’s view but believes that there is a role for
government provision of social insurance benefits because of two reasons
related to asymmetric info
i. Asymmetric information weakens the functioning of private
insurance markets
ii. Asymmetric information because the government is unable to
distinguish people who actually need help vs. people who game the
system by not saving in order to receive transfer payments
3. Principles of Social Insurance
a. Three political principles
i. Permitting individual choice
ii. Creating program transparency
iii. Recognizing political dynamics
b. Four economic principles
i. Recognizing the economic effects of social insurance programs
and their taxes
ii. Designing programs by balancing protection and distortion, while
seeking reforms the improve the available tradeoff
iii. Redesigning programs to keep pace with changing conditions
iv. Separating social insurance from income distribution
Feldstein stresses that insurance adversely affects people’s incentives (e.g. healthcare
insurance), so there is an inevitable tradeoff between protection and distortion. The
optimal point is the point at which the marginal benefit from protection is equal to the
marginal cost from distortion.
He goes in depth into each of the three main social insurance programs: UI, SS, and
Medicare.
The key point that Feldstein makes regarding each program is that a mixed system will be
more effective an will lower long-run costs in all three cases (see the “Main Argument”
section above)
Additional Important Points:
Medicare costs are rising even faster than SS costs, so they present a bigger problem for
the US economy.
UI with high replacement rates and long periods of duration give people an incentive to
stay on UI longer.
There are three distortions caused by the traditional pay-as-you-go SS system:
(1) Reduction in saving and in the present value of consumption
(2) Distortion of labor supply and of the form in which compensation is paid because of
the increase in the marginal tax rate
(3) The incentive to retire early when an implicit tax results from the loss of benefits
caused by delayed retirement.
Summary 694-712
Panel Discussion: Social Security: It Ain’t Broken (p. 694-8)
Thesis: Social Security is a flexible program that can adjust over time. But any
modifications to the program should be made in the context of changing preferences or
goals, not in response to a false perception that the system is going to fail.
1. Social Security has enough money to pay 100% of promised benefits until 2029,
when the trust fund is exhausted. Even after the trust fund is exhausted, revenues
would continue to meet about 3/4ths of program costs.
 Intermediate projects show that between now and 2012, the S.S. system
will bring in more money than it pays out—receipts from annual payroll
taxes and from income taxation of benefits will exceed outlays
 The decline in the fertility rate will increase the ratio of retirees to workers
and cause expenditures to rise above revenues, but in the short run, the
sum of tax receipts and interest on trust fund assets will cover benefit
payments.
 Even if no changes are made, current payroll taxes and benefits would
provide enough for 75% of benefits in 2040 and 70% of benefits in 2075.
2. Social Security is running a 75-year deficit, but actions required to eliminate this
shortfall are well within the bounds of previous changes to the program.
 Under intermediate assumptions, the 75-year deficit amounts to 2.23% of
taxable payrolls. This problem may be solved by increasing the combined
employee-employer tax rate of 12.4% to 14.6%.
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The deficit could be understated in magnitude since the S.S. tax rate is
fixed while costs are rising, and this configuration produces surpluses now
and large deficits in the future—each passing year adds another year with
a large projected deficit and this would increase the 75-year deficit slightly
each year, by 0.08% of taxable payrolls.
3. The economic and demographic assumptions underlying the 75-year projection
are reasonable. The assumption about the size of the real wage differential is the
most controversial in S.S. forecasting, as the actual value has varied dramatically
over time. The current assumption is 0.9%, but even a rather large miscalculation
would worsen long-term Social Security financing by a relatively modest amount
during the next 75 years.
4. Even through deficits reemerged after the 1983 enactment of the Greenspan
Commission recommendations, this is not likely to happen again. These deficits
arose not so much from problems with the economic and demographic
assumptions, which roughly offset one another, but rather from an upsurge in the
disability caseload and technical problems.
5. It I unhelpful to lump together S.S. and Medicare and characterize the problem as
out of control entitlement spending since S.S. spending is not out of control but
rather quite predictable.
Potential Paths of Social Security Reform Part 1 (p. 698-712)
There are only 3 possible responses to the benefits-revenue shortfall: reduce
future retirement incomes, increase the taxes used to finance future benefits, or save more
now and invest those savings in a productive way.
Key assumptions are made in this paper: currently retired or soon to be retirees
will receive full benefits; existing payroll tax rate and base will not increase; the
projected combination of pay-as-you-go benefits and the investment-based personal
annuities will equal or exceed the benefits projected under current law for future retirees;
there will be a permanent financing solution for social security that establishes solvency
over the 75-year forecasting period; PRAs can be bequeathed to anyone the individual
designates.
Basic Mixed System with Equal PRA Contributions:
 All employees shift 1.5% of their 12.45 payroll tax to the PRAs and make an
equal out-of-pocket contribution, 1.8% goes to pay-as-you-go disability program,
and the remaining 9.1% goes to OASI benefits. The aggregate value of the funds
in all PRAs grows with the PRA deposit of 3% of each year’s taxable payroll and
with the 5.5% annual rate of return on the existing PRA assets, and is diminished
by the annuity payouts and lump-sub bequeaths. In contrast to the exploding level
of Trust Fund debt under the current system, Trust Fund balances under the mixed
system would be positive in every year.



This PRA system adds to national savings and therefore increases national
investment in business plant and equipment. Furthermore, the future transfer of
funds from the government budget to the PRA accounts reduce the size of the
government’s unified budget surplus and thereby reduces the likelihood that
future Congresses and administrations will use these funds to finance government
spending. The effect of these estimates on greater tax revenue must be
conservative because behavioral responses are unknown. Feldstein applies a 1%
revenue rate to the PRA balance to estimate the amount of incremental revenues
that the government receives as a result of creating the PRA system, largely
because each dollar of out-of-pocket PRA deposits represents less than a dollar of
additional savings.
While pay-as-you-go benefits will be reduced relative to the levels projected
under current law, the combination of pay-as-you-go benefits and the variable
annuity available under the basic system would exceed the benchmark benefits
projected under current law.
A government-guarantee of benefits would make future taxpayers responsible for
the difference between the benchmark benefit and the actual combined value of
the pay-as-you-go benefit plus the annuity that would be paid on a standard
investment portfolio. An individual who invests in this standard portfolio would
receive from the government the difference (if any) between the combined benefit
that results from this investment play the reduced pay-as-you go benefits and the
benchmark level of benefits in current law for that future year.
Alternative plans with no out-of-pocket contributions
 The four goals of alternative plans are: (1) provide the pay-as-you-go benefits
promised to existing retirees; (2) maintain the projected level of combined
benefits for retirees at or above the levels of benefits in current law; (3) avoid any
increase in payroll tax rates; (4) make the S.S. Trust fund solvent int hat it
remains permanently positive.
 The key to these 4 goals without the out-of-pocket contributions of the basic plan
is to inject some general revenue into the personal retirement accounts. The first
option combined a transfer of 2% of payroll taxes to PRAs with an additional 1%
matching contribution by the government, financed from general on-budget
surpluses (but this probably only possible given the surpluses in 2001). Since the
Trust fund would be depleted faster with a 2 % transfer (as opposed to the 1.5%
payroll transfer in the Basic Mixed System), a more rapid and larger cumulative
adjustment of future pay-as-you-go benefits to 50% of the benchmark level. The
reduction in benefits and the new incremental tax revenue generated by the rise in
the national capital stock (from the increase in national savings), would guarantee
that the combined benefits exceed the benchmark level.
 The second option enriches the program in the early years by adding an
additional $50 billion a year to the PRAs from the on-budget surpluses from
2008-17. With more funds going into the PA accounts, it is possible to reduce the
pay-as-you-go benefits more rapidly and still maintain combined benefits that are
as large or larger than they were in the first general-revenue option.
Alternative Plans without General Revenue Transfers (**it’s hard to get this section
without looking at the table on p. 711)
 One way to avoid insolvency while keeping full benchmark benefits with no
transfer of incremental tax revenues, is to reduce the pay-as-you-go benefits,
particularly in the more distant future when the projected PRA annuities are very
large relative to the benchmark level of benefits. Feldstein projects that without a
transfer of general revenue to the Trust fund, the Trust Fund balance becomes
negative in 2030 and must borrow in order to keep financing the required level of
benefits. However, by 2064, the reductions in the pay-as-you-go benefits are large
enough that the payroll receipts exceed the sum of the pay-as-you-go benefits and
the interest on the Trust Fund debt. At that point, the Trust Fund begins to repay
its liabilities and becomes solvent by 2090.
 Reducing the pay as you go benefits of all cohorts by enough to cut the combined
benefits by 2.75% of the benchmark makes the system solvent by 2075.
 An alternative to reducing benefits is to ad a small surcharge of 0.30% to the
payroll tax. An OASDI rate of 12.70% would lead to solvency by 2075.
Potential Paths of Social Security Reform
Martin Feldstein and Andrew Samwick
5.1 Implications of Past Volatility
- in the next 20 years the mixed system will still be all pay as you go leaving little risk for
those retirees
- Maximum-risk case: once mixed system is fully phased in and pay-as-you-go portion is
reduced to 60% of benchmark; before that the pay-as-you-go benefits are relatively larger
and the risk is correspondingly less
5.2 Alternative Rates of Return
An alternative way of assessing risk in the mixed system:
- calculate the combined benefit that would result if the individual received
substantially less than the 5.5% real rate return each year on the PRA
5.3 Real-principal Guarantees
Optional PRA real principal guarantee- the individual is guaranteed that the value of the
PRA account at normal retirement age will be at least as large as the sum of all the
deposits made to that account; the individual would be guaranteed not to lose any of the
real value of the money put into the account.
- to provide the guarantee without risk the financial institution could invest a
fraction of the PRA saving in zero-coupon TIPs
- the benefit would be similar to that provided by a 60:40 mixture of stocks and
bonds, but the guarantee makes it less risky
collar option- individuals trade some of the potential benefits in excess of the benefits
that could be achieved with the riskless rate of return at 3.5% for a guarantee that the
benefits or the implied rate of return will not be below some floor
6. Lump- Sum Benefits
- by making the annuitization (spread out over retirement years) of benefits mandatory
the problem of self-selection is virtually eliminated
Individuals might be allowed to choose to take all or part of the accumulated principal in
the PRA as a lump sum at age 67.
Retirees might be allowed to withdraw principal funds from their PRA accounts at age 67
as long as the amount that remains is sufficient to finance combined benefits equal to the
benchmark level.
7. Conclusion
Options of the proposed plans:
1. The PRA funds are invested in a portfolio of stock and bond mutual funds. At
normal retirement age, the accumulated fund is used to purchase a variable
annuity invested in the same mix of stocks and bonds.
2. The traditional pay-as-you-go benefits that are financed by the payroll tax are
reduced for retirees in a way that depends on how many years they participate in
the PRA system or are eligible to participate in the system.
3. There is no change in benefits for those who are now retired or who will retire in
the near future.
4. The disability program is kept separate and financed on a pay-as-you-go basis.
5. Personal retirement account (PRA) balances can be bequeathed to anyone if the
individual dies before normal retirement age.
6. The PRA annuity that begins at normal retirement age continues for at least 10
years even if the retiree dies during this period.
7. The survivor and dependent portions of the OASI program continue in addition to
the bequest and 10-yea certain features.
Structural Reform of Social Security
Martin Feldstein
Governments are looking to reform social security by shifting from a pure pay-as-you-go
tax-financed system to a mixed system that combines pay-as-you-go benefits with
investment-based personal retirement accounts.
Social Security Today
- in the US provides retirement benefits equal to 40% of the final year earnings
for someone with median earnings and a normal retirement age.
- Benefits are indexed to CPI
- Benefits are financed by a 15.3% payroll tax.
-
-
Current tax revenue is used to pay current benefits; any receipts to the Social
Security trust fund not used to pay current benefits are loaned to the
government to finance other government activities, these loans increase the
budget deficit
The benefits that are paid exceed the taxes that that generation paid
The Politics of Reform
- the future aging of the population means that the 10.6% tax will not be enough
to finance the benefits projected in current law; benefits must be cut or taxes
must be raised- either way the net rate of return will be reduced.
- Avoiding a future increase in a payroll tax would require an increase in
national saving (of about 0.6%) during the transition from pay-as-you-go to
mixed systems
How a Mixed System Could Work
One Option:
Satisfies 5 requirements:
1. current retirees receive full pay-as-you-go benefits specified in current law
2. for all future cohorts of retirees the combination of pay-as-you-go benefits plus
the expected investment-based personal annuities will equal or exceed the benefits
that the current law projects
3. the tax rate and relative tax base will not be increased
4. the financing solution will be permanent implying that the Social Security trust
fund will be positive and increasing at the end of the 75-year forecast
5. there will be no use of existing general revenue to finance Social Security benefits
Increased savings during the transition period is achieved by individual’s out-of-pocket
contributions to personal retirement accounts.
Once the system is phased in each employee would continue to participate in the pay-asyou-go system and would contribute to an investment-based personal retirement account.
PRAs would be funded by a combination of 1.5% transferred from the payroll tax and an
additional 1.5% that individuals contribute out-of-pocket on a voluntary basis which is
incentivized by a matching payment.
PRA balances would have to be invested in diversified equity and bond mutual funds
(60% in a broad equity mutual fund index and 40% in a corporate bond fund).
At retirement the individual has the option of annuitizing the accumulated fund or taking
out all or some in cash; the amount taken in cash could be limited by requiring that the
remaining annuity provides some minimum replacement of previous earnings.
When the mixed system is completely phased in the pay-as-you-go benefits would remain
at 60% of the currently projected benchmark.
Feldstein and Samwick analysis:
-assumes complete annuitization starting at age 67
- “variable annuity”- funds are always invested in the same 60:40 mix of stocks and
bonds
- “ten-year certain” provision means payments continue for at least 10 years after
retirement even if the individual dies during that interval
 show that expected benefits for individuals with average lifetime earnings who
reach normal retirement age in 2050 would be 121% (135% by 2075) of the
current benchmark
The Cost of Transition to a Mixed System
 many economists believe that the transition generation would have to pay double,
but according to Feldstein the transition is much more manageable than these
critics believe

it is possible to slow the growth of the pay-as-you-go system in a gradual
way so that the combination of remaining pay-as-you-go benefits and the
expected PRA annuities financed with new saving of only 1.5% of taxable payroll
would be equal to or greater than the benchmark benefits projected in current law.

Shift of payroll tax funds to PRA temporarily increases the budget deficit
but does not reduce overall national saving

Feldstein Samwick Formula: pay-as-you-go benefits are reduced by 0.3%
per year during the first 5 years, by 0.6% the next 5 years, followed by 0.9%,
1.2%, and eventually 1.5% for a cumulative reduction of 40% from the
benchmark level of benefits.
Avoiding an Increase in Labor Market Distortions
Shifting to a mixed system that avoids the rise in the OASI payroll tax rate would
eliminate that permanent rise in deadweight loss.
The elasticity that determines the deadweight loss is the elasticity of taxable labor income
with respect to the individual’s net of tax share.
The increase in deadweight loss when the marginal tax rate rises from t1 to t2:
∆ Deadweight loss= 0.5E(t22 – t21)B/(1-t1)
E= relevant elasticity
B = tax base
t1 = 0.38 (initial marginal tax rate)
t2= 0.44 (the rate after tax increase)
- additional deadweight loss is 40% of the revenue that needs to be raised
Shifting to a mixed system would make it possible to avoid the payroll tax increase and
the associated deadweight loss. The reduction in DWL is due to avoiding the increased
labor market distortion. The only deadweight loss that the shift would involve is the loss
that would occur if some individuals were required to save more than they would prefer
to save even at the higher rate of return that the PRA allow.
732-750
Structural Reform of Social Security, by Martin Feldstein
The increase in saving and in the Intergenerational Present Value of Consumption:
Feldstein demonstrates in this part of his essay that the present value of the gain
from a present-value system to the initial generation is much less than the present value
of the losses to all future generation, because of taxes. Many models assume a return of
return for the pay-as-you go system equal the marginal product of capital; however in
reality taxes decrease this return. Furthermore, assuming the marginal product of capital
as a rate of return is wrong in the first place due to the decline of the marginal utility of
consumption.
Due to these two reasons, the present value of loss to all generations of taxpayers
exceeds the windfall to the initial generation, which we could improve through an
investment-based system.
Administrative Costs are likely to be very small (0.3-1%) of assets similar to mutual
funds.
Risk: Pay-as you go benefits and investment benefits are both inherently uncertain. Payas-you go is uncertain, because the government can cut your benefits at any time due to
unpredictable demographics und politics (E.g. Germany and Japan already cut their
benefits). Investment based accounts are subject to market risk, which however can be
quantified and reduced through investment strategies.
Progressivity We know that pay-as-you go is not as progressive because poorer people
have lower life expectancies. A mixed system could provide a greater redistribution.
A Central Investment Account would not be good idea because due to its size (about $6
trillion) it would give the government too much power over the economy.
Strengthening Social Security and Creating Personal Wealth for All Americans,
report of the President’s Commission, December 2001
This report simply summarizes useless historical facts of Social Security and
makes the same point as the previous article that an investment based system could
alleviate future generations of higher taxes.
President’s Commission to Strengthen Social Security
 Solution: voluntary, personal accounts
 Reform Model 1 establishes a voluntary personal account option but does not
specify other changes in Social Security’s benefit and revenue structure to achieve
full long-term sustainability
 Reform Model 2 enables future retirees to receive Social Security benefits that are
at least as great as today’s retirees, even after adjusting for inflation, and increases
Social Security benefits paid to low income workers. It establishes a voluntary
personal account without raising taxes or requiring additional worker


contributions. It achieves solvency and balances Social Security revenues and
costs.
Reform Model 3 establishes a voluntary personal account option that generally
enables workers to reach or exceed current law scheduled benefits and wage
replacement ratios. It achieves solvency by adding revenues and by slowing
benefit growth less than price indexing.
Look at tables at end of article w/comparisons of each model
Reforming Social Security: A Balanced Plan by Diamond and Orszag
 Increased life expectancy
o Deal with half of this by raising the age and half by raising taxes
 Earnings Inequality
o Those who make more are not taxed on it. They usually live longer and
received more benefits
o Readjust the maximum taxed income so that 13% is above this level again
o Benefits reduced for highest earners since they receive benefits longer
 Legacy debt
o Initial contributions to Social Security were less than the fund paid out
o Make Social Security mandatory to all so no one escapes the financial
burden
o Impose legacy tax on earnings above the maximum
o In 2023, when the last of Congress’ benefits reductions finish, benefits go
down and payroll tax increases to finance this debt
o Funds from another revenue source (ie reforming the estate tax) could be
used
 Improvements to benefits for vulnerable beneficiaries
o Increase benefits of those with minimum wage earnings
o Increase benefits of widows and widowers (decrease those of richer
couples)
o Increase benefits for those who are disabled at a young age (decrease for
older)
o Plan modifies benefits in a cost-neutral fashion to account for inflation
 Implementation
o Won’t lower benefits of older workers today
PP 770-775
“Reforming Social Security”
Jeffrey B. Liebman
Two challenges facing retirement policy in the U.S.:
 Long-term imbalance of the Social Security system (although not as huge as that
of Medicare)

Too few Americans have significant savings to supplement their income from
Social Security
The political divide over Social Security reform:
 One group sees PRAs as a politically feasible and economically efficient way to
set aside additional resources to meet future retirement needs; support using new
revenues on top of the current 12.4% OASDI payroll tax to fund PRAs
 Second group sees PRAs as a politically feasible way to cut Social Security
benefits so as to limit the share of the nation’s resources consumed by the elderly;
support diverting a portion of the current payroll tax to PRAs
 Third group believes that Social Security was a mistake in the first place; they see
the mixed plans as the first steps toward total privatization
 Because of the politically charged environment, many strong supporters of social
insurance have become unwilling to advance their own PRA-based proposals;
instead, they choose to oppose any plan that includes PRAs
Economic Effects of PRAs:
 PRAs can increase national savings, thereby raising future standards of living (but
only if PRAs are funded outside of the current 12.4% payroll tax)
 PRAs can increase the perceived link between people’s OASDI tax payments and
their ultimate retirement income, thereby encouraging labor supply by motivating
individuals to work longer or more
There can also be indirect effects on savings:
 If Congress raises taxes or cuts other spending in response to the increase in the
deficit caused by SS reform, then even a plan like that of the second group (above)
could raise national savings
 Individuals might react to legislated lower replacement rates by increasing their
savings, or they might decide that SS reform increases the chance that they will
receive significant benefits and thus decide that the no longer need to save as
much on their own
Reasons to embrace PRAs instead of taking the traditional reform approach (increasing
taxes and cutting benefits):
*Political reason: In the current anti-tax environment, it is unlikely that significant tax
increases are going to be enacted as part of Social Security reform
*Economic reason: We need to save tax increases for Medicaid and Medicare
A mixed system that preserves the best features of the current Social Security system
must have the following six features:
 Maintain replacement rates – SS benefits should rise with wages
 Maintain a substantial guaranteed benefit
 Avoid the slippery slope toward total privatization – do so by establishing a clear
principle that none of the 12.4% payroll tax should ever be diverted to PRAs
 Protect investors from high costs and poor investment decisions during
accumulation – allow people to invest in only a limited number of large broad-
based index funds with regulations on fees and the minimum and maximum
fraction of the portfolio that can be invested in stocks
 Protect retirees during decumulation – mandate annuities, joint-and-survivor
annuities
 Maintain redistribution – either make higher deposits into the accounts of low
earners or make the traditional benefit formula more redistributive to offset the
lack of redistribution in the PRA portion of the system
Protections should be included from the start since PRA reforms typically will require a
reduction in expected retirement income levels.
PP 776-788
“Redistribution in the Current U.S. Social Security System”
Jeffrey B. Liebman







46% of SS benefits go to people in families whose income is below the poverty
line
SS benefits for men are 68% of taxes paid, compared to 120% for women
Ratio of benefits to taxes is highest in the South (higher retiree population) and
lowest in the West (large share of younger workers, including recent immigrants)
Individuals in low-education groups on average receive substantially more
benefits than they pay in taxes, while the reverse is true for those in higheducation groups
Benefits are calculated by indexing earnings to average wage growth, summing
the highest 35 years of earnings and dividing by 420 to get the Average Indexed
Monthly Earnings (AIME)
Spouses’/survivors’ benefits indicate redistribution from single workers to
married couples and from men to women
Initially, transfers rise with income, then fall
Jeffrey Liebman, Maya MacGuineas, and Andrew Samwick, "Nonpartisan Social
Security Reform Plan"
--all-●
The Liebman-MacGuineas-Samwick (LMS) plan demonstrates the types of
compromises
that can help policy makers from across the political spectrum agree on a Social
Security
reform plan—the three writers worked on the Clinton, McCain and Bush
campaigns, respectively.
● Four key elements of the LMS plan:
 Benefit cuts (through progressive reductions in PIA factors and an increase in
the retirement age).
 New revenue (through a mandatory additional 1.5 percent contribution into


personal retirement accounts and a gradual increase in the payroll tax cap to
90 percent of earnings)
Mandatory personal retirement accounts (equal to 3 percent of earnings,
funded half by new contributions and half redirected from the Social Security
Trust Funds, with full annuitization required upon retirement).
Other updates to the traditional system (minimum benefit for low-wage
workers, increase in widow(er)s’
What are the compromises made?
● Revenue increases versus spending reductions - To fill the Social Security
funding gap, roughly half the changes would come from benefit reductions and
half from revenue increases.
● Level of traditional benefits – In the long run, traditional benefits would be no
smaller
and no larger than the existing 12.4 percent payroll tax.
● Level of benefits versus length of time of collecting benefits – Under the plan,
the
combination of traditional benefits and the money accumulated in accounts
produces
replacement rates (the ratio of retirement income to pre-retirement earnings)
roughly
equal to those that are currently promised.
● Sources of PRA financing – Half of the revenue needed to fund the PRAs would
come
from mandatory worker contributions (an “add-on”) and half would come from
redirecting money from the Social Security Trust Funds (a “carve-out”). Rather
than
borrowing to cover the cost of the redirected funds, they would be paid for by
raising the
payroll tax cap and cutting benefits.
● Storage for saving – While new money would be devoted to the Social Security
system,
on net, all of the new revenue would be stored in personal accounts rather than in
government trust funds. Accounts wall off funds from the rest of government,
thereby
increasing the likelihood that they would contribute to national saving.
● Size of the accounts – At three percent, personal accounts would be large enough
to
accumulate significant wealth for participants and to keep the administrative costs
manageable but not so large as to overshadow traditional benefits.
● Level of progressivity – Revenues and traditional benefits would be made more
progressive but not so much as to undermine support for the universal social
insurance
system.
Jeffrey Liebman, "Redistribution in the Current U.S. Social Security System,"
pages 36-41
●
Two implications of Liebman's findings:
 First, they suggest the magnitude of redistribution that an individual accountbased plan would need to achieve in order to maintain the current
redistribution from rich to porr. It would be between $20 and $30 billion per
year.
■ If it's a mix of PIA and standard SS, the distribution would be $7 to $10
billion.
■ How would we implement this? Progressive taxation of PIA earnings
 Second, if we don't redistribute, then low lifetime earners will do substantially
worse than they do under the current system.
Joseph Newhouse, "Health Reform in the United States,"
Economic Journal, 1996, p 1713-1724
Author goal: To describe key facts about health care sector and to appraise recent trends.
●
●
●
●
●
In 1994 Americans spent $949 billion, or I3"7% percent of GDP, on health care,
values that exceed those of any other developed country. Moreover, the sector has
been growing fairly steadily at approximately 4 % per year per person in real
terms for over 50 years
Despite the American medical system's high costs, it does not provide universal or
near universal health insurance coverage. Around 15% of the population has no
insurance, a figure that has inched up in the last fifteen years. The uninsured, of
course, do not entirely forego care; they may receive charity ('uncompensated')
care, or they may use services in certain direct delivery systems (e.g. at local
government or veteran's hospitals).
Evidence of moral hazard in health care is reasonably strong in America. Fully
insured consumers in a random experiment spent 40 percent more than those with
a large deductible.
Additional evidence of moral hazard is the greater likelihood that those elderly
with a heart attack who live near well equipped hospitals will receive an
expensive invasive procedure, but any marginal survival benefit from the
additional procedure seems at best modest.
The higher level of spending in the United States is consistent with its investing
more intensively in each technology than do other countries, but perhaps
●
●
obtaining little benefit at the margin.
In contrast to the traditional indemnity insurance just described, insurers and
providers have now begun to integrate to provide 'managed care', an arrangement
under which the insurer contracts with a network of physicians and hospitals, and
offers the consumer financial savings for seeking care from those in the network.
To reduce moral hazard the insurer may subject those physicians in the network to
commandand- control type utilization review (i.e. a physician may be told a
particular procedure will not be covered for a particular patient) or the insurer
may put physicians at financial risk for services they order, or both.
Whereas private spending between 1990 and 1993 grew only 19%, public health
care spending grew 35%, a difference that some have attributed to the greater
spread of price competition in the private sector. Medicare in particular has not
made much use of managed care." Less than 10% of Medicare enrollees have
chosen to enroll in at-risk managed care contracts; the
remainder are in traditional, fee-for-service Medicare, which functions more
like the traditional insurance plan described above. ^* Bust most of the
differential in spending growth has little to do with greater price competition
in the private sector; my calculations suggest that about 70% ofthe difference
between the real public and private rates of increase in the early 1990s is
attributable to increased enrolments in public plans, especially Medicaid, and
an increased number of uninsured.^*
Newhouse, Joseph. Health Reform in the United States
…continued….
PROBLEMS IN HEALTHCARE:
 Evidence of Adverse Selection in the Medicare context
o Headline: Healthy people (who spend less) opt into at-risk plans
 Details: Between 1989 and 1994 beneficiaries in Medicare who
subsequently enrolled in at-risk plans spent 37% less in the six months
prior to enrolling than the average fee-for-service Medicare enrollee.=
 Of this group, those who remained enrolled in at-risk plans had spent
44% less.
 Mortality rate in this group was 25% than average Medicare enrolee
o Headline: Sick people (who spend more) opt out of at-risk plans
 Those disenrolling from at-risk plans and returning to traditional
Medicare spent 60% more than the average fee-for-service Medicare
enrollee in the six months following disenrolment
 Physician Reimbursement (Principle-Agent problem)
o

Extreme arrangement: physician receives a lump sum (capitation) for each
patient and is responsible for paying for all expenses for the patient from that
sum.
o Useful info for consumers: disclosure of the degree of financial risk on the
physician
Conflict Resolution
o What constitutes a covered benefit?
o Courts get involved in this  costs lost of money  major inefficiency
PUBLIC MEDICAL PLANS
 Congressional Budget Office predicts $444 billion deficit in Medicare Part A in 2006
 Payroll tax will need to increase by 0.7% to 3.6% to cover gap
 Claim: “There will be substantial savings from increasing proportion of Medicare
beneficiaries in managed care or at-risk plans.”
o Wrong!
o 1.) Medicare reimburses at-risk plans at rate of average spending in
traditional Medicare. If less-risky people use at-risk (see Adverse Selection
above), Medicare would be supplying more dollars for reimbursement than it
would have spent had they been in the plan
o 2.) Even if savings could be achieved, number of people required to switch
into managed care / at-risk is unrealistically high for big savings.
 CBO says less than 25% of elderly are in at-risk plans
 Areas of high Medicare spending growth
o 1.) Home Health Care
o 2.) Skilled Nursing Facility Services
o Reason: financial incentives created by Medicare’s lump sum payments for
specific diagnosis and course of treatment.
 If a hospital can unbundled services that were formerly provided in the
hospital, they can profit (empirically shown to be the case).
Feldstein, Martin. Balancing the Goals of Health Care Provision and Financing



Desirable outcome:
o (1) preventing the deprivation of care because of patient’s inability to pay
o (2) avoiding wasteful spending
o (3) allowing care to reflect different tastes of individual patients
Health insurance
o Good: Reduces patients’ financial burden at time of care
o Bad: Lead to excessive spending because patients do not face full cost of care
at the time that decisions on spending are made
Major Problems to address:
o Insulating Patients from True Costs  High Costs
 Simple substitution effect: increases healthcare consumption by
reducing its cost relative to other goods and services.
o Uninsured people – how should this be handled?
o Emerging technologies
 How do you handle new super-expensive treatments
Goal #1: Preventing Deprivation of Care
 Need to balance “avoidance of deprivation of care” with “paying for every possible
treatment, regardless of how low the probability of success”
 Positive improvement: research on identifying which patients can benefit from each
type of treatment
o Reduce number of ineffective treatments  reduce cost of insurance
 Also, individuals differ in willingness to pay for treatments that have low probability
of success – this needs to be addressed
Goal #2: Avoiding Wasteful Spending
 Remember, to consider increase in the price of healthcare (due to legit increases in
quality)
 David Cutler says: the value of the improved health over the past several
decades has exceeded in the increased cost in health care.
 Major Problem #1: Fully insured patients overspend
o If patients spend until the value to the patient of the marginal cost to the
patient equals the marginal value to the patient, significant overspending
results
o This is because the marginal cost to the patient is only 20% of the total cost.
 Major Problem #2: HMOs underspend
o One-size fits all plans cap treatment so that the actual marginal cost equals the
AVERAGE marginal benefit
 Some patients who would have legitimately benefited more get shorted
 Major-risk insurance saves the day!
o Patient pays first $5,000 of spending, insurance covers everything above
o Better still: 50% co-payment up to $10,000
 Same total out of pocket as above plan
 Stretches the horizon over which patient is sensitive to spending
Goal #3: Allowing for Patient Preferences
 One size fits all is bad
 Everyone wants good health, but some are more willing than others to make greater
sacrifices to achieve good health
o Think of people who smoke or don’t work out…..
 If the patient is willing to pay for additional services, they should be allowed to
purchase them
 With low co-payments, patients’ preferences are hidden
 One solution is to buy into different types of HMOs (basic vs. deluxe)
Implications for Reforming HSAs
 The current HSA system
o Like 401(k) or IRA
 Pre-tax contributions, gains on investments aren’t taxed

 Balance carried forward each year
o Size of contribution to HSA = size of deductible for the patient’s major-risk
policy
o Tax advantage creates strong incentive to shift to HSAs
Problems with the current HSA system
o The $5,450 maximum deductible leaves too many dollars of health spending
without effective restraint
 Costs are better controlled with a 50% coinsurance rate on twice the
amount of the current deductible ($10,900)
o Low Income Problem
 People with low income may be afraid of such a large deductible
 Opt instead for a plan with a lower deductible (say, $3,000)
 But since many people will exceed $3,000 at which plan shifts from
perfect-price-sensitivity (patient pays 100% of costs) to perfect-priceinsensitivity (insurer pays 100% of costs), moral hazard is still a
problem
o Bad Debt
 Hospitals know they can extract payments from insurance companies
 But if individuals are solely responsible for first $5,000, hospitals will
face a great deal of bad debt since most people don’t actually have
$5,000 on hand
Feldstein & Gruber. A Major Risk Approach to Health Insurance Reform
Executive Summary
 Study the impact of switching from existing coverage to a policy with a 50%
coinsurance rate and a 10% income limit on out-of-pocket expenditures
o All data and analysis applies to people under 65 years old
 80% of spending on physicians and hospital care is don by 20% of families who
spend over $5,000 per year
 Shifting to a major-risk approach could…
o Reduce aggregate healthcare spending by 20% per year
o Raise national efficiency by $34 billion a year
o Be financed with a premium of $150 per person because of the increased tax
revenue and reduced Medicare outlays that would result from the provision of
universal major risk insurance
Some background
 US tax law permits employers to deduct their payments for health insurance as a cost
of business while excluding those premiums from the taxable income of employees
o For individuals with 30% marginal tax rate, $1 health insurance premium
costs $0.70 of after-tax income
o Causes over consumption of insurance
 Low co-insurance rates cause over consumption of health care
o Marginal cost to patient is less than actual marginal cost of care  DWL
 Four Questions Asked in Paper
o (1) Is it possible to limit total out-of-pocket spending to a moderate percent of
income while still having a sizeable fraction of health spending done by
individuals who are facing a large coinsurance rate?
o (2) How would a major risk insurance structure with a high coinsurance rate
and income related out of pocket maximum affect individuals at different
income levels ?
o (3) What are the explicit welfare effects of shifting from existing insurance
coverage two major risk insurance?
o (4) could a publicly provided major risk insurance policy be financed by
eliminating the current favorable tax treatment of health insurance premiums
paid by employers?
The National medical expenditure survey data
 The weighted mean level of spending in the well insured group of under-65-year-olds
at 1995 levels was $3,985.00
 39% of the insurance units (insurance units = individuals or families) spend less than
$500.00 (1.5% of total spending)
 1/6 of insurance units spend more than $5000 (make up 80% of total spending)
 83% of the sample has out of pocket spending below $1,000.00 per year under their
existing health insurance plans
 Important table:

A major risk insurance policy with a 50% cope a rate and an out of pocket limit of
10% of income would cause a family with $35,000.00 of income to be sensitive on
spending below $7,000 by then have a zero marginal price for health spending above
$7,000.00
Feldstein, “Balancing the Goals of Health Care Provision and Financing” (end)
Implications for Reforming HSAs
 How HSAs now work
- similar to IRA or 401(k) in that funds deposited out of pretax income, and the income
accumulated is tax free
- also better than IRA or 401(k) because withdrawn funds are never taxed
- amount of money deposited in HAS equal to size of deductible in a major-risk
insurance policy – policy also provides protection against hardship by setting a
maximum out-of-pocket amount for deductible and coinsurance
- tax advantage – incentive for individuals and employers to shift from current
common health insurance with low deductible and low coinsurance
 Two problems with current HSA structure
1. $5,450 maximum deductible leaves too many dollars of health spending without a
restraint – for lower income families, risk of this deductible might be larger than they
are willing to accept
2. nonpayment of hospital bills could become more severe with HSAs – people could
put off payments and eventually not pay
- remedy could be allow hospitals easy access to HAS balances of people who have not
paid
Summary
- design of health care financing involves balancing three goals
1. preventing the deprivation of care
2. avoiding wasteful spending
3. allowing care to reflect the different tastes of individual patients
- HSA system provides new framework to balance these goals, but need to modify to
strengthen incentives and avoid bad-debt problems of hospitals and physicians
Feldstein and Gruber, “A Major Risk Approach to Health Insurance Reform”
Summary
- study the impact of switching from existing coverage to major risk policy with 50%
coinsurance and 10% of income limit on out-of-pocket expenditures
- analysis shows that shifting to “major risk” policy could reduce aggregate health
spending by nearly 20% - greatest reductions among high income individuals
-
-
extent of increase in economic efficiency depends on demand elasticities and
extent of risk aversion – modest estimates show increase in efficiency of $34 billion
a year (as high as $110 billion)
government provision could be financed by premium of $150 per person because of
increased tax revenue and reduced Medicare – or even without government,
induce people to select major risk policy by changing existing tax rules to eliminate
insurance advantage
1. National Medical Expenditure Survey Data
- 39% of health care units spend less than $500, only 1.5% of total spending
- only 1/6 spends more than $5,000, constituting 80% of total spending
- the fact that 83% of sample of out-of-pocket spending below $1000 in a year under
existing health plans suggests scope for demand reduction
2. Would a major risk insurance policy reduce excessive spending?
- yes – even with the very skewed distribution of health spending, major risk structure of
high coinsurance and 10% limit on out-of-pocket spending can reduce spending
substantially and leave out-of-pocket spending unchanged
3. How does major risk insurance affect different income groups?
- redistributes to benefit lower-income groups
- average out-of-pocket spending under major risk plan rises very sharply as income rises
- major risk plan reduces total consumption of health care much more for high-income
individuals than for low income
4. The welfare economics of major risk insurance
- reduces the deadweight loss from excessive consumption of health care (unambiguous)
- alters the risk distribution that individual faces, increasing risk of modest spending, but
limiting the maximum risk (ambiguous, depends on distribution of health care spending
and individual’s utility function)
5. Eliminating the tax exclusion to finance government provided major risk insurance
- if government provides major risk insurance, employers would no longer have reason to
provide compensation in form of health insurance
- overall increase in net of tax wages and possible gain through reduced risk bearing if
individuals are sufficiently risk averse
“Equality, Efficiency, and Market Fundamental: The Dynamics of International MedicalCare Reform” (continued)
Evaluating the Regulated System
 Regulated systems can save money in two ways
o Lowering the prices paid for services
o Reducing the quantity
 Providers earn less in regulated systems


Doctors in US now earn twice as much as in other countries – because of
expenditure limits in other countries
Service availability is highly correlated with the stringency of regulatory
constraints – more regulated = less service
New Dilemmas
 Only 10% of Americans think their health care is fundamentally sound,
versus 56% in Canada
 Enthusiasm for rationed system has waned over the past decade for three
reasons
o Limited supply and unlimited demand
 This causes people to be unhappy that they cannot get all
the services that they want
o Inefficiency
 Regulatory constraints do not provide incentives for service
provision to be efficient (e.g. doctors sometimes encourage
patients to have two visits so that they get multiple
payments when all that is necessary is one)
 People purchase supplemental insurance to get around the
system
 People migrate to wherever the best and cheapest care is
given within the country
o One-Time Savings and Long-Run Costs
 This problem is structural – often the regulations help
contain costs for several years, but then costs will begin
growing again in the long run
 One reason for this: technological growth is not
contained, only its manifestations are suppressed for
a few years
 Overall, the failure of the system to limit cost growth has sparked a lot of
unease about the system in general
Incentives and Competition
 Health Care reform has again come to dominate agendas of OECD
countries
 They have started to turn away from strict reliance on rationing and
controls
 Competition is only being used moderately right now because it causes
misalignment between social goals and efficiency (difficulty in paying for
poor people)
 Trend has shifted drastically from unmanaged insurance to managed care
over the past decades because of costs
o Managed care insurers had to bargain for price reductions
o They also cut back on the receipt of some care
o Overall they were successful in reducing cost growth some

o Most managed care savings have come without the adverse health
consequences that often come with more efficiency
Degree of competition is still limited
Summary


Slowness and zigzagging of reform reflects fear of sudden change,
concerns about adverse selection, and concerns about equity
The trade-off between equality and efficiency is essential to understand in
medical care
o But added to that is the increasing cost of the system which makes
the above trade-off even more difficult to work with
“Are the Benefits of Medicine Worth What We Pay for It?” – David Cutler




Conventional wisdom says that it isn’t, but Cutler says it is
He thinks we could spend more and still the benefits would outweigh the costs
To show this he uses improvements in cardiovascular care and low birth-weight
infant care
Overall the U.S. spends more than any other country on health care – 15% of its
GDP
Prof. David Cutler’s lecture, “Are the Benefits of Medicine Worth What We Pay For It?”,
traces the historical roots of the U.S.’s high health care costs. Cutler notes that the U.S.
spends 15 percent of GDP on medical care, by far the highest in the world and describes
the arguments that medical care is overpriced: “Big Medicine” (hospitals and drugs) has
not been responsible for the largest gains in health quality, and the U.S. seems to have no
better health outcomes than European countries which pay less. But Cutler challenges
this conventional wisdom. He notes that some care may be efficient even if not all care is,
and further examines historical trends in health quality.
While health quality (as measured by death rates and life expectancy) has generally
improved over the past century, Cutler breaks down this general movement into more
specific trends. Until the mid-1950s, substantial gains were made against infectious
diseases, but not on other fronts. After a brief plateau (evidence of the dichotomy in
medical advances), health care progress since the 1960s has largely been against
cardiovascular diseases: fighting heart attacks with complex surgical or pharmaceutical
treatments instead of bed rest. (The progress is due in equal parts to technological
advances, newer preventative drugs, and behavioral changes such as reduced smoking.)
Today, “the average 45-year-old will spend $30,000 in present value on cardiovascular
disease,” but can expect to live another three years because of it.
Cutler then weighs whether this tradeoff is reasonable. He notes that, rather than looking
at expected life earnings to determine the value of life, we should examine the prices put
on risky situations (such as when purchasing airbags or smoke detectors). Cutler’s
analysis yields a value of about $100,000 a year for a middle-aged person, suggesting that
we should be “delighted” by the level of medical spending on cardiovascular disease.
Cutler draws similar conclusion for infant mortality, and argues that the advances in these
two spheres alone make the increases in spending since 1950 reasonable.
Cutler concludes by suggesting that the value of a better quality of life is high enough to
justify the increased medical spending. He further argues that future technological
breakthroughs may allow the trend to continue. Increases in medical costs will cause
government revenues to increase and may lead to concern about the status of the poor,
but, due to the increased value of care, Cutler concludes that the benefits of health care
spending justify the costs.
Nathan Taylor – 885-904
Stephen Nickell
Unemployment and the Labor Market Rigidities: Europe versus North
America





Common thinking is that certain rigidities in Europe cause permanent double digit
unemployment. This is partially correct. Certain rigidities cause unemployment,
but others do not.
There are many differences across European countries
o Unemployment rates vary from 1.8 (Switzerland) to 19.7 (Spain) over
1983-1996
o Short-term unemployment is more consistent through Europe than longterm unemployment
o Employment/population ratios have variation among European countries,
but almost all of them are below that of the US
o Countries with low unemployment are not known for labor market
flexibility
US versus Europe
o No evidence that jobs are created or destroyed faster in the US than in
Europe
o Wages in Europe are just as flexible than those in the US
o US workers are more mobile than European workers (geographically and
between jobs)
Although there is much variation between European countries, the US does
have…
o Less employment protection
o More flexible labor markets
o Less union density and union coverage
o Roughly equal unemployment benefits
o Roughly equal payroll tax and other taxes
Authors are careful not to claim causality. They are just claiming correlation.


They focus on the 1980’s and 1990’s because there is more labor market variation
in response to the supply shocks of the 1970’s
Results:
o Labor market legislation (employment protection) has no effect on
unemployment.
o Unemployment insurance replacement rate has a strong positive effect on
unemployment – more generous unemployment insurance systems lead to
more unemployment.
o Unions (density and coverage) increase unemployment
o Payroll taxes (only) do not have a significant effect on unemployment, but
the total tax burden (payroll, income, and consumption) raises
unemployment and reduces labor supply.
Economics 1420 – Readings Summary – Pages 904 – 922
Brock Duke
Continued – Unemployment and Labor Market Rigidities: Europe versus North America
Stephen Nickell






The balance of the evidence suggests that lowering payroll taxes and raising
consumption taxes will have no long-run impact on unemployment.
Where the minimum wage applies, it is low enough not to have an important
impact on the unemployment rates of adult men.
Minimum wages do have a significant though small adverse impact on youth
unemployment rates.
Two much-canvassed solutions to unemployment are reduced hours of work and
early retirement, which are based upon the idea that there is some exogenously
given level of work to be done. However, for a given institutional structure, the
amount of work to be done tends to adjust in line with the available supply of
labor, leaving equilibrium unemployment unaffected.
There is no evidence that skill shifts, ie: the increase in the relative demand for
skilled workers (as against unskilled workers), have made a substantial
contribution to the rise in European unemployment nor that labor market
inflexibility per se is associated in any simple way with such effects as have been
observed.
High unemployment is associated with:
1. Generous unemployment benefits that are allowed to run on indefinitely,
combined with little or no pressure on the unemployed to obtain work and low
levels of active intervention to increase the ability and willingness of the
unemployed to work;
2. High unionization with wages bargained collectively and no coordination
between either unions or employers in wage bargaining;
3. High overall taxes impinging on labor or a combination of high minimum
wages for young people associated with high payroll taxes; and
4. Poor educational standards at the bottom end of the labor market.

Labor market rigidities that do not appear to have serious implications for average
levels of unemployment include the following:
1. Strict employment protection legislation and general legislation on labor
market standards;
2. Generous levels of unemployment benefit, so long as these are accompanied
by pressure on the unemployed to take jobs by, for example, fixing the
duration of benefit and providing resources to raise the ability/willingness of
the unemployed to take jobs; and
3. High levels of unionization and union coverage, so long as they are offset by
high levels of coordination in wage bargaining, particularly among employers.
Chapter 19 – The Emergence of Health, Safety, and Environmental Regulation
Economics of Regulation and Antitrust
W. Kip Viscusi, John M. Vernon, and Joseph E. Harrington, Jr.










The principal focus of the efforts of regulatory agencies is on accidents.
All accidental deaths (unintentional injuries) make up only 4% of the total death
rate, so that even a fully effective safety regulation effort would necessarily play a
small part in reducing overall mortality rates.
Many of the leading causes of death are more in the domain of individual
behavior rather than regulatory action.
Society should pursue regulations that are in our best interests, taking into account
both the beneficial aspects of regulations and the costs that they impose.
The mere presence of a risk within the domain of a regulatory agency is not in and
of itself a reason to institute a regulation. The key ingredient is that there must be
some market failure to warrant government intervention.
As our society has become richer, we have begun to place a greater value on
individual health status and on efforts that can improve our physical well-being.
Individuals tend to overestimate the risks associated with lower-probability events
such as botulism, tornadoes, and floods.
In contrast, there is a tendency to underestimate the risks associated with higherrisk events, such as cancer, heart disease, and stroke.
If risk perceptions are already too high, then the level of safety provided by the
market will be excessive as economic agents will be responding to exaggerated
risk perceptions.
The overestimation of low-probability events also has substantial implications for
government policy. To the extent that there is an alarmist reaction to small risks
that are called to our attention, and if these pressures in turn are exerted on the
policymakers responsible for risk regulation, society may end up devoting too
many resources to small risks that are not of great consequence.
923-927: Viscusi, “The Emergence of Health, Safety, and Environmental Regulation”
Uncertainty and Conservatism
There is a great deal of uncertainty when measuring an activity’s “riskiness.”
Government regulatory agencies tend to be very conservative when assigning an
activity’s level of risk (i.e. they use the upper end of the range of riskiness) and thus can
distort the true risk level by differing amounts. This is particularly true for risks about
which little is known. In addition to conservatism, there are other biases that can make
certain things seem riskier than they are; for example, government agencies usually rely
on tests that have been performed on the most sensitive animal species, as opposed to
weighting across all species.
In addition, many regulatory agencies make unrealistically conservative assumptions
about the way in which the subjects of regulation will be used. For example, the EPA
spent $9.3 million cleaning up a hazardous waste site to point at which it would be safe
for children to eat the dirt for 245 days out of the year, despite the fact that the site was a
swamp and no children would live there for the foreseeable future.
Even in the scientific components of risk assessment, conservatism biases the risk level
upwards by setting variables (e.g. frequency of exposure, effect of exposure on individual
health) at the upper end of the confidence interval. “The net result of the conservatism
biases is to generate a risk assessment that may bear little relationship to the actual risk
posed, making it difficult for policymakers to determine which sites pose risks and which
do not.
The Role of Risk Ambiguity
Viscusi uses the Ellsberg paradox to illustrate a point about risk regulation. The paradox
is one in which you are faced with two urns, both of which are filled with red and white
balls. You have information on the composition of Urn 1 (50 red, 50 white) and no
information on the composition of Urn 2. You must pick one urn from which to draw and
if you guess the color correctly, you win a prize. The statistically correct choices of urn
and color depend on whether it is a one-time or multiple-shot decision.
If it is a one-time decision, then it doesn’t matter what urn or color you pick, because
with whichever urn you pick, your chances are 50/50. Granted, with Urn 1 you have a
“hard” probability, and Urn 2 you have a “soft” probability. But because you are only
making one decision, if you choose Urn 2, you are in essence flipping a coin, which gives
you 50/50 odds.
If it is a multiple-shot decision (after each drawing, the ball is put back into the urn) then
you should pick Urn 2, because you have room to learn what the composition is, and your
odds of picking the right color could become greater than 50/50.
Viscusi generalizes this example to risk regulation policymaking. For one-shot decisions,
the precision of the risk doesn’t matter. But in sequential decisions in which learning is
possible and in which you can revise your decision over time, it is preferable to have a
situation of uncertainty (i.e. Urn 2) than to have a precisely understood risk. In situations
of uncertainty, we can alter a course of action if the risk turns out to be different than we
had anticipated originally.
Therefore, the stringency of regulation depends on the uncertainty of the risk that is being
regulated. If it’s a one-shot deal (e.g. you are preventing environmental catastrophe), then
uncertainty is irrelevant and you should regulate to the extent that you must. But if we
can learn about how serious the problem is and take effective action in the future, then it
will generally be preferable to make less of a regulatory commitment than one would if
this were a one-shot decision.
Conclusion: Policymakers should be aware of and account for the biases and
conservatism factors that distort the “true risk” assessments of both scientists and
regulatory agencies. Otherwise, Viscusi warns, we run the danger of distorting our policy
mix and focusing attention on hazards that offer few expected payoffs but are not well
understood.
927-941: Nordhaus, “Reflections on the Economics of Climate Change”
Nordhaus has two objectives: to identify and to alleviate the human contribution to
environmental destruction in the most efficient way possible. He dubs this process
“managing of the global commons,” alluding to that darling of economic theory – the
tragedy of the commons, in which a public good is abused (and eventually destroyed)
because there are no individual incentives to prevent such abuse.
Scientific Background: “Greenhouse gases” are those in the atmosphere that let
incoming solar radiation but trap outgoing solar radiation, effectively warming the
surface of the Earth (without this “greenhouse effect,” the Earth would have a climate
similar to that of the moon). In the past century or so, human activities have increased the
concentration of greenhouse gases, which means that the same amount of solar radiation
comes in, but less goes out, which contributes to “global warming.”
Impacts of Climate Change: The future impacts of increased greenhouse gas
concentration on climate change are hotly contested amongst atmospheric scientists.
Nordhaus first notes the reduction of human “climate sensitivity” – in most cases, climate
has ceased to be a factor in whether or not humans can live in a particular region or, more
importantly, whether businesses can produce. Thus, the socioeconomic impacts of
climate change will result less because it is one or two degrees hotter; they will result
from the fact that such a temperature change affects other things like precipitation, water
levels, etc, which in turn affect the way we live our lives.
Developing countries are more vulnerable to climate change than, say, the U.S. or Japan.
DCs are also the places in which the least research has been to done as to the potential
impacts of climate change.
The Balancing Act in Climate Change Policies: The greenhouse effect is, at heart, a
public goods problem. Because individuals who emit greenhouse gases do not face the
social/“true” marginal cost of their actions, they will emit an inefficiently high level.
What economists can contribute is a policy that balances a) costs of slowing emission and
b) benefits of reducing future damages from climate change. In other words, good policy
will identify and balance the marginal cost and marginal benefit of emissions reduction; it
will get the maximal benefit of reduction for a given level of expenditure. Graphically,
this means that the most efficient rate of emissions reduction occurs where an upwardsloping MC equals a downward-sloping MB.
The trick, of course, is to determine how to model mathematically the MB and MC
functions. Nordhaus outlines a Dynamic Integrated Model of Climate and Economy
(DICE), which employs a basic intertemporal choice framework. Holding inputs and
technology constant, he asks, what are the optimal paths of 1) capital accumulation and 2)
emissions reduction?
The model uses a utility function that includes three variables: 1) consumption of goods
and services, 2) investment in productive capital, 3) slowing of climate change via
reduction of greenhouse gas emissions. The optimal path for society is the one that
maximizes the discounted sum of these utilities (per capita). Its measurement in terms of
discounted present value of consumption units.
Empirical Modeling of Optimal Policies: Nordhaus lays out three outcome options. 1)
emissions are reduced to the economically efficient level (as defined by the DICE
model’s solution), 2) emissions are stabilized at 1990 levels1, 3) emissions are restrained
such that temperature change is limited to .2 degrees per decade. The policy tool that
Nordhaus assumes is the use of carbon taxes; these taxes would be highest for options 2
and 3.
For the global economy, Option 1 has a net benefit over doing nothing at all (.05% net
gain of world output). Option 2 and 3 impose major costs to the global economy: $7
trillion and $41 trillion of net present value (which translate into 1.4% and 8.2% losses in
world output), respectively.
Anxieties and uncertainties: Though our current models of temperature change may not
predict socioeconomic impacts as pressing as, say, endemic poverty in developing
countries, Nordhaus argues that “given the potential for catastrophic surprises, perhaps
we should conclude that the major concern lies in the uncertainties and imponderable
impacts of climate change rather than in the smooth changes foreseen by the global
models.” There is debate about how likely these catastrophic surprises are (hence the
term “surprise”), but Nordhaus concludes with the critical role that social scientists have
to play in rational decision-making about climate change: identifying possible scenarios,
weighing the values of different possibilities, and devising strategies in the face of
uncertainties.
Some Economics of Global Warming, Thomas C. Schelling, 1992
Page 942-955

1
Future temperature and climate changes will unquestionably be on a scale unlike
anything during the last 10,000 years.
The article was written in 1993








The greenhouse influence depends on the global concentration, and not on any one
nation’s emissions.
The cost of reducing carbon emissions will be huge: to cut emissions in half is expected
to cost hundreds of billions in perpetuity.
Atmospheric carbon concentration has increased 25% in the last 100 years.
Today, very little of US GDP is produced outdoors (i.e. susceptible to climate).
o Manufacturing, finance, healthcare, and education are all unaffected by climate.
o Agriculture and forestry accounts for less than 3% of GDP.
 However, even if agricultural productivity declined by 1/3 over the next
50 years, the levels of per capita GNP we might have achieved by 2050
would be achieved in 2051.
 Agricultural productivity continues to improve worldwide.
o Schelling believes that the impact of climate change on economic output in
developed countries will be negligible.
The developing world is vulnerable to climate change in a way that the US is not.
o Climate-sensitive outdoor activities like agriculture account for 30+% of GDP in
the developing world.
o Health: parasitic and vector-borne diseases are sensitive to climate and affect
hundreds of millions of people.
o However, their continued development might be their best defense against
climate change, as they move away from agriculture and improve healthcare
and transportation.
Population growth
o More people means more carbon.
o More people means that catastrophes have more devastating effects. The
adverse impact of climate change on food production will affect 12 billion
people worse than it will affect 9 billion people. Thus the population size might
be a more pressing concern than increasing carbon concentrations for
developing nations.
Current models estimate sacrificing 2% of world GNP in perpetuity to slow climate
change
o Arguments for sacrificing
 Developing countries are vulnerable
 However, might cost $200-400 billion a year to the developing
world to slow emissions and climate change
 It might be better for the countries to invest in their economic
development instead
 Natural environment will be damaged
 Slow emissions and climate change to prevent catastrophes (e.g.
Katrina)
o How big is a 2% sacrifice in world GNP?
 A politically unmanageable sum (~$100B per year)
 However, does not postpone GNP growth significantly (e.g. from 2050
to 2051)
 Thus from a larger perspective it is not a huge sacrifice
Possible policy solutions
o Slowing deforestation has a much larger impact than reforestation
o

Universal uniform carbon tax
 Reducing emissions in the developing world will be at the expense of
the developed world
 Politically complicated
o Tradable permits
 A bad idea because it is difficult to estimate reasonable costs and
reasonable emissions levels (thus these will lead to more inefficiency)
o Schelling believes that specific policies (e.g. taxes, regulations, subsidies) must
be agreed upon, rather than specific emissions goals.
Important to emphasize the transfer of technology and R&D between countries
The Stern Review on the Econmics of Climate Change, William Nordhaus, 2006.
Page 956-961
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In 2001, the US opposed the Kyoto Protocol because it exempts 80% of the world from
compliance.
On the other hand, in 2006 the UK agreed (in the Stern Review) that there was need to
reduce carbon emissions immediately.
o Estimates that the costs of climate change are like losing at least 5% of world
GDP per year
 Possibly as much as 20%
Previous models find it most efficient to follow the “climate policy ramp” which means
modestly reducing emissions in the short run, followed by sharp reductions in the
medium run and long run.
o This allows countries to develop their capital until it becomes efficient to shift
investments towards more emissions-aggressive policies.
The Review argues against the ramp and instead argues that strong current action is
necessary.
The Review argues for increasing the price of carbon emissions.
o Critical to have a harmonized carbon tax
 This provides incentives for firms and households to reduce emissions
 This also stimulates R&D in low-carbon technology
o The Review holds an extreme assumption about discounting
 The Review uses a very small social discount rate
 This magnifies future costs enormously
 This rationalizes large emissions reductions and consumption reductions
today.
961-979
The Stern Review on the Economics of Climate Change
William Nordhaus November 17, 2006
(Begin on page 6 of article until end)
-fundamental flaw of Kyoto protocol is that it did not link climate-change policies to both
economic and environmental objectives.
The social discount rate: concepts and assumptions
 The social discount rate (SDR) measures the importance of the welfare of future
generations relative to the present. Calculated in percent per year, but refers to
discount in future utility, not future dollars or goods.
o 0 rate means future generations are treated equally with present generations
o positive rate means welfares of future generations are reduced compared to nearer
generations.
 The Stern Review on the Economics of Climate Change of November 2006 by the
british government argues it is indefensible to make long-term decisions with a
positive SDR. The only ethical way is to have a 0 rate
 Nordhaus says that instead, should hold that each generation should leave at least as
much total societal capital as it inherited (tangible, natural, human, technological).
This would allow social discount rates. OR could have a Rawlsian perspective to
maximize economic well-being of poorest generation, allowing current consumption
to increase to reflect future improvements in productivity.
o there are alternative ethical perspectives
Measuring impacts with near-zero discounting
 The review says that the cost in climate change is the “equivalent of a 20% cut in
consumption now and forever” (this is really the average annual consumption loss
over the indefinite future. The measure is akin to an annuity.)
o The damage estimates are much higher than the standard estimatesassumptions
that tilt up damage curve: rapid economic growth forever, high economic damage
estimate, high climate impacts of GHG accumulation, catastrophic risks, adverse
health impacts, etc. Also, review drew selectively from studies emphasizing high
damage estimates.
o These impacts are FAR into the future, so calculations depend critically upon the
assumption of low discounting.
o i.e. the scenario placed has less than 1% losses in world output in 2050 which
turns into 2.9% in 2100 and 13.8% in 2200. “this somehow turns into a mean
annual impact of 14.4%
o 5% damages to output over the next two centuries, under this system, turn into a
14.4% reduction in consumption now and forever because near-zero discounting
magnifies distant impacts. Low damages get overwhelmed by long term average
over many centuries.
o Nordhaus says that the assumption of near-zero discount rate drives most of the
economic results in the Review
Implications for saving and investment

Global consumption reduces by 14% under plan. Where would these come from:
developed or developing? Also, reducing current consumption to prevent the decline
of future consumption. Ethical questions
Hair triggers and Uncertainty
 Present decisions become extremely sensitive to uncertain events in the distant future
under the plan’s near zero social discount rate. As apposed to conventional
discounting where contingencies many centuries ahead have a tiny weight in today’s
decisions.
 “an infinitesimal impact on post 2200 income stream could justify a large
consumption sacrifice today. Likewise, far-future uncertainties are magnified by low
discount rates.”
 If military used these near zero social discounting, then Countries might start wars
today because of the possibility of nuclear proliferation a century ahead; or because
of a potential adverse shift in the balance of power two centuries ahead; or because of
speculative futuristic technologies three centuries ahead.
Summary Verdict
 The Review is unambiguous in saying we need urgent, sharp and immediate
reductions in greenhouse-gas emissions. Decisive and compelling answers.
 But these answers, while a politicians dream come true because there is only one side,
have another side. The conclusions are not based on any new economics, but depend
decisively on the assumption of a near-zero social discount rate.
 Nordhaus shows that the Review’s model cannot stand up to changes in the discount
rate and its conclusions change drastically.
George Borjas, “Reframing the Immigration Debate,” 1999
(Beginning of article until page 4)
 Immigration debate in a nutshell: How many people should the US admit? And,
since there are many more persons who will want to migrate to the US than the
country is willing to admit, which should they accept?
 Us had open door immigrant policy until 1924. Then admitted very vew immigrants
from 1924-65.
 Cost-benefit calculus frames debate: who loses and wins and by how much?
 Issues: immigrants can make extensive use of social services, not “paying their way”,
labor market competition, and difficulty in assimilating into American society.
 Benefits: could spur economic growth, by perhaps creating new industries (as in
silicon valley), reduces prices paid by American consumers on goods. In short,
immigration can increase size of economic pie.
o Also they may do jobs that natives refuse to take. Some industries could
disappear without them (agriculture in CA) and reintroduce ambition and drive
into the American economy.
 all of the costs and benefits depend on how much and which people admitted.
 Borjas wants to shift terms of immigration debate away from arguing over the
validity of the above symptoms (benefits and costs) Go to the two questions in first
bullet point. They are what is important.
 To decide the answers, must decide what the objective of immigration policy is.
Borjas sketched the implication of the objective: THE MAXIMIZATION OF THE
ECONOMIC WELL BEING OF THE NATIVE BORN POPULATION.
 This objective has dominated immigration debate throughout American history in his
view. Even if one disagrees with the choice, there is much to learn by comparing
how any proposed immigration policy deviates from the one the policy above.
Borjas “Reframing the Immigration Debate”
The Top Ten Symptoms of Immigration
1. The number of immigrants entering the US is at record levels
a. 1901-1910 peak of immigration
b. some say that because the percentage of foreign born is lower today,
immigration is not a problem
c. but Borjas thinks this analysis understates the problem
d. foreign born people have made up most of America’s population growth
because of low American fertility rates
2. The relative skills and economic performance of immigrants have declined
a. immigrants used to be better educated than natives, but this has changed
b. also earn about 1/4 less than native population
c. fall in average skill level of immigrants
3. Immigrant earnings will continue to lag behind
a. economic gap between natives and immigrants may not decline
substantially during natives lives
b. the most recent wave of immigrants will probably suffer substantial
differences in wages
4. National Origin matters
a. 1965 Amendments to the Immigration and Nationality Act repealed lots of
the favoritism for coming from Western Euro countries, and allowed for
family ties
b. this has increased immigration from Latin America and Asia
c. substantial differences in wages between immigrations of different
nationality, Latin Americans earn little
5. Immigration Harmed the Economic opportunities of least skilled natives
a. immigrants are clustered in 6 states
b. people have examined the wages of the native population in these highimmigration areas versus the rest of the country and found little difference,
concluding that immigration doesn’t negatively affect wage
c. Borjas argues that this analysis is wrong because the native population of
these areas probably left to find higher wages elsewhere
6. Immigration had a severe fiscal impact on the affected states
a. .25% of immigrants receive welfare, vs .15 of natives
b. study showing that immigration raised annual taxes of native by more than
$1,000
7. the measurable net economic gains from immigration are small
a. gains to firms who can now employ cheap immigrant labor exceeds losses
to native workers who get lay-offs
b. estimated net gain at .1% of GDP
c. wealth transfers to firms
d. redistribution from those who compete with immigrant labor to those who
use it
e. can be benefits in the form of externalities, new introduction of ideas
8. ethnic skill differentials may persist for at least 3 generations
a. children of immigrants still earn less than native counterparts, and this
takes decades to undo
b. skill differentials are passed from generations
9. Ethnic spillovers influence the social mobility of immigrant groups
a. the cultural environment a child grows up in determines much of his life
skills; ethnic capital
b. this makes it difficult for people from disadvantaged ethnicities to move
up socially
c. children of immigrants tend to follow not just their parents, but their
ethnic groups path
10. ethnic ghettos incubate ethnic differences and slow down the melting pot
a. segregation creates a vicious cycle of poverty
Implications for immigration policy
Any policy discussion needs to be explicit about what it considers to be in the national
interest.
If you only care about welfare of native population, there are still lots of considerations,
like do you want to focus on increasing native income, or decreasing income inequality?
Theory; US should admit immigrants until their benefit to country equals their cost.
But the debate will reach a consensus about what is the goal of immigration policy, and
this will shape the policy.
The Economic Benefits from Immigration- Borjas
The immigration debate isn’t about net benefit (which is small) from immigration, it is
about the distribution of gains and losses.
How do natives benefit?
Immigrants are consumers
Immigrants can increase productivity of native born, possibly increase GDP
Difficult to measure benefits from immigration
difference between winners and losers is immigrant surplus
the nation as a whole gains
redistribution between native workers and firms who employ immigrants
999-1010
 Blacks
o Do not gain from immigration
o Surplus mainly to owners of capital
o Blacks disproportionately underrepresented as owners
o Loss to workers, so blacks have net loss
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What if immigrants increase the capital stock?
o Model assumed no change in capital stock
o If immigrants bring own or foreign capital stock, surplus actually less
o Imagine: US economy has 100 million workers; government allows 100
million immigrant workers on condition that they together bring $7 trillion
of capital stock (exactly how much US has); then it would be like having
two parallel economies, where native US born and immigrants operate in
separate economies
o Therefore, native born do not gain b/c the returns to capital do not go to
US born but to those who brought the capital
What if immigrants do not lower wages of native workers?
o Then there would be no surplus at all
o b/c surplus comes from lowering wages (thereby increasing profits to
firms)
Do immigrants generate externalities?
o Too hard to measure, and not clear if net is positive or negative
o Positive: new information, diversity, new products, new methods of doing
same things
o Negative: some don’t appreciate the diversity; cultural and linguistic
barriers that hamper social and economic exchanges among large
segments of American population
Skill levels of immigrants
o Most post-1965 immigrants low skilled
o Therefore, most of loss to less-skilled (redistributed their surplus to more
skilled)
o Immigrants help natives when their skill level is different; since most
natives are skilled, it would be better to have more unskilled
o However, because of technology, skilled workers are more productive
than unskilled workers; therefore, more surplus to owners if more skilled
immigrants
o Simulation of gain from all skilled or all unskilled immigrants shows that
all skilled surplus is greater, so economically, best immigration policy is
to admit more skilled immigrants
1011-1017
David Card: The Impact of the Mariel Boatlift on the Miami Labor Market
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Why look at this evidence?
o Problem with trying to look at effect of immigrants on labor markets is
that it’s only correlational (maybe immigrants come because of rising
wages, so we cannot draw causation)
o Mariel boatlift – when Castro decided to allow anyone who wanted to
come to US to come from Cuba
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o This influx of immigrants was chosen by Castro at an arbitrary time
(related to Miami economy) for an arbitrary place, so any difference btw
Miami and other similar cities probably caused by immigrants
Who were the immigrants?
o 120,000-125,000 immigrants
o May to September of 1980
o Lower education, some inmates, young, male, more sales/laborers than
other Cubans in Miami at the time
No effect on Miami Labor Market
o Compared to similar cities in terms of demographics and economics
(Houston, LA, Tampa, Atlanta)
o No difference in changes in general wages, unemployment, or wages of
unskilled workers
Card
Very hard to measure the effect of immigration:
-Immigrants have, on average, only slightly lower skills than the native population
-Locational choices of immigrants and natives presumably depend on expected labor
market opportunities
This paper looks at the Miami labor market after the Mariel Boatlift
- Sept 1980
- 125,000 Cuban immigrants arrived in Miami
- 50% settled permanently in Miami
- 7% increase in the labor force in Miami
- 20% increase in the number of Cuban workers
This paper looks at 1979-1985 wages and unemployment
Good situation to study because:
1) Large sample size
2) 1980 census provides background from which to measure differences
3) Cubans are separately identified on many Govt documents
Prior to the Boatlift Miami 35.5% immigrant
56% of immigrants were Cuban
The new immigrants, on average, had less education, were younger, and more likely to be
male than other Cubans. Therefore we would expect them to affect the market for
unskilled labor.
Procedure
Compared employment wages in Miami to other cities, found that while nominal wages
decreased 1979-1985, the comparative wages did not decrease significantly.
Credits drop in wages to recession of early 1980's
Once you account for the general economic condition of the country, virtually no effect
on the wage rates/unemployment of less-skilled non Cuban workers.
These results may not be entirely applicable because Miami good for immigrants
-high concentration of textile and apparel industries
-very Spanish friendly
Other locations might see a larger effect.
Borjas,Katz
Looks at Mexican immigrants as part of the US work force
Uses US census between 1900 and 2000
Mexicans have not kept pace with native laborer's education (much higher rate of drop
out)
1037-1055
Key takeaway: Borjas and Katz attempt to explain the connection between the growing
disadvantage in educational attainment of Mexican immigrants and the growing
disadvantage in relative wages. They find that (between 1940 and 2000) educational
attainment is explaining more and more of the wage difference between Mexican
immigrants and native workers. Moreover, education attainment explains a large portion
of why Mexican immigrants are paid less than other immigrants. Mexican immigrants do
not seem to “catch up” to natives like other immigrant groups, but they do catch up to
natives with similar educational background.
Examining Trends in Relative Wage
1. Summary of wage disadvantage
a. Sizeable and steady decline in the wage of Non-Mexican immigrants
relative to native workers. Non-Mexican immigrants were actually making
more than native workers in 1940. Non-Mexican immigrants currently
make about 3% less.
b. Relative wage gap much higher for Mexican immigrants, but decline has
not been steady. gap closed between 1940 and 1970 before widening again
between 1970 to 2000.
c. To put it in perspective, in 2000, Mexican immigrants made 41% less
relative to natives, while Non-Mexican immigrants made only 3% less.
2. Regression: log w jt   t X jt   t I jt   jt
a. wjt is the log weekly wage of worker j in year t
b. X is a vector of socioeconomic characteristics that depends on the specific
regression (Borjas and Katz runs a few regressions). These characteristics
include:
i. variables indicating the worker’s education (less than high school,
some college, etc.)
ii. worker’s age
iii. state of residence
c. Ijt is a vector of two variables indicating if worker j is a Mexican
immigrant or a non-Mexican immigrant
3. Results
a. While observing only education and age, regression shows that skill
characteristics and particularly educational attainment gradually
explains more of the wage gap between Mexican immigrants and
native-born men.
i. 1940- skill characteristics accounts for almost none of the wage
gap between Mexican immigrants and native-born men
ii. 1970- almost half of the wage gap
iii. 1980- almost 70% of the wage gap
iv. 2000- almost all of the wage gap
v. Moreover, in 2000, education accounts for the gap between
Mexican immigrants and non-Mexican Immigrants
b. Holding for state of residence did not affect the results. Theoretically, state
of residence could be important because immigrants cluster in different
states
c. Results for women are similar. A minimal set of skill characteristics
(mainly education) explains about 80% of the wage gap between Mexican
and native women.
Examining Cohort Effects
1. Cohort effects: wage of Mexican immigrants may be affected by by newer waves
of immigrants with inherently different skills or earlier waves acquiring
marketable skills. In this section. Borjas and Katz look at wages of newly arrived
immigrants
2. Summary of cohort effects on relative wage
a. Relative wages of newly arrived immigrants decreased from 1940 until
1990, when a reversal took place and relative wages increased
i. while reversal is true for both Mexican and Non-Mexican
immigrants, it was a much more substantial reversal for NonMexican immigrants
b. Relative wages of new Mexican immigrants have always been lower than
new non-Mexican immigrants
i. In 2000, the typical newly arrived Mexican immigrant earned 53.4
percent less than the typical native worker, as compared to an 18.4
percent wage disadvantage for non-Mexican immigrants
3. Results
a. Skill characteristics (mainly education) explain a great deal of the
wage gap between newly arrived Mexican immigrants and native
workers, but explains only a relatively small part of the wage gap
between non-Mexican immigrants and natives.
i. In 2000, skill characteristics account for nearly 80& of the
observed wage gap between recent Mexicans immigrants and
natives.
ii. Account for only 20% of the observed wage gap between recent
non-Mexicans immigrants and natives
b. Education explains a great of the wage gap between newly arrived
Mexican immigrants and newly arrived Non-Mexican immigrants
Examining Economic Assimilation
1. Borjas and Katz look at whether immigrants experience improvements in relative
wages over time (i.e. they are economically assimilating, gaining skills, etc.)
2. Results:
a. Tracking non-Mexican immigrants from the 1960s and 70s: There is
evidence of economic assimilation by non-Mexican immigrants as
compared to similarly aged native workers in the same period.
i. In other words, being in the country for more time decreases the
gap in the relative wage, with most of the wage growth occurring
in the first 20 years after immigration. In fact, non-Mexican
immigrants overtake comparable native workers after 20 years.
b. However, for Mexican immigrants there is far less evidence of
consistent pattern of economic improvement.
i. In other words, Mexican immigrants are not experiencing relative
wage growth even as they are (hypothetically) gaining experience
in the U.S. labor market.
c. Borjas and Katz also find that regardless of being a Mexican or nonMexican immigrant, an immigrant that is older upon entering the US
will experience less economic assimilation and therefore less increase
in relative wages. This is in contrast to those who enter the US as children
(5-14 yrs. old) who has much smaller wage differential.
d. They find that there is a much smaller wage gap between Mexican
and native-born workers that have Mexican ancestry, and there is
more of a “catching-up” effect for Mexican immigrants as compared
to natives of Mexican ancestry.
e. There is a significant narrowing of the wage gap between Mexican
immigrants and those with similar educational attainments (native US
high school dropouts), but the convergence slows down so that in the end
Mexican immigrants still earn lower wages.
They realize that there may be a problem with their analysis since there are
many return migrants in the Mexican immigrant group when looking across
time periods. However, they conclude that even when they put that into
account, there is little likelihood that Mexican immigrants will ever reach
wage parity with native US workers.
MISSING 1056-1088