Chapter 18: The Economics of the Welfare State

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Let's start with the story.

Think about Kenneth Young, a plumber in Virginia, 53 years old.

For years, he had this serious heart condition, but often, well, he just couldn't take his medication.

Couldn't afford it.

He didn't have insurance, you see, and the costs were just too much.

But then, January 1st, 2019, things changed.

Virginia expanded Medicaid, that's the government health program for lower income folks, and Kenneth, he was one of the very first to sign up.

Suddenly his treatment was covered, he could finally get the medicine he needed.

It was a real lifeline.

Kenneth's story, it actually comes straight from Paul Krugman and Robin Wells of Microeconomics, the sixth edition, and it's our jumping off point today.

This deep dive, it's all about the economics of the welfare state.

It's a really important chapter that looks at how governments step in to help people.

So our goal today is pretty straightforward.

We want to unpack this complex topic for you, give you a clear, comprehensive, and hopefully pretty conversational summary.

We'll define the key terms, use real examples, help you kind of picture the data behind things like poverty or health care spending, basically arm you with the insights you need, maybe for an econ course or an exam, or honestly, just to be better informed about what's going on.

We'll also try to tackle some common misunderstandings and give you some ideas for how these concepts apply out there in the real world.

So what's on the agenda?

First, what is the welfare state?

Why do we have it?

Then we'll dig into poverty and inequality here in the U .S.

After that, we'll look at how the big government programs actually function, especially health care.

And finally, we'll touch on that big ongoing debate about its size and role.

Sound good.

Okay, let's get into it.

When we say the welfare state, what are we really talking about?

Is it just handouts?

No, not really.

It's basically the whole collection of government programs designed to cushion people from economic hardship,

often through what economists call government transfers, payments or services going directly to individuals and families.

And the scale in the U .S., it's huge.

I mean, think about it.

Over 110 million Americans get health coverage through Medicaid or Medicare.

That's like a third of the country.

Then you've SNF or food stamps, millions more getting the earned income tax credit.

It's massive.

And interestingly, it's actually even more extensive in most other wealthy countries.

Wow.

Okay.

So that's the but why?

What's the core logic behind it?

Why does the welfare state exist in the first place?

Well, the authors point to three main economic reasons.

The first one is about tackling income inequality.

It's kind of that classic Robin Hood idea, right?

A dollar just means a lot more to someone who's struggling than to someone who's already well off.

So the thinking is if the government taxes the rich a bit more and transfer some of that to the poor,

the benefit to the poor outweighs the cost to the rich.

More good than harm, basically.

These are often called poverty programs.

Okay.

Alleviating inequality.

What's the second reason?

The second one is alleviating economic insecurity.

This is about protecting people from those unpredictable financial hits.

Think about natural disasters like those huge floods in Texas a few years back, or maybe a sudden catastrophic medical bill that could just wipe a family out.

Social insurance programs are designed for this.

Even if you're not getting help now, just knowing that safety net is there if disaster strikes, it makes everyone feel a bit safer.

It connects to that idea from tax policy, the ability to pay principal.

Makes sense.

And the third?

The third is about reducing poverty and providing access to things like healthcare because they generate positive external benefits for society, especially when it comes to kids.

Research shows pretty clearly that children growing up poor often face lifelong hurdles like trouble finding steady work, higher crime rates, chronic health issues.

These aren't just individual problems.

They actually impose real costs on all of society down the road.

So programs that help these kids have a better shot.

They benefit everyone.

They generate those positive externalities.

But as you mentioned, it's not like everyone agrees on this.

There's a constant political debate, isn't there?

Oh, absolutely.

It's often described as like the central argument in modern politics, right?

How big should the welfare state be?

Should we expand it, shrink it?

But it is worth noting, even with that debate, there's a fairly broad consensus that some help should be there for families in trouble.

Even conservatives generally accept a pretty extensive welfare state exists.

But economists, you know, they're always weighing the benefits against potential downsides, things like deadweight losses from taxes or how it might affect people's incentives to work.

We'll definitely come back to that trade off.

OK, so we understand the why.

Let's pivot to the problems it's trying to fix.

Poverty and inequality.

How do we even measure poverty in the U .S.?

Yeah, the official measure is the poverty threshold.

It's a minimum annual income level, supposed to be just enough to cover basic necessities, and it gets adjusted each year for inflation.

So back in 2018, for example, it was around $12 ,000 for a single person, about $25 ,000 for a family of four.

What's kind of striking, though, is that even though the U .S.

is much richer now than in the 1960s, this official poverty rate hasn't really shown a clear long term drop.

It's hovered around similar levels.

Why is that?

Well, part of the issue is the official measure doesn't fully count a lot of government aid, like food stamps or housing assistance.

That's why economists developed the Supplemental Poverty Measure, or SPM.

It does include government aid and adjusts for living costs in different areas.

And the SPM does show a bit more of a decline, but honestly still less than you might expect given overall economic growth.

And who are the people living in poverty?

Does it fit the stereotypes?

Often, no.

While it's true that poverty rates are disproportionately higher for African Americans, Hispanics, and families headed by single women, the single largest group of poor Americans,

in raw numbers about 41 % are non -Hispanic whites.

And a really crucial point, about a third of everyone in poverty are children.

That means roughly one in six kids in the US lives below the poverty line.

Plus you have the working poor people who are working, sometimes multiple jobs, but still don't earn enough to get above that threshold.

Often part -time work, no benefits.

The pandemic really highlighted this group's vulnerability.

What drives poverty?

What are the main causes?

It's complex, obviously, but lack of education is huge.

That wage gap between college grads and high school grads, it nearly doubled between 1979 and 2019.

Lack of English proficiency can be a barrier.

Racial and gender discrimination, unfortunately, still play a persistent role.

You still see gaps in pay and employment, even with similar education levels.

And then there's just plain old bad luck.

Losing a job unexpectedly, a business failing, a serious illness, any of those can push a family over the edge.

You see it concentrated in some areas like Harlan County, Kentucky, that old coal mining region where poverty rates are incredibly high.

And the impact, especially on kids.

It's really severe and the effects can last a lifetime.

We're talking lack of consistent healthcare, unstable housing, which can lead to learning disabilities.

There was this depth of education study, pretty shocking.

It found that among kids from disadvantaged backgrounds who showed high academic talent early on, only 29 % ended up finishing college.

Compare that to 74 % of equally talented kids from higher income families.

Yeah, it shows how poverty can just trap people, make it self -perpetuating.

And newer research, like from the Opportunity Insights Project, really highlights how the neighborhood you grow up in matters immensely.

Things like family structures in the community, the presence of role models.

It can significantly impact a poor child's chances of moving up later in life, sometimes even more than their own family situation.

Okay, so that's poverty.

What of the broader picture of inequality?

The US is rich, average household income over $90 ,000 in 2018, but clearly it's not shared equally.

Not at all.

If you divide households into five income groups, quintiles, the gap is just enormous.

In 2018, the richest fifth, their average income was something like 17 times higher than the average income of the poorest fifth.

It really shows how wealth is concentrated at the top.

And this is where the difference between mean and median income becomes really important, right?

Exactly.

The mean income, that $90 ,000 figure, is the average total income divided by households, but it gets pulled way up by the super rich.

The median income is the one smack in the middle, half earn less, half earn more.

In 2018, that was closer to $63 ,000.

Think of the Silicon Valley billionaire walking into a coffee shop analogy.

The mean income in the shop skyrockets, but the median income, what the typical person there makes, barely budges.

So median income gives you a much better sense of the typical American family is doing.

How does U .S.

inequality stack up internationally?

We use a measure called the Gini coefficient for that.

It runs from zero, which is perfect equality, to one, which is total inequality, where one person has everything.

You see high inequality, like genus, around 0 .5 or higher in parts of Latin America and Africa.

Europe, especially Scandinavia, tends to be much more equal, maybe around 0 .25.

The U .S., our Gini coefficient, is about 0 .41.

That's unusually high for a wealthy developed country, significantly higher than, say, Canada or most of Western Europe.

For context, the top 1 % in the U .S.

took home about 20 % of the national income recently, compared to just 6 % in Denmark.

Is all inequality bad, though?

Don't we need some to reward hard work or innovation?

That's a fair point.

Some level of inequality probably is desirable, provides incentives, but the concern is when it becomes extreme.

High inequality means a big chunk of the population isn't really sharing in the country's overall prosperity.

It helps explain why our poverty rate hasn't fallen much despite economic growth.

Plus, high inequality can lock people in, limit opportunities across generations, and potentially even contribute to social unrest or instability.

And beyond long -term poverty or inequality, there's that issue of sudden shocks, economic insecurity.

Right.

Two main forms.

First, sudden income loss, like losing your job.

The pandemic was a brutal example.

40 % of low -income workers lost jobs early on versus only 13 % of high -income workers.

A huge difference.

Yeah.

And the second form is a sudden surge in expenses.

Historically, before the Affordable Care Act, medical bills were the biggest culprit here.

Back in 2009, something like 60 % of all personal bankruptcies were linked to medical debt.

Okay.

So with those problems laid out, poverty,

inequality, insecurity, let's look at the tools.

How does the welfare state actually try to help?

What are the means tested, right?

And cash versus in -kind benefits.

That's a good way to think about it.

Means tested means your eligibility depends on your income or assets.

Non -means tested, everyone who meets other criteria like age gets it.

And yeah, cash is money.

In -kind is a service like healthcare or food vouchers.

And just looking at the sheer spending tells a story.

Social Security is the giant, over a trillion dollars a year.

Medicare is next, around $645 billion.

Those two dwarf most other programs.

Let's start with the means tested ones.

These are often what people mean when they just say welfare, right?

Often, yeah.

The main cash assistance program for poor families is TNF Temporary Assistance for Needy Families.

It replaced the old AFDC program back in the 90s.

It's generally less generous now, has time limits, work requirements.

Other key ones are SSI, Supplemental Security Income, which helps disabled folks with little or no other income.

And SNP, the Supplemental Nutrition Assistance Program, that's food stamps, though now it's usually a debit card, helps low -income families afford groceries.

Okay.

And there's one you mentioned earlier that sounds really interesting.

The Earned Income Tax Credit, EITC.

What's special about that one?

The EITC, yeah, it's pretty clutter.

It's often called a negative income tax.

The key thing is it specifically helps low -income working families.

It supplements their earnings.

The way it's designed is smart because it actually encourages work.

For lower incomes, the more you earn, the bigger the credit gets, up to a point.

For example, a couple with two kids might get a credit worth 40 percent of their earnings up to a certain level, maybe close to $6 ,000.

Then it phases out gradually as income rises.

So it really boosts income for the working poor without creating a big disincentive to earn more.

It's widely seen as pretty effective.

Gotcha.

Okay.

What about the non -means tested program?

Social Security is the big one there.

Absolutely the biggest.

Social Security guarantees retirement income for older Americans who paid in during their working years.

It also covers disabled workers and survivors.

It's funded by dedicated payroll taxes.

And while your benefit is linked to your past earnings, the formula is weighted to be more generous to lower earners.

And its impact is just immense.

For over half of married seniors and 70 percent of unmarried ones, Social Security provides more than half their total income.

For many, it's pretty much all they have.

It keeps millions out of poverty.

What else falls under non -means tested?

Another crucial one is unemployment insurance.

If you lose your job through no fault of your own, it provides temporary income support, typically around 35 percent of your previous salary, for up to 26 weeks usually.

It's a vital safety net during recessions.

So the multi -trillion dollar question, do all these programs actually make a difference?

Do they reduce poverty and inequality?

Yes, definitely.

The government's own data shows a pretty significant impact.

Social Security, as we said,

slashes the poverty rate for seniors by nearly 40 percentage points.

That's enormous.

Things like the EITC and other refundable tax credits make a big dent in child poverty, too.

And if you look at income distribution, taxes and transfers together really do shift things.

They significantly boost the share of total income going to the bottom 80 percent of households while lowering the share going to the top 20 percent.

So they are redistributing income.

They are.

And you could really see their importance during the Great Recession around 2008 -2009.

Those safety net programs, some expanding automatically, others boosted by legislation, they really cushion the blow.

Without them, estimates suggest the poverty rate would have jumped by 4 .5 percentage points.

With them, it only rose by about half a percentage point.

They acted as a critical shock absorber.

OK, let's shift gears a bit to a huge piece of the welfare state puzzle.

Health care.

Why is it such a unique challenge and why is it so incredibly expensive here in the U .S.?

Yeah, health care is different.

First, the costs are just staggering and unpredictable.

Back in 2018, the U .S.

spent over $11 ,000 per person on health care.

That was almost 18 percent of our entire economy, our GDP.

And the costs aren't spread evenly.

Most people have minor expenses in a given year.

But a small fraction, maybe 10 percent of the population, accounts for something like two thirds of all the spending.

Anyone could suddenly face one of those massive medical bills, tens, even hundreds of thousands of dollars.

It's way beyond what most families can handle.

And that's why health insurance is basically a necessity, not a luxury.

And who actually pays for it all?

Is it mostly private insurance?

That's a common perception, but look at the numbers.

Only about 12 percent of health care costs are paid directly out of pocket by individuals.

The other 88 percent comes from insurance.

But private insurance only covers less than half of that total bill.

A huge chunk is paid by government programs, primarily Medicare for seniors and Medicaid for low income individuals and families.

So yeah, the government is a massive payer in the U .S.

system.

And you mentioned earlier that private insurance markets have this inherent problem,

adverse selection.

Exactly.

That's the core market failure here.

If insurance is voluntary, healthier people might think, why pay high premiums?

I probably won't need much care.

So they opt out.

That leaves the insurance pool with people who are, on average, sicker and more expensive to cover, which forces insurers to raise premiums, which then causes more relatively healthy people to drop out because it's getting too expensive.

And you get this downward spiral, the private health insurance market death spiral.

The market can unravel.

Historically, insurers tried to avoid this by denying coverage to people with preexisting conditions or dropping them if they got sick.

But that obviously left millions vulnerable.

So given that problem, how do most Americans actually get insurance?

The most common way by far is through an employer,

employment based insurance.

This covers well over half the population.

It works better because employers pool risk.

They get a mix of healthy and less healthy employees, which avoids that adverse selection death spiral.

Plus, there are tax advantages for employer sponsored plans.

But the big limitation is it doesn't cover retirees or people who are unemployed or often part time workers.

So where do they turn?

That's where government health insurance comes in.

Medicare is the big one for folks 65 and older.

It's funded by payroll taxes.

Everyone eligible gets it.

And it's absolutely vital for seniors.

Average Medicare payments per person were over $13 ,000 in 2018, while the median income for that group was around $43 ,000.

Then there's Medicaid, which is means tested, jointly funded by the federal government and states.

It covers low income individuals and families.

Millions and millions of children rely on Medicaid.

And there's also separate health care for the military.

Okay.

Now, how does the U .S.

system, this mix of private and public, compare to other wealthy countries?

We always hear we spend more.

We absolutely do.

Compared to places like the UK, Canada, or even Switzerland, the U .S.

system stands out.

We were relying much more on private insurance than they do.

We spend vastly more per person, often twice as much or even more.

And crucially, even with recent improvements, we're the only wealthy nation that still leaves a significant chunk of its population completely uninsured.

How do the systems work?

They vary.

The UK has the National Health Service, the NHS, where the government directly provides most care, largely free at the point of service.

Canada has a single payer system.

The government pays the bills, like Medicare, but for everyone.

Switzerland actually mandates private insurance, but with heavy regulations and subsidies for lower incomes.

And here's the thing.

Despite spending so much more, the U .S.

doesn't consistently get better results.

On many quality measures, other countries match or beat us.

And on basic outcomes like life expectancy or infant mortality, we often lag behind other wealthy nations.

So why do we spend so much more if the outcomes aren't necessarily better?

It's complex, but a couple of big factors stand out.

One is administrative costs.

Our fragmented system, with hundreds of private insurers all negotiating separately with providers, creates a ton of overhead.

Private insurers spend way more on administration per dollar of claims than, say, Medicare does.

One study suggested the U .S.

spends six times more per person on healthcare admin than comparable countries.

Wow.

Six times.

Yeah.

And the other big factor is prices, especially drug prices.

Unlike most other countries, the U .S.

government doesn't broadly negotiate drug prices with manufacturers, so we end up paying significantly more for the same medications.

This all sets the stage for the Affordable Care Act, the ACA, or Obamacare.

What problems was it trying to solve?

Right, the ACA.

Passed in 2010 really took effect around 2014.

It came about because the U .S.

system was facing these twin crises, rising numbers of uninsured people, nearly a quarter of working -age adults at the peak and runaway healthcare spending growth.

So it had two main goals.

First, cover the uninsured, and second, try to control costs.

How did it try to cover the uninsured?

A few key ways.

It expanded Medicaid eligibility,

offering federal funds for states to cover adults up to 133 % of the poverty level.

That's exactly how Kenneth Young, our plumber, got covered.

It also reformed the private insurance market, banning denials for pre -existing conditions, requiring plans to cover essential benefits.

And it provided subsidies, tax credits to help lower and middle -income families afford private plans bought on new marketplaces.

And the cost control part.

That involved a range of things, encouraging new models like accountable care organizations to coordinate care better, penalties for hospitals with high readmission rates, trying to tax high -cost Cadillac insurance plans, eliminating co -pays for preventive services to catch problems earlier, a whole mix of strategies.

Did it work?

What were the effects?

On coverage, definitely a big impact.

The uninsured rate for working -age adults dropped sharply after 2013, basically cut almost in half by 2017.

That's millions more people with insurance.

Now, gaps remained undocumented, immigrants aren't eligible, and some states chose not to expand Medicaid, leaving millions in a coverage gap.

And the repeal of the individual mandate penalty in 2017 did cause premiums to rise in the individual market somewhat, as fewer healthy people signed up, although the subsidies protected many people from those increases.

And did Medicaid expansion actually help people?

Yes.

The Oregon experiment mentioned in the book is fascinating here.

Back in 2008, Oregon had limited funds to expand Medicaid, so they held a lottery for the available spots.

It created a natural randomized control trial.

The results are pretty clear.

Getting Medicaid made a real difference.

People who got it were significantly more likely to get preventive care, like 60 % more mammograms, 45 % more PAP tests.

They reported better access to doctors, felt healthier overall, 25 % more likely to rate their health as good or excellent.

And importantly, they had better financial security, 40 % less likely to have to borrow money to cover medical bills.

So real benefit.

Real measurable benefits to health and financial well -being, yes.

Okay.

So the goals seem worthwhile, helping the poor, providing security, ensuring health care.

But as we said, the debate over the welfare state is fierce.

Why?

Well, some of it is philosophical, right?

Just fundamental disagreements about whether redistributing income is a proper role for government at all.

But the core economic argument usually revolves around the efficiency equity trade -off.

The idea is that a larger welfare state needs higher taxes to pay for it, often progressive taxes hitting higher earners more.

And those higher taxes, the argument goes, could potentially reduce incentives for people to work hard, save or take business risks, which might, in theory, make the overall economic pie slightly smaller, even if it's distributed more evenly.

It's seen as this fundamental tension.

And there are potential pitfalls even in how programs are designed, right?

Like benefits notch.

Yes.

That's a tricky one, especially with means -tested programs.

It's counterintuitive.

Imagine a family gets a small raise, earns maybe a thousand dollars more, but that extra income pushes them over a cliff, an eligibility threshold, and they suddenly lose $2 ,000 worth of benefits, maybe childcare subsidies or food stamps.

So they're actually worse off for earning more.

Exactly.

Which obviously creates a really bad incentive.

Why work harder or take that promotion if it makes you financially worse off?

Some studies found cases where almost all of an after -tax pay increase was wiped out by lost benefits.

Designing programs to phase out smoothly is a real policy challenge.

And this whole debate seems to map almost perfectly onto the left -right political spectrum in the U .S.

It really does.

Arguably, the size and scope of the welfare state is the defining issue separating Democrats and Republicans today.

Look at the vote on the ACA almost perfectly along party lines.

And American politics has become much more polarized on these issues over recent decades.

Less middle ground.

Now, economic analysis can help sometimes.

It can clarify the facts, explain the tradeoffs, correct misunderstandings like, say, how health insurance markets actually function or the real impact of tax change.

But economics can't resolve those fundamental differences in values.

Should society prioritize equality more or individual economic freedom?

Economics can inform the debate, but it can't tell you which value is right.

So let's look outside the U .S.

for a moment.

The book contrasts the U .S.

with one of the smallest welfare states among rich countries, with Denmark, which has one of the largest.

What does that comparison tell us?

It's a fascinating comparison.

Denmark has much higher taxes, much more government spending on social programs.

Critics might assume this must cripple their economy, right?

Lower efficiency.

That would be the prediction based on the efficiency equity tradeoff.

Right.

But when you look closer, it's more nuanced.

Yes, Danish GDP per person is lower than in the U .S., about 16 percent lower in the year studied.

But why?

It's not because Danes are less likely to work.

Their employment rate is slightly higher.

And it's not because they're less productive.

Their productivity is similar, maybe even a bit higher per hour worked.

The big difference,

Danes work significantly fewer hours, about 20 percent fewer hours per year than Americans.

It seems to be largely a result of deliberate policy choices and social norms.

Things like generous legally mandated paid vacation and parental leave,

strong unions negotiating for shorter work weeks.

So the authors argue it's not necessarily a sign of economic failure.

It looks more like a societal choice.

Danes seem to have collectively decided to trade some potential income for more leisure time, more family time, maybe a less stressful pace of life.

And interestingly, Denmark consistently ranks near the top in global surveys of life satisfaction and happiness.

So for them, this larger welfare state, this different balance, seems to work and reflects different priorities.

What a fascinating journey we've taken from Kenneth Young's personal story right through to the big economic principles driving the welfare state.

We've looked at the why, the rationales like tackling inequality and insecurity.

We've dug into the realities of poverty and inequality here in the U .S.

We've examined how key programs like Social Security, EITC, and especially health care workers sometimes struggle.

And we've unpacked those core trade -offs between efficiency and equity that fuel the whole debate.

Yeah.

And what really stands out is that while the policy answers differ hugely from place to place, look at the U .S.

versus Denmark.

The underlying challenges are pretty universal.

Poverty, inequality, economic shocks, access to health care.

Every society grapples with these.

So maybe a final thought for you, our listener, to chew on is this.

Beyond the pure economics, what other factors, maybe history, culture, societal values might shape the choices different countries make about their welfare state?

It's clearly not just about maximizing GDP.

It's a great question to end on.

Definitely something to think about.

We really hope this deep dive has been helpful,

maybe clarified some things or sparked some new questions for you.

We encourage you to take these ideas and apply them as you read the news or think about policy debates.

From all of us here at The Deep Dive, thank you so much for tuning in and diving deep with us today.