Three different approaches to raising the standard of living of the poor are wage subsidies (whereby employers are subsidized by the government to pay higher wages to low wage employees), a means-tested cash welfare program (whereby all individuals are guaranteed a minimum standard of living and that minimum grant is reduced as their earnings rise), and categorical welfare (whereby certain groups, such as single mothers or disabled individuals, receive cash or in-kind assistance).

a) Some individuals claim that a wage subsidy is the optimal means for raising the income of the poor, since it necessarily increases the incentive for working by raising the wage that they are paid. Is this argument correct? Why or why not? (HINT: consider both substitution effects and income effects in your answer.)

b) How do the incentives for working under a means-tested cash welfare program compare to those of a wage subsidy? Remember that under a means-tested cash welfare program individuals are entitled to a certain benefit guarantee (G) that is taxed away at some rate (t) as earnings (E) increase (whereby B = G – tE). Consider this question for both the poor and for other groups. Illustrate your answer in figures and explain.

c) Describe advantages and disadvantages of categorical welfare relative to the cash welfare system. What rule should guide the government as it decides what the appropriate categories are to use in designing these programs; that is, which types of categorical definitions will minimize the distortions from the system (e.g., single motherhood, blindness, etc.)? Do you know of empirical evidence on the question of whether categories used to establish welfare eligibility affect behavior? (HINT: for the latter part, we briefly discussed one example in class, and you can also rely on the textbook here.)

d) Imagine that you are designing a means-tested cash transfer program to combat poverty. That is, you are choosing a guaranteed benefit level and an implicit tax rate (benefit reduction rate) at which this grant will be taken away as income rises. What are the efficiency and equity implications of choosing different grant levels and different tax rates? (Here you should just provide a short discussion.)