Transfer Payments

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Transfer payments are a form of income to individuals for which no current good or service is expected in return. They differ from other payments to individuals for whom either a service (including labor services) is performed in return for such payments or a good is exchanged.

Transfer payments can originate from either business or government sources. Business transfer payments include corporate gifts to nonprofit institutions, payments for personal injury, and taxes paid by domestic corporations to foreign governments. Far more important, in dollar terms and policy significance, are transfer payments originating from government sources. Government transfer payments can be made by any level of government (federal, state, or local) and can take the form of either cash or in-kind benefits. Cash benefits include Social Security; government employee, military, and railroad retirement pensions; unemployment insurance; veterans' benefits; workers' compensation; cash public assistance (including Temporary Assistance for Needy Families [TANF] and Supplemental Security Income [SSI]); and educational assistance. Also included are government payments to nonprofit institutions that do not involve work under research-and-development contracts. Major in-kind government transfer payments include food stamps, medical insurance (Medicaid and Medicare), and housing assistance.

Size and Significance of Transfer Payments

The size of the U.S. government, measured as public expenditures, increased more than threefold from 1940 to 2000, and much of this increase was due to the growth in transfer payment expenditures, especially on Social Security, Medicare, and Medicaid. In the United States at the end of the twentieth century, transfer payments accounted for 44 percent of government spending by all levels of government (Economic Report of the President, 1999).

By their very nature, government transfer payments are excluded from the calculation of a nation's gross domestic product (GDP) since they do not represent compensation for the production of currently produced goods and services. Instead, transfer payments represent a redistribution of income, taking money away from some individuals (taxpayers) and giving it to others who are eligible for the various programs noted above. It is also important to recognize that while a considerable amount of transfer payments represent spending on public assistance, such as programs to aid the poor, other transfer payments are for social insurance programs (e.g., Social Security, Medicare, unemployment insurance) that bring significant benefits to the middle class. Public assistance programs are typically "means-tested," implying that the recipient must have household income below some threshold level to qualify and that the amount of the benefit decreases as household income increases.

Rationale for Transfer Payments

Government transfer payments are rationalized in various ways depending on the nature of the programs involved. Public assistance transfer payments are often justified using Richard Musgrave's (1959) "distribution function" of government. Here it is argued the market outcomes may lead to a distribution of income that in the judgment of society is "too unequal." In particular, a government safety net is needed to insure that all members of society, including children and those unable to work, have a minimally adequate standard of living. Most public expenditures on low-income programs involve in-kind benefits, rather than cash assistance, because they allow the public some control over the spending patterns of recipients.

It should be noted that this rationale for government intervention and income redistribution through transfer payments is not without critics. Some would argue that nongovernmental organizations (e.g., churches and other forms of private philanthropy) are better equipped to meet the needs of low-income individuals.

Social insurance transfer-payment programs are rationalized in several ways. One relates to private market failure due to the phenomenon of adverse selection. Consider a private firm selling unemployment insurance to individuals without knowing the details of their employment status. If the firm were able to offer an insurance policy to a large group, the firm could make a reasonable estimate of the fraction of the group that would become unemployed over some period of time and charge rates accordingly to make a normal profit. However, the firm does not have information on the employment status of any single individual. When selling an unemployment insurance policy to a single individual, the firm must assume that individuals prone to unemployment are the most likely participants in this market. Accordingly, the firm would have to charge higher rates to individuals than for the group as a whole to make a profit. The higher cost of insurance would lead many people to choose not to insure, leading to less than the economically efficient amount of insurance being provided.

Social insurance transfer payments can also be rationalized on the grounds that some individuals lack the fore-sight to purchase sufficient insurance. For example, in the absence of Social Security some individuals might not save adequately for retirement. Society would then be faced with either letting such individuals retire with less-than-adequate resources or coming to their aid. The possibility of the latter further reduces the incentive for individuals to save during their working years.

Effect on Economic Behavior

Critics sometimes charge that major transfer-payment programs have adverse effects on household decisions to work and save. Regarding work effort, the benefits from means-tested programs are reduced as income from labor increases; in some cases the reduction is dollar-for-dollar, implying an implicit tax of 100 percent on the wages of program participants. In 1996 Congress addressed the work disincentive for the major cash transfer-payment program to low-income persons by changing the name of the program from Aid to Families with Dependent Children (AFDC) to Temporary Assistance for Needy Families (TANF) and mandating work requirements for most program participants.

Many economists believe that Social Security contributes to lower saving rates by individuals and influences their retirement decisions. Individuals view Social Security as an alternative saving vehicle for retirement, leading them to save less than they would in the absence of this program. Nationally, this may depress the level of saving because the Social Security system is financed on a pay-asyou-go basis, whereby current workers pay for the benefits of current retirees; benefits are not financed out of any past saving on the part of the retiree. The potential effect that Social Security has on retirement decisions has been mitigated by legislation passed by Congress in 2000 that eliminated the implicit tax (reduced benefits) of individuals over 65 who choose to continue to work while nonetheless drawing Social Security benefits.

see also Balance of Trade ; International Trade


Council of Economic Advisors (1999). Economic Report of the President, Tables B-82, B-94. Washington, DC: U.S. Government Printing Office.

Feldstein, Martin S. (1996, June). "Social Security and Saving: New Time Series Estimates." Journal of Political Economy, 151-164.

Moffit, Robert (1992, March). "Incentive Effects of the US Welfare System." Journal of Economic Literature, 1-61.

Musgrave, Richard A. (1959). The Theory of Public Finance. New York: McGraw-Hill.

Rosen, Harvey S. (2005). Public Finance (7th ed.). Boston: McGraw-Hill/Irwin.

Michael Nelson

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Transfer Payments

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