Relative Prices and Substitution Across Wage, Welfare, and Disability Income

Abstract

In this paper I exploit the fact that the social and economic reforms over the past two decades differentially affected the opportunity costs of non-participation in work, welfare, and disability programs for single mothers across different birth-year and education cohorts. This cohort variation in after-tax wages and transfer benefits is used to identify own- and cross-price elasticities of demand for and substitution across wage, welfare, and disability income over 1979 to 2001 in the Current Population Survey. To estimate these key parameters I model household preferences with a conditional Almost Ideal Demand System that admits corner solutions, nonseparability, endogenous wages and incomes, and latent heterogeneity via cohort and state fixed effects. I match individual and family-level data in the CPS both with family-specific federal, state, and payroll tax rates, and with state-specific and time-varying benefit levels and effective tax rates in the AFDC and SSI programs. Using a two-limit Tobit instrumental variables estimator I find strong evidence of sizable own and cross-programmatic substitution effects. For example, the estimated elasticities imply that between 1979 and 1999 the increase in the generosity of SSI relative to AFDC accounts for about 40 percent of the average growth in SSI, while the increase in real wages accounts for about one-half of the average decline in AFDC shares over the past two decades. Simulations suggest that changes in relative after-tax wages and transfer-program benefits over the past two decades lead to a substantial pull out of cash welfare and into expanded reliance on employment and disability as a means of financial support among single mothers.