The Optimal Subsidy to Private Transfers under Moral Hazard

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Private income transfers are increasingly viewed as an alternative to government income transfers such as social insurance and foreign aid. This paper models the incentive effects of government-subsidized private transfers and finds that although there is a significant welfare benefit to subsidizing private transfers, there is also a significant welfare cost. It is shown analytically, as well as through simulations, that the optimal subsidy to private transfers falls when the market reaction is taken into consideration. Copyright 2002, International Monetary Fund