What’s it: Transfer payments are payments by the government to the private sector without having to pay for the goods and services provided. These payments do not involve the goods and services exchanged and, therefore, are not counted in GDP. Examples are pension payments and unemployment benefits. Social security and student grants are other examples. Meanwhile, subsidies and bailouts are not described as transfer payments.
Transfer payments are considered a way to redistribute wealth within an economy. The government distributes the collected taxes back to those in need. In addition to aiding those in need, the program maintains public consumption, which is important to stimulate demand for goods and services.
However, critics argue the program tends to make recipients lazy. They have no incentive to be more productive, for example, looking for work. And often, these programs are expensive and poorly targeted.
How is the payment made?
Transfer payments are usually made by governments or government agencies to individuals who need such assistance. But, unlike payment in general, it does not involve goods and services in return. In other words, giving is one-way, from the government to the recipient. The recipient does not have to deliver goods or provide services to the government, for example, performing social services.
There are many ways to make payments. For example, it is sent by post to the recipient’s address. Or it is sent through a bank.
In other cases, payments may be by government agencies and nonprofits serving households. Meanwhile, programs such as food stamps are distributed as vouchers in booklets or as Electronic Benefit Transfer (EBT) cards.
Why is transfer payment important?
Transfer payments are one way for the government to redistribute wealth in the economy back to society. For example, money collected through taxes is returned to society through programs such as old-age or disability pensions, student grants, and unemployment compensation.
The program is important to support those in need. With the government’s help, they can survive. For this reason, such programs are often introduced or expanded during severe economic recessions.
During a recession, the economy is struggling. Consequently, many people lost their jobs and income. Thus, many people find it difficult to sustain their daily lives. Finally, with help from the government, they can still eat and maintain consumption.
Then another reason why transfer payments are important is to stimulate the economy. It is considered to be able to prevent the economy from getting worse. And, Keynesian economists believe it can have a multiplier effect by stimulating a chain reaction to generate more spending than just the initial given dollar.
Take unemployment benefits as a case. The unemployed do not have to spend all the money in their accounts on consumption. Instead, they can use the unemployment benefits they receive for their daily needs. Consequently, their demand for goods and services can still be positive – although decreasing, but not significantly – because their consumption is relatively stable.
In other cases, food stamps can support demand for related goods and services. For example, households can use it as a budget to buy certain foods such as vegetables, meat, dairy products, bread, and cereals. And such demand helps maintain jobs and household incomes in related businesses.
What are the types of transfer payments?
Transfer payments can take various types, varying from country to country. For example, it could be a social insurance program. The program benefits households regardless of their income level. Social security for retirees, unemployment benefits, and health benefits such as Medicare are examples.
Alternatively, transfer payments can also be a welfare program. This program provides special benefits to the poorest. Examples include Medicaid, food stamp programs, and Temporary Assistance for Needy Families (TANF).
The following are examples in more detail:
- Cash payment is a program of giving cash to the community. Payment can be via electronic transfer method or in person.
- Foodstamps provides food purchase assistance for low-income and homeless people. Those with less income receive this assistance to buy the food they and their families need to stay healthy.
- Medical benefits are several developed countries’ most common transfer payment. They are government payments made through intermediaries to beneficiaries. Medicaid and Medicare are examples, both run and target different beneficiaries.
- Unemployment insurance benefits individuals when they lose their job and meets certain eligibility requirements. In some cases, the payment of these benefits is subject to taxes and social security contributions.
- Social security insurance replaces a percentage of workers’ pre-retirement income. How much is received varies depending on the recipient’s income and when they choose to start benefits.
- Education grants can be student assistance programs to achieve higher education or interest payments on student loans.
- Veterans’ benefit is a transfer payment consisting of veteran’s and disability benefits, veterans’ life insurance benefits, and other types of veteran assistance.
Are transfer payments included in the GDP calculation?
Under the expenditure approach, we calculate gross domestic product (GDP)by adding household consumption, business investment, government spending, and net exports. They represent spending by the four sectors (households, business, government, and external) on domestically produced goods and services.
However, government spending excludes transfer payments from GDP calculations. This is because they are simply a money reallocation from one party to another, without exchanging goods and services in return. Thus, they do not represent expenditure on newly produced goods and services.
What are some criticisms of transfer payments?
Transfer payments have drawn criticism despite being a way to redistribute wealth within the economy to society. First, the program did not produce economically favorable outcomes. Transfer payments do not increase production or economic activity and, as noted earlier, are excluded from GDP calculations.
Second, it reduces the incentive to be more productive. For example, assistance such as unemployment benefits can reduce the unemployed’ incentives to seek paid work. Likewise, social security can encourage people to be lazy and rely more on government assistance. As a result, they are reluctant to work hard to escape poverty or find new jobs. Instead, they are simply trying to rely on transfer payments.
Third, it increases the fiscal burden. The government must spend taxes to finance the program. Such spending may increase during a tough economy where many people face deteriorating income and job prospects. In fact, the government should be able to allocate more spending to productive expenditures such as investment in physical and non-physical infrastructure to increase the economy’s productive capacity. Such investments are important for increasing future economic activity and output.
Fourth, the program may be mistargeted. Those who receive are not the ones who are really in need. In other cases, it may give rise to social jealousy or inequality. For example, the Chinese government pays more transfer payments to urban areas than rural areas because of the higher cost of living. The effect is an increase in the income gap between urban-rural residents.
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