Agency and the design of welfare systems

Transfers to the needy are administered by social workers whose job it is to tag welfare applicants to determine eligibility for disability benefits. The accuracy of tagging depends on the effort of the social workers, which is private information. To prevent shirking and induce optimal effort, costly monitoring is required. Using the framework of optimal non-linear taxation, we characterize the form of the optimal tax-transfer system when the government operates a costly welfare system financed by income taxation. Higher-income persons self-select into the income tax system. The needy apply for welfare. If tagged, they receive a disability benefit; if untagged, they receive general welfare benefits. We characterize circumstances under which welfare recipients should or should not be induced to work, the structure of the optimal tax-transfer system, and the optimal payment and monitoring of social workers. (C) 1999 Elsevier Science S.A. All rights reserved.