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The welfare trap (or unemployment trap or poverty trap in British English) theory asserts that taxation and welfare systems can jointly contribute to keep people on social insurance because the withdrawal of means-tested benefits that comes with entering low-paid work causes there to be no significant increase in total income. An individual sees that the opportunity cost of returning to work is too great for too little a financial return, and this can create a perverse incentive to not work.
The term used for this concept varies depending on country. In the United States, where government benefit payments are colloquially referred to as "welfare", the welfare trap often indicates that a person is completely dependent on benefits, with little or no hope of self-sufficiency. The welfare trap is also known as the unemployment trap or the poverty trap, with both terms frequently being used interchangeably as they often go hand-in-hand, but there are subtle differences.
In other contexts, the terms "welfare trap" and "poverty trap" are clearly distinguished. For example, a Southern African Regional Poverty Network report on social protection clarifies that "poverty trap [means] a structural condition from which people cannot rescue themselves despite their best efforts. A welfare trap in this context, by contrast, refers to the barrier created by means-tested social grants that have in-built perverse incentives." The South African definition is typically used with regard to developing countries.
This concept may include other adverse effects of welfare such as on the family structure: it may encourage the increase in the numbers of single-mother families and divorce rates, as individuals see a distinct benefit in such a lifestyle.
In the UK, there is a distinction between two concepts within the welfare trap:
- The unemployment trap occurs when the net income difference between low-paid work and unemployment benefits is less than work-related costs (bus pass, work clothes, daycare), discouraging movement into work;
- The poverty trap is the position when means-tested benefit payments are reduced as income rises, combined with income tax and other deductions, with the effect of discouraging work with a higher income, longer hours or acquiring skills. In some cases, if a recipient's wage income rises too much, they may lose some or all of their social assistance.
If a person on welfare finds a part-time job that will pay the minimum wage of $5 per hour for eight hours per week (totaling $40), and, of the amount earned per week, $20 is deducted from welfare, there is a net gain of only $20. If the government imposes taxes on the $40, at say 15% ($6), and there may be extra child-care and commuting costs as well since that the person can no longer remain at home all day, the person is now worse off than before getting the job. This result occurs despite performing eight hours of work per week that is productive to society.
A welfare trap is an example of a perverse incentive. The welfare recipient, such as the one above, has an incentive to avoid raising productivity because the resulting income gain is not enough to compensate for the increased work effort.
An incentive to get out of the welfare trap is that the return to the labour market gives a person chances of moving up the career ladder, improving old and acquiring new job skills, etc., thus eventually improving standard of living. Policies that allow for the continued receipt of benefit payments for a period of time after entering work or up to a specific earnings ceiling may also eliminate the welfare trap. For example, for UK claimants of Incapacity Benefit or Employment Support Allowance, "permitted work" arrangements allow for paid work up to either 16 hours or £95 per week without the withdrawal of the disability benefit payments, leading to a net overall increase in income. However, any earnings over £20 may be taxed, and additional earnings may affect receipt of Housing Benefit and Council Tax Benefit, which is an example of the welfare trap remaining potentially in effect. To eliminate the welfare trap entirely would require a policy that permanently continues benefit payments regardless of any conditions, with no income from paid work being withdrawn. One example of this would be unconditional basic income.
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- An example of the use of "welfare" as shorthand for public assistance in an academic publication. 
- "The Unemployment Trap", CentrePiece Spring 2008. Barbara Petrongolo, London School of Economics. 
- "Escaping the Poverty Trap" by Lawrence Kay, The Policy Exchange
- pdf, webpage, a SARPN (Southern African Regional Poverty Network) report
- "The state of working America, 1996-97". Lawrence Mishel, Jared Bernstein, John Schmitt, section "Government Benefits and Family structure: Is there a Welfare Trap?"
- "Gassing up the welfare trap machine", an Atlantic Institute for Market Studies webpage
- "Equalization:Welfare Trap or Helping Hand", a Brian Lee Crowley speech, June 8, 2005
- "Basic Income and Labor Supply: The German Case" by B. Michael Gilroy & Mark Schopf & Anastasia Semenova, 2012.