Comparing Forms of Entitlement Programs, Part II

In my previous article, I compared some of the advantages and disadvantages of different methods of “welfare”.  Near the end, it seemed that the Earned Income Tax Credit was clearly the best option, especially as compared to the only other possible method, that of the Living Wage.  There is one important, and significant, advantage to the Living Wage: it provides much more liquidity than the EITC.

Before I go into why this is and the problems that arise, I think it is important to have a brief discussion of liquidity.  In layman’s terms, liquidity is a measure of the ease in which an asset can be converted to cash.  Liquidity is not measured in any definitive unit, meaning it can be described in time, money, or effort.  For example, in a Certificates of Deposit, the lack of liquidity lies in the timeframe in which one can claim their money.  If the CD has a six month maturation, it means that the CD isn’t entirely liquid until six months from now.  CDs are an easy example to describe an illiquid asset, but most forms of assets (except cash, the most liquid asset) inherently have some trouble in liquidation.  A house needs time to find a buyer and the also usually involves closing costs and other fees which cut into the ease of converting a home to cash.  Even checking accounts may not be entirely liquid if you cannot find an ATM nearby and need to pay a small ATM fee to obtain cash.

For the purpose of the rest of this article, even though there are many ways to “measure” liquidity, I will be discussing the ‘time’ involved in obtaining money.  Now, in this vein, we can compare the Living Wage laws and the EITC.  The EITC is a benefit that is received once it is applied for and after a tax return is filed.  Therefore, the wages you earn from January 1st – December 31st will not be supplemented until after April of the next year.  In other words, the advantages of the EITC program for an underprivileged citizen will not be realized until up to fifteen months after the first wages are earned.  This clearly shows a lack of liquidity on the part of the program, which the Living Wage laws do not encounter.  The Living Wage laws, as part of their nature, pay out benefits as beneficiaries earn wages.

Now, at first glance, this seems like a minor caveat and a mere inconvenience in the EITC program.  But, many citizens will be depending on this extra source of income and may need it many months before they will eventually receive the benefits.  What happens when there is a minor disconnect in supply and demand? (in this case: demand for money, supply of money two months from now)  A private firm will enter and fix this market failure.  Enter the payroll advance industry.

Could Payday Advance firms such as these be encouraged with government programs like the EITC? (from Wikipedia)

Could Payday Advance firms such as these be encouraged with government programs like the EITC? (from Wikipedia)

The payroll advance industry makes a lot of its money in its ability to provide short-term liquidity against proven future income sources. The EITC helps provide a guarantee of income to the industry and a much more diverse customer base.  If a citizen is receiving $500 in two months but needs money now, the payroll advance industry could step in and offer $400 now for the EITC check in two months.  The difference in liquidity in this case (time) has been converted into $100 by the industry.  Thus, they are simply offering a service for converting liquidity.

These companies have been given a bad rap by the media and the present administration.  Now, it is difficult to determine what predatory lending practices actually are.  In this sense, these companies are only fixing a gap in liquidity (even to those customers who do not have EITC, they provide liquidity for the few days before the paycheck is received).  President Obama has signaled his intent to cap payday advance loan amounts and interest rates (consistent with most usury laws).  When constructing any laws or restrictions, it is important to understand why these firms have sprung up, and what effect they actually have.  If a firm is a lender of last resort, it is not its fault that its customers have run out of options for any other liquidity solutions.

Cheers,

Cameron Daniels

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Comments

  1. says

    I noticed you said payday lenders are lending to consumers without bank accounts. This, however, is false. Consumers seeking payday loans need to provide proof they have a checking account in order to receive a loan.

    Like other financial services, payday advance companies are regulated and supervised by states, plus they adhere to numerous federal regulations as well.

    A payday advance is a viable consumer choice. Sometimes it is the least expensive choice–particularly compared to the high costs of bank and credit card fees—while at other times it is the only financial option for a consumer.

    For more information, check out: http://www.wddagroup.org

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