Opponents of work obligations in return for transfer payments argue that workfare
can crowd out private sector work, that workfare harms the welfare of the poor and
thereby reduces a society’s welfare in general. This paper analyzes these objections
against workfare in a discrete optimal income tax model. Workfare productivity
emerges to be the crucial determinant. We identify a productivity threshold. If workfare
productivity exceeds this threshold, then crowding out indeed happens, but it is
second-best. Crowding out occurs entirely in the sense that workfare and private sector
employment are mutually exclusive. Welfare increases due to the fact that out of
the three effects workfare entails, beyond the detected threshold, the output effect and
the incentive effect dominate the negative utility effect. Numerical simulations calibrated
on the distribution of gross hourly wages in Germany reveal that on an individual
level, the poor may even be better off under a tax-transfer scheme with workfare
rather than without workfare. This is due to the fact that a higher degree of redistribution
can be achieved.
