Free Lunch!

What harm does running a European-style high-spending welfare state do to a country’s GDP? The answer, surprisingly, turns out to be “none at all”. Peter Lindert’s paper, “Why the Welfare State Looks Like A Free Lunch”, shows that a welfare state doesn’t depress GDP in the way that conventional economic analyses predict. Why not? Over to Lindert…

All our well-known demonstrations of the large deadweight losses from social programs overuse imagination and assumption. There are good reasons why statistical tests keep coming up with near-zero estimates of the net damage from social programs on economic growth. It’s not just that the tales of deadweight losses describe bad policies that real-world welfare states do not practice. It’s also that the real-world welfare states reap offsetting benefits from a style of taxing and spending that is pro-growth.

The keys to the free lunch puzzle are:

(1) For a given share of social budgets in Gross Domestic Product, the high-budget welfare states choose a mix of taxes that is more pro-growth than the mix chosen in the United States and other relatively private-market OECD countries.

(2) On the recipient side, as opposed to the tax side, welfare states have adopted several devices for minimizing young adults’ incentives to avoid work and training.

(3) Government subsidies to early retirement bring only a tiny reduction in GDP, partly because the more expensive early retirement systems are designed to take the least productive employees out of work, thereby raising labor productivity.

(4) Similarly, the larger unemployment compensation programs have little effect on GDP. They lower employment, but they raise the average productivity of those remaining at work.

(5) Social spending often has a positive effect on GDP, even after weighing the effects of the taxes that financed the spending. Not only public education spending, but even many social transfer programs raise GDP per person.

(6) The design of these five keys suggests an underlying logic to the pro-growth side of the welfare state. The higher the social budget as a share of GDP, the higher and more visible is the cost of a bad choice. In democracies where any incumbent can be voted out of office, the welfare states seem to pay closer attention to the productivity consequences of program design. In the process, those countries whose political tastes have led to high social budgets have drifted toward a system that delivers its tax bills to the less elastic factors of production, in the Ramsey tradition.

Or, to summarise, social spending is good for personal productivity, and democracy is effective in ensuring that real-world governments avoid the costly mistakes that anti-welfare theorists assume. Apart from illustrating the dangers of hand-waving economic arguments, this tells us that the choice between a European-style high-welfare state, and a US-style low-welfare state, has nothing to do with promoting economic growth and is simply a matter of which kind of society we find more pleasant to live in.

[Via this Electrolite comments thread]

13 thoughts on “Free Lunch!

  1. “Government subsidies to early retirement bring only a tiny reduction in GDP, partly because the more expensive early retirement systems are designed to take the least productive employees out of work, thereby raising labor productivity.”

    This I think is an important point, in the sense that relatively lower participation rates can mean relatively higher productivity. But of course as we all know retirement ages are set to shoot up to 70 or 75 over the coming 10 to 15 years. So think about the impact that this is likely to have on productivity and living standards.

    It seems that the welfare state was a nice thing while it lasted, but now other items may be on the agenda. Of course whether it was used wisely, maybe that would be better left to history to decide.

  2. There is no free lunch – it’s just a matter of perspective. I haven’t read the paper (yet), but looking at the main points you mention, I’d say, yes, true, more emphasis should be given to the positive external effects of a welfare state but also that – this might be a matter of perception – I can’t really see how, say Germany, adopted a pro-growth tax regime and created incetives for young adults. And even if rasing productivity by keeping people out of jobs should indeed not lower GDP (this is very counter intuitive) it is not a viable solution in an economy based on specialisation and division of labour. These people probably will not become great artists. So feeding them is not a viable solution to anyone either.
    I think the whole thing comes down to difficult to measure cultural effects. Which is exactly why reducing the perceived dead-weight loss and adapting more anglo-saxon style economic policies will not instantly lead to leaps in either productivity (well, the opposite here) or GDP growth. There is much unlock here, but there won’t be any miracles, in my opinion.

  3. I’d be more inclined to believe this if there weren’t conflicting data points like Singapore, Hong Kong and the United States, or the acceleration in UK growth since Thatcher’s reforms, to think about.

  4. Abiola,

    Very good point, and one we all like to make. For such arguments, could you show us that acceleration? How about the growth rate 1980-1989 (a cycle) with say the 1950s, 1960s and 1970s?

    Thanks

    Matt

  5. Tobias said (of the unemployed) –

    These people probably will not become great artists. So feeding them is not a viable solution to anyone either.

    I don’t think a programme of mass starvation is a viable solution.

    Feeding people who aren’t in paid work has benefits for the wealth of a country, disregarding the obvious humanitarian considerations. It means less begging, less crime, less street prostitution, and it means that people can do vital work that doesn’t earn money, for example caring for the sick and disabled in the home. It means that people with mental or physical illness, very low IQ, autism, etc. aren’t forced to work at inappropriate jobs.

    It means people in temporarily disadvantaged circumstances can survive, and be available to work when the circumstances are better – for example a new factory opens and needs employees.

    It means that children of unemployed people develop without malnutrition so that they can eventually contribute to society at full mental and physical capacity.

    This is just off the top of my head. It isn’t counter-intutive at all.

  6. These people probably will not become great artists. So feeding them is not a viable solution to anyone either.

    Welfare isn’t historically a socialist do-good-because-were-good type program…

    It’s corporatist.
    It’s protection money to placate a potential mob
    that will shoot czars, and cut off the heads of kings, queens, and lesser aristocracy.

    In both those cases, that angry, hungry mob so devoid of artists took over a good chunk of the world for a while.

    …food for thought.

  7. Alison,

    when I was saying “feeding” I wasn’t literally referring to withholding social protection from those in dire need. This protection is what the positive external effects of a welfare state are mostly about, as I also said. And I wasn’t reffering to temporary adjustment measures either, as I think one of the main points of the original post was the claim that longer unemployment duration is offset by higher productivity due to better matches of labour demand and supply. Although I think what’s important there are micro-incentive structures and I don’t know how the study dealt with that. But there certainly is a problem of what’s happening to people who fall between the cracks who are perfectly able to work yet still fed by a welfare state, as it is happening, say, in Germany. I was mostly referring to their loss of self esteem as a part of a society based on the divison of labour. As they won’t become happy just on their own (ie. “artists”), feeding beyond a transitional period isn’t a solution. But neither is making them accept five jobs to make ends means. It’s a tricky one and I suppose it’s not grand schemes that will work in the end but small micro adjusted incentive arrangements. That, on the other hand, is not exactly, what the classic “welfare state” was about.

  8. What rather worries me about Lindert’s paper is that it appears to leave open the question as to whether a tax burden of 100% average effective tax rate on GDP – with the proceeds net of government costs and non-transfer public spending redistributed according to official assessments of “needs” – would have any adverse impact on GDP and GDP growth.

    But a little googling yielded this paper by Stefan F?lster & Magnus Henrekson:

    Abstract: “A number of cross-country comparisons do not find a robust negative relationship between government size and economic growth. In part this may reflect the prediction in economic theory that a negative relationship should exist primarily for rich countries with large public sectors. In this paper an econometric panel study is conducted on a sample of rich countries covering the 1970-95 period. Extended extreme bounds analyses are reported based on a regression model that tackles a number of econometric issues. Our general finding is that the more econometric problems are addressed, the more robust the relationship between government size and economic growth appears. Our most complete specifications are robust even according to the stringent extreme bounds criterion.”

    The paper concludes:

    “. . In the case of the relationship between public expenditure and economic growth it appears that exploiting within-country variation by means of panel regressions, correcting for heteroscedasticity between countries, and addressing the issue of country selection, in fact permits a more robust conclusion. The results point to a robust negative relationship between government expenditure and growth in rich countries. The size of the estimated coefficients imply that an increase of the expenditure ratio by 10 percentage points is associated with a decrease in the growth rate on the order of 0.7-0.8 percentage points.”
    – from: http://swopec.hhs.se/hastef/papers/hastef0391.pdf

    However, in the abstract from comments by Jonas Agell, Henry Ohlsson and Peter Skogman Thoursie on the Stefan F?lster & Magnus Henrekson paper, we have:

    “In a recent article Stefan F?lster and Magnus Henrekson [2001] argue that ‘. . the more the econometric problems that are addressed, the more robust the relationship between government size and economic growth appears’. But in failing to control for simultaneity in a valid manner the regressions reported by F?lster/Henrekson are flawed. Moreover, using theoretically valid instruments we find that the estimated partial correlation between size of the public sector and economic growth is statistically insignificant and highly unstable across specifications. A policy-maker who wants to promote growth is well-advised to look for other evidence than cross-country growth regressions.” – at: http://www.ne.su.se/paper/wp03_14.pdf

    Can one of the econometricists here, please, explain for the benefit of those here who aren’t the glaring divergences in conclusions?

  9. Glad to have pointed it out to y’all. It’s an interesting paper, though, as a friend commented to me, “It works in practice, but does it work in theory?”

    Two things that struck me:

    a) high welfare states apparently develop more regressive tax policies, in that to maintain growth, capital is overall less taxed than labor or consumption;

    and b) the reliance of the standard claim that social transfers reduce wealth on “educated fiction”: unchecked computer simulations, untested blackboard macro, and Charles Murray’s ‘parables’.

    The former I find surprising; the latter, dismaying. An analogy to the Club of Rome report seems appropriate.

    C.

  10. Further proof that, as Orwell said, some ideas are so crazy that only an intellectual would believe them.

    Or was it idiotic?

  11. Interesting indeed. I would however think that the welfare state may get in trouble because of its reluctance to allow immigrants. Let’s hope not!

  12. As an alternative to Peter Lindert, readers here may be interested to know of a relating and more recent paper on: Globalisation and Social Spending, co-authored by Paul De Grauwe, the distinguished Belgian economist, and Magdalena Polan, both at the Center for Economic Studies, KU Leuven: http://www.econ.kuleuven.ac.be/ew/academic/intecon/Degrauwe/PDG-papers/GlobalisationAndSocialSpending.pdf

    Among the hypotheses emerging from an arguably more transparent and tighter analysis: ” . . The results suggest that there is a negative relation between the competitiveness ranking and social spending. It means that the countries that spend larger proportions of their domestic products on social needs also score best on the competitiveness scale (they have a low number in the ranking). . . The first thing to note is that most likely there is simultaneity in the relation between competitiveness and social spending, i.e. causality is likely to run in both directions. Thus, countries that are highly competitive generate a lot of value added (they have a higher GDP), what allows them to spend more on social needs. Conversely, high social spending may influence the productivity of workers and, through this channel, affects the competitiveness of nations. We would like to disentangle these two causal relations. . . “

  13. As a counter to the idea that there’s something ‘anti-productive’ about a non-expiring unemployment benefit…

    J.K.Rowling wrote the first HP book while on the Scots dole. She’s probably returned, in tax, …oh, a million times what she got from the dole? Ten million? Some Very Large Number, certainly.

    That kind of payoff mightn’t happen often, but when it happens it’s very nice indeed.

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