The Debate over the Welfare State

The goals of the welfare state seem laudable: to help the poor, to protect against severe economic hardship and to ensure access to essential health care. But good intentions don’t always make for good policy. There is an intense debate about how large the welfare state should be, a debate that partly reflects differences in philosophy but also reflects concern about the possibly counterproductive effects on incentives of welfare state programs. Disputes about the size of the welfare state are also one of the defining issues of modern American politics.

Problems with the Welfare State

There are two different arguments against the welfare state. One, which we described earlier in this chapter, is based on philosophical concerns about the proper role of government. As we learned, some political theorists believe that redistributing income is not a legitimate role of government. Rather, they believe that government’s role should be limited to maintaining the rule of law, providing public goods, and managing externalities.

The more conventional argument against the welfare state involves the trade-off between efficiency and equity, an issue that we first encountered in Chapter 7. As we explained there, the ability-to-pay-principle—the argument that an extra dollar of income matters more to a less well-off individual than to a more well-off individual—implies that the tax system should be progressive, with high-income taxpayers paying a higher fraction of their income in taxes than those with lower incomes.

But this must be balanced against the efficiency costs of high marginal tax rates. Consider an extremely progressive tax system that imposes a marginal rate of 90% on very high incomes. The problem is that such a high marginal rate reduces the incentive to increase a family’s income by working hard or making risky investments. As a result, an extremely progressive tax system tends to make society as a whole poorer, which could hurt even those the system was intended to benefit. That’s why even economists who strongly favor progressive taxation don’t support a return to the extremely progressive system that prevailed in the 1950s, when the top U.S. marginal income tax rate was more than 90%. So, the design of the tax system involves a trade-off between equity and efficiency.

A similar trade-off between equity and efficiency implies that there should be a limit to the size of the welfare state. A government that operates a large welfare state requires more revenue than one that restricts itself mainly to provision of public goods such as national defense. A large welfare state requires higher tax revenue and higher marginal tax rates than a smaller welfare state.

Table 18-8 shows “social expenditure,” a measure that roughly corresponds to total welfare state spending, as a percentage of GDP in the United States, Britain, and France. It also compares this with an estimate of the marginal tax rate faced by an average single wage-earner, including payroll taxes paid by employers and state and local taxes. As you can see, France’s large welfare state goes along with a high marginal rate of taxation. As the upcoming Economics in Action explains, some but not all economists believe that this high rate of taxation is a major reason the French work substantially fewer hours per year than Americans.

 

Social expenditure in 2012 (percent of GDP)

Marginal tax rate in 2009

United States

  19.4%

  43.6%

Britain

23.9

40.3

France

32.1

59.8

Source: OECD. Marginal tax rate is defined as a percentage of total labor costs.

Table : TABLE 18-8 Social Expenditure and Marginal Tax Rates

One way to hold down the costs of the welfare state is to means-test benefits: make them available only to those who need them. But means-testing benefits creates a different kind of trade-off between equity and efficiency. Consider the following example: Suppose there is some means-tested benefit, worth $2,000 per year, that is available only to families with incomes of less than $20,000 per year. Now suppose that a family currently has an income of $19,500 but that one family member is deciding whether to take a new job that will raise the family’s income to $20,500. Well, taking that job will actually make the family worse off, because it will gain $1,000 in earnings but lose the $2,000 government benefit.

This feature of means-tested benefits, which makes a family worse off if it earns more is known as a notch. It is a well-known problem with programs that aid the poor and behaves much like a high marginal tax rate on income. Most welfare state programs are designed to avoid a notch by setting a sliding scale for benefits. With a sliding scale, benefits diminish gradually as the recipient’s income rises rather than come to an abrupt end.

Even so, the combined effects of the major means-tested programs shown in Table 18-3, plus additional means-tested programs, such as housing aid, that are offered by some state and local governments, are to create very high effective marginal tax rates. For example, one 2005 study found that a family consisting of two adults and two children that raised its income from $20,000 a year—just above the poverty threshold in 2005—to $35,000 would find almost all its increase in after-tax income offset by loss of benefits such as food stamps, the Earned Income Tax Credit, and Medicaid.

The Politics of the Welfare State

In 1791, in the early phase of the French Revolution, French citizens convened a congress, the Legislative Assembly, in which representatives were seated according to social class: the upper classes, who pretty much liked the way things were, sat on the right; commoners, who wanted big changes, sat on the left. Ever since, political commentators refer to politicians as being on the “right” (more conservative) or on the “left” (more liberal).

But what do modern politicians on the left and right disagree about? In the modern United States, they mainly disagree about the appropriate size of the welfare state. The debate over the Affordable Care Act was a case in point, with the vote on the bill breaking down entirely according to party lines—Democrats (on the left) in favor of the ACA and Republicans (on the right) opposed.

You might think that saying that political debate is really about just one thing—how big to make the welfare state—is a huge oversimplification. But political scientists have found that once you carefully rank members of Congress from right to left on past legislation, a congressperson’s position in that ranking does a very good job of predicting his or her votes on future legislation.

FOR INQUIRING MINDS: “We Are the 99%!”

In the fall of 2011, Zuccotti Park, a small open space in Manhattan’s financial district, was taken over by protestors, part of a movement known as “Occupy Wall Street.” The protestors had a number of grievances, but the most pressing were their complaints about Wall Street and its perceived contribution to growing inequality in the United States. “We are the 99 percent!” became the movement’s favored slogan, a reference to the large increase in share of income going to the top 1% of the American population. Wall Street, they charged, contributed to growing inequality by paying its bankers huge salaries and bonuses, while engaging in overly risky behavior that led to the housing boom and bust of 2007-2009 that decimated the economy. Was this a reasonable charge?

In 2011 growing income inequality prompted protests in the United States.
Howard Simmons/NY Daily News via Getty Images

Those who found it unreasonable pointed to the contributions that Wall Street, and the American finance industry in general, have made to the U.S. economy. Compared to other countries, the United States is a leader in financial services and innovation, generating billions annually in revenues, and attracting trillions of dollars of investment from abroad. High salaries on Wall Street, they contend, are simply the rewards for skill and hard work in the competitive market for talent on Wall Street.

What is incontrovertible, however, are the data that show that incomes in the finance industry have contributed to growing inequality in the United States. This is especially clear when you look not at the top percentile of the income distribution, but at an even smaller group, the top 0.1%—those with a median annual income of $5.6 million.

Although financial industry people are a minority (18%) within this income elite—consisting also of executives, managers, lawyers, and others—they are greatly overrepresented since only about 6% of American workers are employed in finance. So, the protesters were making a valid point: Wall Street salaries are indeed one of the sources of the rapid rise in incomes at the top.

The same studies that show a strong left-right spectrum in U.S. politics also show strong polarization between the major parties on this spectrum. Forty years ago, there was a substantial overlap between the parties: some Democrats were to the right of some Republicans, or, if you prefer, some Republicans were to the left of some Democrats. Today, however, the rightmost Democrats appear to be to the left of the leftmost Republicans. There’s nothing necessarily wrong with this. Although it’s common to decry “partisanship,” it’s hard to see why members of different political parties shouldn’t have different views about policy.

Can economic analysis help resolve this political conflict? Only up to a point.

Some of the political controversy over the welfare state involves differences in opinion about the trade-offs we have just discussed: if you believe that the disincentive effects of generous benefits and high taxes are very large, you’re likely to look less favorably on welfare state programs than if you believe they’re fairly small. Economic analysis, by improving our knowledge of the facts, can help resolve some of these differences.

To an important extent, however, differences of opinion on the welfare state reflect differences in values and philosophy. And those are differences economics can’t resolve.

!worldview! ECONOMICS in Action: French Family Values

French Family Values

The United States has the smallest welfare state of any major advanced economy. France has one of the largest. As we’ve already described, France has much higher social spending than America as a percentage of total national income, and French citizens face much higher tax rates than Americans. One argument against a large welfare state is that it has negative effects on efficiency. Does French experience support this argument?

France guarantees health care for all its citizens—a benefit of having one of the largest welfare states in the world.
Tarek El Sombati/Getty Images

On the face of it, the answer would seem to be a clear yes. French GDP per capita—the total value of the economy’s output, divided by the total population—is only about 75% of the U.S. level. This reflects the fact that the French work less: French workers and U.S. workers have almost exactly the same productivity per hour, but a smaller fraction of the French population is employed, and the average French employee works substantially fewer hours over the course of a year than his or her American counterpart. Some economists have argued that high tax rates in France explain this difference: the incentives to work are weaker in France than in the United States because the government takes away so much of what you earn from an additional hour of work.

A closer examination, however, reveals that the story is more complicated than that. The low level of employment in France is entirely the result of low rates of employment among the young and the old; about 80% of French residents of prime working age, 25–54, are employed, exactly the same percentage as in the United States. So high tax rates don’t seem to discourage the French from working in the prime of their lives. But only about 30% of 15-to 24-year-olds are employed in France, compared with more than half of 15- to 24-year-olds in the United States. And young people in France don’t work in part because they don’t have to: college education is generally free, and students receive financial support, so French students, unlike their American counterparts, rarely work while attending school. The French will tell you that that’s a virtue of their system, not a problem.

Shorter working hours also reflect factors besides tax rates. French law requires employers to offer at least a month of vacation, but most U.S. workers get less than two weeks off. Here, too, the French will tell you that their policy is better than ours because it helps families spend time together.

The aspect of French policy even the French agree is a big problem is that their retirement system allows workers to collect generous pensions even if they retire very early. As a result, only 45% of French residents between the ages of 55 and 64 are employed, compared with more than 60% of Americans. The cost of supporting all those early retirees is a major burden on the French welfare state—and getting worse as the French population ages.

Quick Review

  • Intense debate on the size of the welfare state centers on philosophy and on equity-versus-efficiency concerns. The high marginal tax rates needed to finance an extensive welfare state can reduce the incentive to work. Holding down the cost of the welfare state by means-testing can also cause inefficiency through notches that create high effective marginal tax rates for benefit recipients.

  • Politics is often depicted as an opposition between left and right; in the modern United States, that division mainly involves disagreement over the appropriate size of the welfare state.

18-4

  1. Question 18.9

    Explain how each of the following policies creates a disincentive to work or undertake a risky investment.

    1. A high sales tax on consumer items

    2. The complete loss of a housing subsidy when yearly income rises above $25,000

  2. Question 18.10

    Over the past 40 years, has the polarization in Congress increased, decreased, or stayed the same?

Solutions appear at back of book.

!worldview!Welfare State Entrepreneurs

Erika Larsen/Redux

“Wiggo Dalmo is a classic entrepreneurial type: the Working Class Kid Made Good.” So began a profile in the January 2011 issue of Inc. magazine. Dalmo began as an industrial mechanic who worked for a large company, repairing mining equipment. Eventually, however, he decided to strike out on his own and start his own business. Momek, the company he founded, eventually grew into a $44 million, 150-employee operation that does a variety of contract work on oil rigs and in mines.

You can read stories like this all the time in U.S. business publications. What was unusual about this particular article is that Dalmo and his company aren’t American, they’re Norwegian—and Norway, like other Scandinavian countries, has a very generous welfare state, supported by high levels of taxation. So what does Dalmo think of that system? He approves, saying that Norway’s tax system is “good and fair,” and he thinks the system is good for business. In fact, the Inc. article was titled, “In Norway, Start-Ups Say Ja to Socialism.”

Why? After all, the financial rewards for being a successful entrepreneur are more limited in a country like Norway, with its high taxes, than they are in the United States, with its lower taxes. But there are other considerations. For example, at least until the Affordable Care Act kicked in in January 2014, an American thinking of leaving a large company to start a new business needed to worry about whether he or she would be able to get health insurance, whereas a Norwegian in the same position was assured of health care regardless of employment. And the downside of failure is larger in the U.S. system, which offers minimal aid to the unemployed.

Rank

Country

1

United States

2

Australia

3

Sweden

4

Denmark

5

Switzerland

6

Taiwan

7

Finland

8

Netherlands

9

United Kingdom

10

Singapore

Source: The Global Entrepreneurship and Development Index 2014, by Zoltan Acs, Laszlo Szerb and Erkko Autio.

Table : TABLE 18-9 The Top 10 Entrepreneurial Countries, 2014

Still, is Wiggo Dalmo an exceptional case? Table 18-9 shows the nations with the highest level of entrepreneurial activity, according to a study financed by the U.S. Small Business Administration, which tried to quantify the level of entrepreneurial activity in different nations. The United States is at the top of the list, but so are several Scandinavian countries which have very high levels of taxation and extensive social insurance. (Norway, for example, is number 14.)

The moral is that when comparing how business friendly different welfare state systems really are, you have to think a bit past the obvious question of the level of taxes.

QUESTIONS FOR THOUGHT

  1. Question 18.11

    bIMfIM+VbHb/YCceBkoJzISKKpVuB/G+AmRaPEojbDgPCVXZL2mHBNOhJr+0Wh/wr6t7BGJ8SdiI17oHoVDawZXEafuBUBAQuRl9EXOySu4=
    Why does Norway have to have higher taxes overall than the United States?
  2. Question 18.12

    AHQHGCU09fDLYLdWmG5nA3p5vzip5Rx0wHSxm7EjvVCea3ZUqQB1y929FvhKf/LGo5a3OnP2RFr8ScVIxnxmr8f4g1UfJ6xoExTFDLogaD3BYOBomXDsI5pfln41IdbkFKqKyOebItW9Uba3+V/MQ/GCg70WBAwInGnBW3sfBlAEwRG9U+CAL1FNsy6ixP26QnVett8OEWC+nZiZein3unnLAXrNj4nrzN7ENe4xYZEOSW/lasCHG59obFdp8mKpy8ol3A==
    This case suggests that government-paid health care helps entrepreneurs. How does this relate to the arguments for social insurance in the text?
  3. Question 18.13

    AAoF7Hce6S5cQN9qYNDrJQZobwFFZ3PMXmueJ74hUbdZcB59G3pyXTXl79Pm0LOqQ+Re0kCH2qIjXQf8odDNEQ9zBp2ZSYqWDL7v+7XqyYtNQBhL9EGk5XUOKaIyiOXUeNGWakytILUwU0xU3vsyv6tzPsLh0ypjdWBifB8mkbbZFGm95F65Vpp9qR1kbaOSLp/5PcC3tLpRhGI4xGG7be0xIiW7LJZKINg5MD/6QxsZD5luyAtSDfMiius=
    How would the incentives of people like Wiggo Dalmo be affected if Norwegian health care was means-tested instead of available to all?