THE WELFARE STATE AND ECONOMIC PERFORMANCE A.B. ATKINSON* Abstract - The Welfare State has come un- ern world. In the United States, the der attack from economists, particularly in movement to halt and, if possible, re- Western Europe, who argue that it is re- verse the upward trend of government sponsible for poor economic performance, spending has gathered strength in re- and that public spending should be re- cent years. In Great Britain [the duced. The present paper seeks to clarify Thatcher government] has committed the nature of the charges leveled against itself to a gradual reduction in the share the We/fare State and the mechanisms by of national income taken by public ex- which it may adversely affect economic penditure. Pressures to restrain the performance. The first section considers growth of government spending . the aggregate empirical evidence. Not seem to be intensifying in other Euro- only is the evidence mixed, but also such pean countries too” (Morris Beck, Pref- an argument is difficult to establish. The ace to Government Spending, 1981, p. second section of the paper describes a ix). number of the problems with aggregate cross-country evidence. In particular, the interpretation depends on the underlying theoretical framework. The third and INTRODUCTION fourth sections of the paper examine a selection of the theoretical mechanisms, What Morris Beck wrote remains as valid distinguishing between those that affect today as it was 15 years ago, and in no the level of output, taking a model of the field of public spending is the pressure labor market, and those that influence for reductions greater than that of the the rate of growth, drawing on recent Welfare State. In many OECD countries developments in growth theory. An im- there are calls for the Welfare State to portant role is played by the institutional be scaled down. It is argued that the structure of benefits, which can signifi- size of transfer programs is responsible cant/y change their impact on economic for a decline in economic performance, behavior. and that cuts in spending are a prereq- uisite for a return to the golden age of “The size of government has become a full employment and economic growth. major issue in many parts of the West- The critique of government spending has *Nuffleld College, Oxford, United Kingdom, OX1 1NF been especially forceful in Europe, where 171 the Welfare State has traditionally played They conclude that a major social role. In Sweden, the Eco- nomics Commission, chaired by Assar “the agenda should be to make the Lindbeck and including distinguished Welfare State leaner and more effi- economists from other Nordic countries, cient” (Dreze and Malinvaud, 1994, p. has referred to “the crisis of the Swed- 82). ish model,” arguing that it has While recognizing the diversity of na- “resulted in institutions and structures tional circumstances within Europe, and that today constitute an obstacle to that in sorne countries spending may be economic efficiency and economic too low, their overall recbmmendation is growth because of their lack of flexibil- to ity and the/r one-sided concerns for in- come safety and distribution, with lim- “reduce expenditure in some countries, ited concern for economic incentives” perhaps by 2 percent of GDP or so” (Lindbeck ef a/., 1994, p 17). (Dreze and Malinvaud, 1’994, p 98). They seek cuts in social security benefit The present paper does not attempt ‘to levels in order that determine whether or ndt spending “the social-security (or social insurance) should be cut. The aim is rather to clar- system should not overburden the ify the nature of the charges leveled economy through distorted incentives against the Welfare State, and specifi- or large deficits” (Llndbeck et al., 1993, cally against social transfers, and the p. 238). mechanisms by which it may adversely affect economic performance. I consider In the European Union, a particularly in- in the first section of the paper the ag- fliuential document has been the paper gregate empirical evidence which ap- om “Growth and Employment: The pears to underlie much of the case Scope for a European Initiative,” pre- against the Welfare State,. Countries pared by Jacques Dreze and Edmond with high spending, it is alleged, have a Nlalinvaud, on the basis of discussions poorer economic performance. However, with a group of Belgian and French not only is the evidence mixed, but also, economists. This report emphasises the such an argument is more difficult to es- positive functions of the Welfare State tablish than it may at first appear: the but lists three major objections: second section of the paper describes a number of the problems with aggregate “(i) measures of income protection or cross-country evidence. In particular, the social insurance introduce undesired interpretatilon of such stubies depends rigidities in the functionng of labour on the underlying theoretical framework. markets; Aggregate empirics of the relation be-- (ii) welfare programmes increase the size tween the Welfare State and economic of government at a risk of inefficiency; performance are open to ‘the objection their funding enhances the amount of of being “measurement without the- revenue to be raised, and so the mag- ory.” The third and fourth sections of nitude of tax distortions; the paper examine a selection of the (iii) . welfare programrnes may lead theoretical mechanisms, distinguishing to cumulative deficits and mounting between those that affect the level of public debts” (D&e and Malinvaud, output and those that influence the rate 1994, p. 95). of growth. 172 I THE WELFARE STATE AND ECONOMIC PERFORMANCE I should stress at the outset that my noticeably between countries: in 1960 concern in this paper is with the impact West Germany had the highest spending of the Welfare State on economic per- of the countries shown, but it was over- formance and not with the success of taken by Sweden around 1975. social transfers in meeting the objectives which they are intended to perform, The availability of such aggregate data such as the alleviation of poverty, the re- on a comparable basis for different distribution of income across the life countries means that it is tempting to cycle, and the provision of a sense of se- see how far there is an association with curity. The positive contribution of the differences in economic performance. It Welfare State clearly forms part of the would be possible to regress the level of overall balance sheet. A cut in govern- GDP, denoted below by V, on the size ment spending may well reduce the ex- of the welfare state, relative to GDP, de- tent to which social objectives are noted by WS. This kind of relationship is achieved, but here I am concentrating referred to below as a levels equation. on what may be the “cost” of the Wel- Alternatively, the rate of growth of GDP, fare State in terms of reduced economic denoted by g,, could be regressed on success. VVS. This kind of relationship is referred to as a growth-rate equation. [The dis- It should also be noted that I concen- tinction between these two hypotheses trate solely on social transfers (social se- is discussed by Bourguignon (1993), who curity and welfare) and do not consider shows graphically the difference.] other elements of the Welfare State such as education or health care. In view There have been many such empirical in- of the direct role that the latter may quiries. Some simply carry out a bivariate play in human capital formation, I am analysis of economic performance intentionally tackling the areas where against the size of the Welfare State. For the critique seems most likely to apply. example, the European Commission has examined the relationship between AGGREGATE EMPIRICS growth and social protection expenditure (percent of GDP) in the 12 member states. On the basis of a graphical plot It has been argued that a large Welfare of the change in employment between State has depressed economic perfor- 1980 and 1990 and the average social mance, causing output to fall below po- protection expenditure 1980-91 (alter- tential or for the annual growth rate to natively, the change in social protection be lower than in countries without such expenditure), they conclude that a level of transfers. This argument is often supported by reference to mea- “It is clear that there is little sign of so- sures of the size of the Welfare State, cial protectton having a negative effect typically measured as a proportion of on employment creation. The graph Gross Domestic Product (GDP), as illus-. shows a wide variety of combinations trated in Figure 1, which shows the ratio between employment growth and level to GDP of spending on social security of social protection . The same lack transfers.’ For the United States, the ra- of relationship is also apparent if the tio in 1990 was around ten percent; in change in social expenditure is taken” Sweden it was twice that amount. (European Commission, 1993, p. 86). Transfers increased as a percentage of GDP in all countries shown in Figure 1, In a much earlier study, Smith (1975) although the rate of increase differed found that the growth rate of real GDP FIGURE 1. Social Security Transfers as Percent GDP 25 r -- 20 5 0 1960 1970 19x0 1990 Note: linear interpolation before 1980. per capita 1961--72 was negatively re- cial security or other government trans- lated to public spending excluding trans- fer payments; it should be stressed that fers but that the effect was smaller and the authors crted are noti concerned less significant when public spending in- solely with the impact of social transfers, cluded transfers: and that in some cases it represents only a minor part of their results.