Annual average, Annual % change, Difference 1995-2002
1995-2002 1995-2002 (percentage points) Denmark 49.9 0.0 -0.4 Sweden 52.2 0.3 1.1 Finland 46.6 -0.1 -0.1 Austria 44.1 0.5 2.1 Germany 41.4 -0.2 -0.7 Netherlands 40.6 -0.2 -1.1 Belgium 45.9 0.4 1.5 France 44.9 0.1 0.2 UK 36.3 0.7 0.5 Ireland 31.9 -1.9 -4.8 Italy 42.8 -0.1 0.6 Greece 35.7 2.0 3.6 Spain 34.8 1.1 2.7 Portugal 35.2 1.1 2.8 EU 15 41.4 0.0 -0.1 SourceEurostat (2004).
The absence of evidence for any general downward trend in tax revenue across OECD countries until 2000 at least may be due to agglomeration economies. Baldwin and Krugman (2000) conclude that, while profit maximising firms — other things being equal — seek the lowest cost location, the level of taxation is only one influence on their decision. Countries with generous welfare states and high taxation tend to be wealthy countries. They have a range of advantages for mobile investors such as excellent infrastructure, established customer and supplier bases, accumulated experience, well trained workforces and so on. Within limits, this allows rich countries to retain mobile factors of production despite having higher tax rates than poorer countries. In the latter, lower tax rates can help attract mobile investment, which helps them to attain convergence with richer countries. As the poor countries become richer, the demand for public services tends to increase so countries may be willing to accept higher tax levels. As noted above, there is some evidence that this occurred in the EU. It should also be noted that Ireland’s relatively recent status as a country generating a high level of GDP per capita does not mean it can yet count on these agglomeration economies. A large literature explores the link between economic performance and levels of social spending. Again, the competition state scenario of intensifying international competition leading to lower social spending finds little empirical support. De Grauwe and Polan (2003), for example, find no evidence that social spending in OECD countries has declined with globalisation or that its level impacts negatively on a country’s economic performance in the global economy. They look for evidence that successful economic performance came first and enabled higher social spending as a subsequent political choice (the ‘grow first, spend later’ thesis), but their econometric work points to the causality running in the opposite direction. Their preferred explanation is that higher social spending supports good economic performance in OECD countries because it is associated with effective administrations that use it in ways which reduce industrial conflict and increase the willingness of populations to cooperate with change.
This perspective on social spending found strong support earlier in the work of Cameron (Cameron, 1978). Cameron studied a group of 18 OECD countries and showed that the best single predictor of the increase in an OECD government’s tax revenue (as a share of GDP) between 1960 and 1975 was the economy’s openness in 1960 (exports plus imports divided by GDP). The correlation coefficient was 0.78. By way of explanation, Cameron argued that more open economies have higher rates of industrial concentration, which tend to foster higher unionisation, greater scope for collective bargaining, and stronger labour confederations. These in turn result in larger demands for government transfers — social security, pensions, unemployment insurance, job training, etc. — which mitigate external risk. Subsequently, Rodrik (1998) studied a much larger group of countries which included many developing ones. He believed Cameron’s explanation for his finding would not be applicable to developing countries (which are dominant in the 100 plus included in his study) where it was implausible to attach such importance to the role of trade unions in most of them (see Kapstein and Milanovic, 2002, for developing countries where it does apply). His own finding was that the empirical
Economic Performance and Social Protection 15
relationship between an economy’s openness and the level of government
spending held primarily for government consumption in developing countries
while, in advanced countries, just as Cameron had found, it was primarily spending on social security and other transfers that correlated with exposure to external risk. He, too, concluded that small countries, in particular, appear to benefit from higher social spending and ‘bigger government’. This is because, being small, they tend to have open economies that are vulnerable to fluctuations in the level and
terms of international trade. “Societies seem to demand (and receive) an
expanded government role as the price for accepting larger doses of external risk. In other words, government spending appears to provide social insurance in economies subject to external shocks”, (Cameron, 1978).
Cameron and Rodrik, therefore, are in agreement that the evidence suggests public spending is a risk-reducing instrument on which there is greater reliance in more open economies.
More open economies have greater exposure to the risks emanating from turbulence in world markets. Larger government spending can be viewed in such economies as performing an insulation function, insofar as the government sector is the ‘safe’ sector (in terms of employment and purchases from the rest of the economy) relative to other activities, and especially compared to tradables. Hence, in countries significantly affected by external shocks, the government can mitigate risk by taking command of a larger share of the economy’s resources. …. One might object that the government’s risk-reducing role would be best played through the establishment of a safety net, in which case it would show up mainly in government spending on social security and welfare, and not in government consumption. This prediction is borne out in the case of the more advanced countries, which have the administrative capacity to
manage social welfare systems. In these countries, government
consumption is uncorrelated with exposure to external risk, while spending on social security and welfare is strongly correlated. …In most developing countries, however, income-transfer schemes tend to be rudimentary for reasons of administrative capacity. Consequently, their governments tend to rely on a broader set of instrumentalities – public employment, in-kind transfers, and public-works programs – all of which show up in government
consumption-in order to broaden safety nets. (Rodrik, 1998).
Lindert (2004) examines the origins and course of public social spending in today’s industrialised countries from the late 19th century onwards. He concludes: ‘nine decades of historical experience fail to show that transferring a larger share of GDP from taxpayers to transfer recipients has a negative correlation with either the level or the rate of growth of GDP per person’ (2004: 18). He articulates two general principles that serve as an explanation as to why the welfare state appears to have done no net damage to growth in GDP per capita.
(i) Democracies with large public sectors show more care in designing taxes and transfers so as to avoid compromising growth. For example, he finds evidence for ‘a style of taxation that few have noticed when debating the effects of the welfare state’ (31), viz., countries with large welfare states like Sweden tend to have a more pro-growth and regressive mix of taxes. Behaviour with a low elasticity bears the brunt of taxation — labour’s earnings are taxed more than income from capital; consumption is taxed (e.g. VAT) more heavily than savings; and addiction goods (alcohol, tobacco, etc) are taxed heavily. These high-spending countries have also fine-tuned the work incentives of their welfare and unemployment compensation programmes so as to limit welfare dependency, principally among young adults; several of their ‘transfers’ to the unemployed and poor are in effect purchases of behaviour and investments in job qualifications. This leads him to formulate ‘the budget-stakes principle’ by which, the larger the budget, the greater the stakes in designing social programmes in ways that minimise the unit costs of the extra transfers and taxes. High-budget welfare states, he believes, have done more to address the dangers of getting taxes and transfers wrong than have low-spending countries like the US - their administration costs are lower (there is a small reliance on means-testing) and their broad-based consumption and income taxes create little distortion.
(ii) In second place, Lindert argues that a broad universalism in taxes and entitlements fosters growth better than strict means testing and complicated tax procedures. This is for three principal reasons. The wide tax bases to which taxes are applied (such as a general consumption tax) and the non-conditionality of the social protection provided mean nothing is gained by changing behaviour; tax avoidance is a starved industry as all alternatives are taxed at the same rate, basic life choices (to take employment, parent alone, etc.) do not influence the level of social support received, and marginal tax-cum-benefit-withdrawal rates are low. The administrative costs per euro collected and spent are low because procedures are simple and there is little need for intrusive inspection or close monitoring. Finally, several of the universal services providing social protection also serve to make people more employable and productive, e.g., public education, public health, childcare, maternity and parental leave.
Economic Performance and Social Protection 17
Research on the micro level
While there is no empirical support for the hypothesis that high social spending, in an increasingly competitive global economy, is inherently damaging to economic performance, there are many examples of how poorly designed social protection can damage employment and reduce individuals’ participation in the labour market.
For example:
s Levying high social insurance on the wages of low skilled workers significantly
reduces the demand for them. It has been a characteristic reform strategy of Continental European welfare states in particular to target reductions in social insurance on low skilled workers (Drèze and Malinvaud, 1994).
s If social protection is concentrated on people in existing jobs, new entrants to
the labour market shoulder disproportionate responsibility for ensuring some flexibility in the labour market, a dual labour market develops and considerable talent remains underdeveloped or is lost to the economy (Saint-Paul, 1997).
s Reliance on disability benefits can become a form of disguised unemployment
and grow to absorb more resources than unemployment compensation if the policing of unemployment benefits is allowed to substitute for tackling the deeper underlying issues of low skills and poor employment prospects.
s Sickness payments can become so attractive that taking time off for sickness
becomes quasi built-in to employees’ expectations of a normal working year (Henrekson, 2004).
s Continuing with wholly unfunded pension arrangements whereby people at
work pay the pensions of those currently retired would be unfair to future workers whose numbers, relative to those in retirement, will be much smaller.
s While there is little evidence that people are attracted into long-term welfare
dependency because of its availability, there is considerable evidence that leaving it for employment can be made difficult by high marginal benefit withdrawal rates.
While there are multiple examples from the international literature of whatnotto do, much more can be learned from the literature which points to how social protection can be designed so as to support people’s engagement with economic restructuring. For example, a theoretical (Sinn, 1995, 1996) and empirical literature (Bird, 2001; Blanchflower, 2000) has explored the hypothesis that people protected by benefits may embrace more change and take more risks they would otherwise do, with outcomes that are positive for the functioning of the labour market and economic performance. Some examples are:
s a generous level of unemployment benefit for an interval of time enables
people to hold out for a better job match than they would do if means-tested assistance immediately beckoned;
Economic Performance and Social Protection 19
s mobility between jobs is easier if individuals know that being in transit will not
entail a large drop in their standard of living;
s maternity benefits, parental leave, access to childcare and flexi-time can
strengthen attachment to the labour force over a person’s life-time, preventing more definitive breaks with employment by facilitating temporary breaks for caring purposes.
Lundvall (2002: 82)4
sees the high replacement rate and long period for which benefits can be drawn that characterise unemployment compensation in Denmark as integral to the country’s successful innovation system rather than as handicaps to the efficient functioning of its labour market. Their generosity, he argues, contributes to the workforce being willing to practice a high level of mobility between jobs and employers, and to the population at large valuing a permanent (if periodically interrupted) attachment to the labour force.
The OECD (2004: 96-98)5
also cites Denmark as successfully combining the provi- sion of high net replacement incomes (as high as 89 per cent to 96 per cent for low-income groups) for a long period (up to four years) for people becoming unemployed with a range of activation measures that procure their effective preparation for new employment. The Danish system (termed ‘flexicurity’) features moderate employment protection legislation, generous income protection on becoming unemployed, and strong activation measures preparing and requiring unemployed people to seek new jobs. These features support each other in a dynamic way as Figure 2.2 (below) illustrates.
4. Lundvall (2002),Innovation, Growth and Social Cohesion. The Danish Model.UK: Edward Elgar.
5.OECD Employment Outlook 2004, Chapter 2: ‘Employment Protection Regulation and Labour Market Performance.’
Figure 2.2
The ‘Golden Triangle’ of Flexicurity
SourceAdapted from OECD (2004: 97). The real economy Flexible Labour Market ALMPs/ Activation Generous Welfare System Aggregate labour demand Resources
From the perspective of the individual employee, the security provided is not against the loss of their existing job but against struggling to manage on a low income if unemployed and being without a new job for long. The OECD notes evidence that Danish employees have a strong feeling of security despite the high level of job mobility and low average job tenure in their economy. This policy of ‘flexicurity’ does not come cheap. No country spends as high a proportion of its GDP on unemployment compensation and labour market programmes as Denmark, but the country has consistently maintained the highest employment rate in the EU 15. It is noteworthy in this regard that Denmark also has one of the highest rates of adult participation in further education and learning in the OECD. Goodin et al (1999)6
exploited the opportunity provided by the availability of longitudinal data sets (covering 10 years) in the US, West Germany and the Netherlands to track movements in the level and composition of people’s incomes over time. A major interest was whether receipt of state transfer payments was associated with a greater or lesser likelihood of an individual improving her or his income from market sources over time (the theory of welfare dependency would suggest it should lessen it). They found clear evidence that the state which intervened most promptly and vigorously to alter the distribution of market income was also the state in which those on low incomes were most likely to improve their market earnings over time, viz., the Netherlands.
Table 2.2 presents an example of their findings. Column 3 suggests that some 18 per cent of those poor in a given year in the USA on the basis of their market income alone earned their way out of poverty over the next five years and 31 per cent over ten years; this was in a country where taxes and transfers made virtually no impact on the proportion below the poverty line (column 4). By contrast, some 42 per cent of those below the poverty line on the basis of their market income in a given year had earned their way above it within five years in the Netherlands and some 53 per cent did so over ten years; the context in this case is of a Dutch welfare state which redresses income poverty promptly and sees a dramatic drop in the likelihood of the same individual being below the poverty line the longer the time period that is considered.
20
This type of evidence suggests that the relatively generous Dutch transfer payments did not weaken other correcting mechanisms which strengthened the market position of poor households in the long-term. The findings for the US, on the other hand, gave no support to the view that financial poverty, if allowed to persist, spurs ‘market discipline’ and greater self-reliance such that, over time, more poor households exit poverty through their own means. Americans who were poor and received meagre benefits by Dutch or German standards were much more likely to remain poor over longer periods than people below the poverty line in either the Netherlands or Germany. This study can be interpreted as further support for the argument that it is the interaction between the level of cash transfers and their design which is most critical to addressing poverty. On its evidence, the government that most ‘looked after’ poor people turned out to be the country where the poor were most able to ‘look after’ themselves in the long run.
Economic Performance and Social Protection 21
Table 2.2