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Economics of the Welfare State Summary - Lectures + Literature
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Contains all the lectures, literature and book chapters required (and optional) for the course EWS at the VU
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Lecture 1Chapter 1 - Introduction
The Economics of the Welfare State by Nicolas Barr (2020)
Welfare state = a system whereby the state takes responsibility for the welfare of its citizens, in case
of unemployment, illness, old age of poverty.
The welfare state exists to enhance the welfare of people that are:
• Weak and vulnerable, largely by providing social care;
• Poor, largely through redistributive income transfers;
• Are neither of the above, by organizing cash benefits to provide insurance and consumption
smoothing, and by providing medical insurance and school education.
Ingredients of the welfare state:
- State involvement (not voluntary welfare)
- Benefits in cash (unemployment, health benefits), or in kind (health care, education)
- Provides insurance against risks or provides minimum income.
The welfare state can be thought of both:
- As a series of institutions which provide poverty relief, redistribute income and wealth, and
seek to reduce social exclusion - the Robin Hood function.
- As a series of institutions which provide insurance and offer a mechanism for redistribution
over the life cycle - the Piggy Bank function.
There seems to be a general agreement that the major purposes of policy in Western societies
embrace efficiency in the use of the resources; their distribution in accordance with equity or justice; and
the preservation of individual freedom. However, these purposes might me shaped differently: to a
utilitarian, the purpose is to maximize total welfare; to libertarians individual freedom is the most
important, to Rawls the aim is social justice, defined in a particular way.
When defining the welfare state, 3 areas of complications stand out:
1. Welfare derives from many sources in addition to state activity. Individual welfare comes at
least from the following 4 sources:
a. The labour market is the most important, first through wage income, but also firms
provide occupational welfare in the face of sickness, injury, and retirement.
b. Private provision includes voluntary private insurance and individual saving.
c. Voluntary welfare arises within the family and outside, where people give time free
or at a below-market price, or make voluntary charitable donations.
d. The state provides cash benefits and benefits in kind. It also contributes through tax
concessions to the finance of occupational and private provision. Cash benefits have
two major components:
i. Social insurance is awarded without an income or wealth test, generally on
the basis of (1) previous contributions and (2) a specified event, such as
becoming unemployed or reaching a specific age.
ii. Non-contributory benefits. Universal benefits are awarded on basis of a
specified contingency, without either a contribution or and income test. Social
assistance is awarded on basis of an income test. It is to help families that are
really in poverty.
2. Modes of delivery are also diverse. A service may be financed by the state, but it does not
necessarily have to been produced publicly.
3. The boundaries of the welfare state are not well defined.
Lecture 1: Introduction
1
, After WW2 there were high economic growth rates, low unemployment ➜ creation of the welfare
state. In the 1970s, there were lower growth rates, higher unemployment, lower participation
(especially in older workers) ➜ growth in welfare states.
Looking at the future, a number of long-term trends with major implications for the design of the
welfare state occur:
- Globalization; international trade has become increasingly open and - due to technological
change - economic activity has dematerialized (exchanging computer programs rather than
bottles of wine) ➜ less room for countries to act independently in designing welfare state and
competition among countries.
- Demographic change; increase in life expectancy and lower birth rates lead to fewer workers
to pay for more pensions ➜ if current policies remain unchanged, expenditure might double.
- Changes in family structure; marriage is not so important anymore, single parents raising a
child and women having jobs ➜ higher child support expenditures.
- Changing structure of jobs; with skill bias there is more demand for highly educated people,
causing their wage to increase and creating inequality. Part time employment has also
becomes more attractive.
Welfare states are mixtures of public and private finance
At the extremes, we have purely private production - allocation of products by consumers and
producers, and private finance. Or purely public production: public production and financing, and
allocation by government (e.g. NHS). Income transfers like social assistance are not in this scheme (as
no production involved).
Private production Public production
Private finance Food Public transport
Formerly: electricity, post
Public finance Health sector Health care (NHS)
Educational vouchers Education
Military equipment Defence
Home care
Categorization of benefits with a social purpose
Public expenditure Private expenditure
Mandatory Voluntary Mandatory Voluntary
Redistribution Means-tested benefits (payment Voluntary participation Employer-provided sickness Tax-advantaged benefits,
available to people who can in public insurance benefits accruing from e.g. individual retirement
demonstrate that their income and programs mandatory contributions to accounts, occupational
capital (their 'means') are below pension or disability pensions
specified limits) insurance
BIJSTAND PENSIOEN
SPAREN
No Benefits from government to lower Non tax-advantage Exclusively private: benefits
redistribution income households to encourage actuarially fair pension accruing from insurance
them to save more money benefits plans bought at market
prices given individual
preferences
2
,From gross public to net public and private social spending:
- bars = gross public social expenditure
- diamonds = net public and private social expenditure
USA: big difference because of large private spending on
health care. USA is one of the biggest welfare states
Welfare State Typologies
Three types of welfare states - according to the Esping-
Andersen Model:
- Liberal: These are characterized by minimal welfare
provisions, and tend to prioritize market individualism and individual responsibility. Use strict
means testing.
o Examples of liberal welfare states include the United States, Canada, and Australia
➜ Anglo-Saxon countries
- Corporatist: These are characterized by a high degree of cooperation between the state,
employers, and trade unions, and tend to emphasize social insurance programs. Selective
coverage of social insurance, based on work history.
o Examples of corporatist welfare states include Germany, the Netherlands, and
Austria ➜ Europe and Japan
- Social-democratic: These are characterized by universal and generous welfare programs,
and tend to prioritize egalitarianism and social equality. High level of social protection,
strong link between welfare and work.
o Examples of social-democratic welfare states include Sweden, Norway, and Finland
➜ Scandinavian countries
Problem: The strategic design of the welfare state is based on a past social order with stable, two-
parent families, with high levels of employments, and where most jobs were full-time and relatively
stable. Also, the conflict between economic growth and equality has become sharper of the years.
• The neo-liberal approach: Policy sought to increase the demand for labour by liberalizing
labour markets, not least through increased wage flexibility.
o Advantages: avoids heavy fiscal costs that the other two approaches incurred.
Employment growth in countries that adopted this approach in the 1980s was
significantly higher than in the rest of the OECD.
• The corporatist approach: Policy tried to reduce the supply of labour, notably through early
retirement.
o The cost in this case is not that of public employment but public pensions.
• The social-democratic approach: Policy was aimed at increasing the demand for labour
through active labour-market policies and increased public-sector employment.
o The problem with this approach was its costs.
EA-model: collective benefits
Liberal Corporatist Social-democratic
Coverage Very limited: the poor Selective and hierarchical: Universal
professional groups
Entry conditions Very strict: Fairly strict: Generous
- Incapable of work - Employment history
- Means testing
Limitation of duration Strict: as long as no capability Actuarial: potentially long Not strict
to work
Level of benefit Meager High (wage related) High guaranteed minimum
Separate collective Few Many None
provision?
Method of funding General taxation Mealy through contributions General taxation
3
, EA-model: employment
Liberal Corporatist Social-democratic
Minimum wage Absent or low High (for sector) High
(Dis)incentives for None Many disincentives: Many incentives: individual
women to work breadwinner benefits, child benefit entitlement, extensive
allowances, few childcare child care, activation
facilities
Subsidized employment Virtually absent Limited Extensive, mainly public
The Welfare State: Theoretical Considerations
➢ First theorem (the ‘invisible hand’ theorem): in a first-best economy, the operation of perfect
competition will lead to a Pareto efficient allocation of resources i.e. the contract curve.
➢ Second theorem: in a first-best economy it is possible to reach any desired point on the
contract curve by establishing a suitable set of initial endowments. Pareto efficient outcomes
can be reached by redistribution of endowments (lump-sum taxes).
There are two general rules for government intervention
➢ Failure of 1st Welfare Theorem: Government intervention can help if there are market or
individual failures
o Government intervention desirable, otherwise:
▪ Pigouvian taxes, public good provision
▪ Regulation
▪ Adverse selection may call for mandatory insurance
▪ Nudging, mandatory pensions
➢ Fallacy of 2nd Welfare Theorem: Even in the absence of market failures, distortionary
government intervention is required to reduce economic inequality
o Due to lack of information, the government needs to use distortionary taxes
▪ Example: Suppose economy consists of 50% able individuals that can earn
100 euros and 50% disabled without possible earnings
▪ According to the 2nd welfare theorem, the government should be able to
distinguish between the two groups and redistribute 50 euros to the non-
working group by taxing the working group
▪ Real world: government cannot differentiate between the groups, so
implementing a 50 euros tax to nonworking people only reduces the work
incentive ➜ induces distortions
Why state intervention? Governments are concerned with outcomes on income, health, education and
housing. There are always trade-offs between equity and efficiency. With regards to efficiency; there
is no justification for intervention when the first-best economy assumptions hold.
Types of government intervention:
- Regulation (affects supply);
o Quality standards such as hygiene laws, laws forbidding unqualified people to
practise medicine and consumer protection.
o Quantity regulations such as mandatory school attendance or car insurance.
o Price regulations such as minimum wages and rent control.
- Finance (affects demand);
o Subsidies (public transport) and taxes (congestion) affect the budget constraint and
thereby the price.
- Production (even though regulation and finance modify market outcomes, they leave the basic
mechanism intact);
o The state takes over the whole supply side (defence, school).
- Income transfers (equity concerns);
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