September 4, 2016


The freedom lover's case for the welfare state (Will Wilkinson, September 1, 2016, Vox)

Here's the puzzle. As a general rule, when nations grow wealthier, the public demands more and better government services, increasing government spending as a percentage of GDP. (This is known as "Wagner's law.") According to standard growth theory, ongoing increase in the size of government ought to exert downward pressure on rates of growth. But we don't see the expected effect in the data. Long-term national growth trends are amazingly stable.

And when we look at the family of advanced, liberal democratic countries, countries that spend a smaller portion of national income on social transfer programs gain very little in terms of growth relative to countries that spend much more lavishly on social programs. Peter Lindert, an economist at the University of California Davis, calls this the "free lunch paradox."

Lindert's label for the puzzle is somewhat misleading, because big expensive welfare states are, obviously, expensive. And they do come at the expense of some growth. Standard economic theory isn't completely wrong. It's just that democracies that have embraced generous social spending have found ways to afford it by minimizing and offsetting its anti-growth effects.

If you're careful with the numbers, you do in fact find a small negative effect of social welfare spending on growth. Still, according to economic theory, lunch ought to be really expensive. And it's not.

There are three main reasons big welfare states don't hurt growth as much as you might think. First, as Lindert has emphasized, they tend to have efficient consumption-based tax systems that minimize market distortions.

When you tax something, people tend to avoid it. If you tax income, as the United States does, people work a little less, which means that certain economic gains never materialize, leaving everyone a little poorer. Taxing consumption, as many of our European peers do, is less likely to discourage productive moneymaking, though it does discourage spending. But that's not so bad. Less consumption means more savings, and savings puts the capital in capitalism, financing the economic activity that creates growth.

There are other advantages, too. Consumption taxes are usually structured as national sales taxes (or VATs, value-added taxes), which are paid in small amounts on a continuous basis, are extremely cheap to collect (and hard to avoid), while being less in-your-face than income taxes, which further mitigates the counterproductively demoralizing aspect of taxation.

Big welfare states are also more likely to tax addictive stuff, which people tend to buy whatever the price, as well as unhealthy and polluting stuff. That harnesses otherwise fiscally self-defeating tax-avoiding behavior to minimize the costs of health care and environmental damage.

Second, some transfer programs have relatively direct pro-growth effects. Workers are most productive in jobs well-matched to their training and experience, for example, and unemployment benefits offer displaced workers time to find a good, productivity-promoting fit. There's also some evidence that health care benefits that aren't linked to employment can promote economic risk-taking and entrepreneurship.

Fans of open-handed redistributive programs tend to oversell this kind of upside for growth, but there really is some. Moreover, it makes sense that the countries most devoted to these programs would fine-tune them over time to amplify their positive-sum aspects.

This is why you can't assume all government spending affects growth in the same way. The composition of spending -- as well as cuts to spending -- matters. Cuts to efficiency-enhancing spending can hurt growth as much as they help. And they can really hurt if they increase economic anxiety and generate demand for Trump-like economic policy.

Third, there are lots of regulatory state policies that hurt growth by, say, impeding healthy competition or closing off foreign trade, and if you like high levels of redistribution better than you like those policies, you'll eventually consider getting rid of some of them. If you do get rid of them, your economic freedom score from the Heritage Foundation and the Fraser Institute goes up.

This sort of compensatory economic liberalization is how big welfare states can indirectly promote growth, and more or less explains why countries like Canada, Denmark, and Sweden have become more robustly capitalist over the past several decades. They needed to be better capitalists to afford their socialism. And it works pretty well.

The reason the party most closely identified with the Third Way wins every election in the Anglosphere/Scandinavia is that it just consists of using capitalist means (markets) to achieve socialist ends (social welfare).

Posted by at September 4, 2016 11:04 AM