We know that prosperous countries with bigger governments (mostly as a result of larger social support systems) don’t grow any more slowly than those with small governments.
How can that be? The deadweight loss from those additional taxes should hurt national GDP growth, right?
Answer: there are many economic effects that are exogenous to the price/supply/demand/quantity model by which deadweight loss is calculated. It’s a simplified, toy model/thought experiment that ignores a whole plethora of economic effects. It’s useful, even necessary, but far from sufficient in assessing a policy’s full economic effects.
But still: deadweight loss is very real and can be quite large. How do big-government countries avoid its ill effects?
Here’s the best explanation I’ve found. (It echoes another paper I read years ago, but haven’t been able to find.)
Imagine two countries. One taxes 10% of GDP, one taxes 40%.
Now imagine a proposed policy that increases the budget by 10% and has a deadweight loss of 40%.
In the first country, the policy costs .04% of GDP. In the second country, it costs .16% of GDP — four times as much. The policy is going to get a heck of a lot more (political) pushback in the high-taxing country.
This suggests that:
1. Government budgets are to some extent (over long periods) self-correcting via the democratic process. When deadweight losses overwhelm the exogenous benefits (of fruitful government spending, for instance), spending is curtailed or policies are improved.
2. Larger government budgets provide the political incentive to create more efficient policies and kill inefficient ones.
In the author’s words:
The higher the budget, the higher the marginal cost of making the wrong policy choice, both economically and politically.
He suggests that America’s inefficient taxation policies (like double-taxation of corporate profits) have remained in place because our tax levels are so low. Other countries have been forced to implement more efficient policies because the costs of inefficient policies were so great. See the paper for many examples.
Further, from the abstract:
- First, it shows conventional analysis imagines costly forms of the welfare state that no welfare states have ever practiced.
- Second, better tests confirm that the usual tales imagine costs that would be felt only if policy had strayed out of sample, away from any actual historical experience.
- Third, the tax strategies of high-budget welfare states are more pro-growth and less progressive than has been realized, and more so than in free-market OECD countries.
- Fourth, the work disincentives of social transfers are so designed as to shield GDP from much reduction if any.
- Finally, we return to some positive growth and well-being benefits of the high welfare budgets,
SSRN-Why the Welfare State Looks Like a Free Lunch by Peter Lindert.
Ungated PDF here.
Comments
8 responses to “Is the Welfare State a Free Lunch?”
The other possibility is that the entire dead-weight loss of taxation concept is a crock.
Cheers!
JzB
@jazzbumpa
I would not consider arguments to that effect to be off-the-cuff nuts, but I’d have to see more than a mere surmise.
I’m ashamed to say I haven’t gone through Rivlin and Deminici’s budget yet. I have such high respect for Alice Rivlin I’m just apt to say “Well if Rivlin put it together it must be a good budget” but I guess that doesn’t count as real policy analysis, does it?? I have about 15 books I’m behind reading on and I want to start doing posts on my blog, so I think it will be like forever until I get around to reading Rivlin’s budget. But I think your last 3 posts have been super Steve and I hope you will carry the torch on this topic and beat it to death long after it has “become a dead horse”. I think most probably Rivlin’s budget is best one come up with so far, which makes me extremely confident to say it won’t even make it out of Congressional Committee for a floor vote.
Somebody, anybody, please prove me wrong. I would be so happy to be wrong on this particular issue.
@Ted K
I have gone through it a bit more and haven’t had the energy for the post it requires. Very shortly: long term it hits payroll taxes too hard, and makes unnecessary cuts to social security. That shouldn’t be the source of our fixes; SS is working fine. Its increase in progressivity is not very profound, and we really need a more profound transformation. State, local, federal taxes combined:
http://graphics8.nytimes.com/images/2009/04/13/business/economy/shares.jpg
Still I agree: “I think most probably Rivlin’s budget is best one come up with so far, which makes me extremely confident to say it won’t even make it out of Congressional Committee for a floor vote.”
Except I’d go further: as a cohesive entity, it won’t get anywhere near any kind of legislative embodiment.
I think there is a parallel here with the great debate over maintaining full employment which motivated James Tobin’s famous quip that “it takes a lot of Harberger triangles to fill an Okun gap.” (http://www.econ.yale.edu/alumni/reunion99/yellen.htm)
It seems altogether possible to me that the gains from eliminating grinding poverty far out way the loss from higher earners “going Galt.”
And the evidence seems to support that…
Hey Leroy just to say thanks for all the thoughtful comments. I’m kind of swamped with a business product launch right now, but hope to respond soon. Thx.
–We know that prosperous countries with bigger governments (mostly as a result of larger social support systems) don’t grow any more slowly than those with small governments.—
This is absurd.
@Anon http://www.asymptosis.com/europe-vs-us-who%E2%80%99s-winning.html
I haven’t pulled post-2006 numbers — been meaning to do that — but it’s clear that the (non) trend continues.