Institutions and government spending

in 20th century

17th December 2012

Lessons from last Thursday…• Institutions are important factors affecting long-

term development (growth vs stagnation)– This is particularly true for property rights

• Institutions have “a life of their own”– They are far from engineered or designed– They have potentially long life-span– Their dynamics is affected by needs of the economy

as well as the vagaries of politics

• Most destructive economic upheavals have been associated with sudden upsets in property rights

Source: John J. Wallis: American Government Finance in the Long Run, 1790 – 1990, Journal of Political Economy 14, 2000

Peter Lindert: Growing public (2004)• Welfare state (& public sector in general) has grown

with extension of suffrage• This is true across countries and decades• This is true regardless of political system or parties

in place• It is tied, then, with the politics as well as

“technology” of public-sector operation– It is not a left-wing conspiracy– It is not a result of just cautious, thorough design either

• The welfare state and current public sector is a result of of spontaneous growth/bloating

Examples of such spontaneous development

• Changes to taxes • Changes to expenditures

Overall impact• PIT rates have declined and are simplified• Revenue from direct income tax has grown less

important and less available• Revenues have been replenished through other

sources:– Indirect taxes (VAT)– Payroll taxes (Social insurance payments)– Most of these are regressive! (Why?)

• The result is a regressive overall tax system in many welfare-state countries

Source: http://economix.blogs.nytimes.com/2010/12/01/who-pays-for-big-government/

Expenditure: spending on welfare

• Biggest items as a % of GDP of OECD countries:– Year 1995

2009– Public pensions 6.9 7.0– Unemployment benefits 1.8– Basic assistance (welfare) 2.9– Healthcare 6.8 7.0– Public housing 1.0– Public education 5.2 5.1

Life expectancy and retirement in Europe

Benefits from pension system• Low-income earners:

– Low education => early labor force entry (by up to 10 years)• Long period of contributions• Social insurance rates are overall regressive

– Low life expectancy => short period of benefits (by up to 6 years)• Earlier exit from the system relative to other groups

– Replacement ratio• Highly progressive (benefits lower incomes)

• High-income earners– High education => late entry into labor force

• Shorter period of contribution• Social insurance rates are overall regressive

– High life expectancy => long period of benefits– Hit by progressive replacement ratio

• Note: this is often the only publicly discussed item when discussing the redistributional consequences of pension systems

• Middle-income earners– Maturita/university => more similar to high-income earners (late entry)– Life expectancy in-between: close to high-income groups in some countries and low-income groups

in others– Replacement ratio: progressivity usually strongly hits at higher than middle incomes, so middle-

income groups are not his as badly• Conclusion: who benefits and who pays over the life-time is unclear a priori – it DOES

NOT follow that pension systems benefit the poor, they likely benefit the middle

Benefits from pension system (continued)

• Men vs women– Women have higher life expectancy (by many years)– Women retire earlier– Women also spend less time in labor force (childbearing)

but have lower unemployment– Women have lower wages

• Immigrants vs natives– Frequently natives contribute (if they work) but may have

limited access to benefits in old age (+ migration)– Illegals only contribute, limited chance of benefits

Education

Education• Education is treated in most rich states as a

public good• Primary and secondary education– Highest return to education (>15, even 20%)– (Mostly) universal in access and provision– Highly educated people reap greater benefit, of

course• Tertiary education– Enrolment far from universal– Children of highly educated parents have significantly

higher chances of enrolment

Many welfare state policies operate as subsidies for the better-off

• Not just tertiary education and pensions• Tax breaks– Mortgage interest deduction– Business expenses– Lower rates on interest on savings and capital

• Public sector employment– Requires higher education– Higher rate of unionization than unskilled labor– Higher incidence of guaranteed job tenure

• Labor market regulations– Job protection (affects hiring and firing)– Severance pays– Untaxed fringe benefits (work hours, overtime compensation)

Evaluating the welfare state• Some policies are redistributive towards the poor • Many public policies, however, redistribute

FROM the poor to the middle (or rich)– Public (tertiary) education– Public pensions (potentially)– Public sector jobs (require high education)– The tax system with loopholes

• Why? See Wallis (2000) and Lindert (2004):– Because those are the people who VOTE!– They are also very adamant about keeping their perks

How does that relate to the whole property rights story?• Property rights enable growth when they are stable• Property rights are stable…– When they are sustainable technologically (e.g. ripping off CDs)

– but this change is usually gradual– When they are not undermined by politics (i.e. no sudden

movement, revolutions, expropriations)• This means clear-cut support by majority of decision-makers

• Current welfare state – has been supported by a wide coalition of middle-income voters– This coalition has lasted at least since WW2– The coalition supports it precisely because they benefit from it– But recently, the status quo is upset by technology:

• Medical technology increases life-span, affecting demographic make-up• Communications technology improves mobility of jobs and capital

Deficit as % of GDP in OECD

Same stats, PIIGS

Same stats, chronic offenders

The punch-line• Instability of the whole system has lasted for some

time now• The trends are getting more ominous– Not only higher mobility undermines tax base– Growth has slowed down– Claims on public resources have shot up and will even

more so in the future

• Yet, reform has been elusive– In spite of international pressure (Maastricht treaty)– In spite of continuing public debate– This is because the powerful coalition can defeat reform

The austerity policy in Europe• Who is against?– The pensioners (Greece – pensions are under attack)– The public servants (Greece – cuts in public sector)– The university students (Spain – indignados)

• Where are the cuts?– Unemployment benefits and welfare– Some in education– Some in pensions

• Where reform is slow in coming?– Labor market regulations– Privatization of SOE– Public sector jobs (halt in hiring – indignados again)

Conclusions• The problem is chronic, recession only put it front

& center(Buffet: “When the tide turns, that’s when we learn who’s been swimming naked”)

• It looks like many governments have hit the budget constraint

• Long-term shift in what is taxed and how it is taxed (tax avoidance)

• Upshot: either find a new source of income or face the inevitable cuts

Sources• Peter Lindert: Growing Public (Volumes 1 & 2), Cambridge University

Press, 2004• John J. Wallis: American Government Finance in the Long Run, 1790 –

1990, Journal of Political Economy 14, 2000• Klara Sabirianova-Peter, Steve Buttrick & Denvil Duncan: Global Reform

and Personal Income Taxation: Evidence from 189 countries, IZA working paper 4228, June 2009

• Casey Mulligan’s blog & NYT• “Taming Leviathan”, 17th March 2011, The Economist• OECD website