Welfare state
1. Concept, evolution and challenges
1) Welfare state, traditional definition:
A system in which the government undertakes the chief responsibility for providing for the social
and economic security of its population, usually through unemployment insurance, old-age
pensions, and other social-security measures.
2) OECD on
• Social policy
o “Social policy addresses social needs and protects people against risks, such as
unemployment, poverty and discrimination, while also promoting individual and
collective well-being and equal opportunities, as well as enabling societies to
function more efficiently. The OECD analyses social risks and needs and
promotes measures to address them and improve societal well-being at large.”
• Economy and society
o Effective social policy protects individuals and their families and helps them lead
a fulfilling life. We identify policies that help individuals and their families, and
make societies and economies work more effectively.
3) Why/what government?
Why does government produce/distribute certain goods (such as health and education) and
leave other goods (such as food) to the private sector?
→ Economic theory offers a framework to explain/justify this, the main arguments are:
✓ Efficiency (section 2)
✓ Social justice (section 3)
4) Objectives of the welfare state
Efficiency
Private sector (free markets) needs
government corrections
Social justice
✓ Supporting living standards
▪ Poverty relief
▪ Protection of accustomed
living standards
✓ Inequality reduction
✓ Social integration
5) Update – social spending OECD (as % of GDP)
“Social expenditure comprises cash benefits, direct in-kind provision of goods and
services, and tax breaks with social purposes”
6) History of social policy – for compensation to prevention
After the second world war – the ‘golden sixties’
Feelings of national solidarity (shared by all classes) + economic growth and prosperity →
generous and unconditional system of social security
→ Curation and compensation (for damage, e.g. Income loss due to social risks) using
income benefits
“After the fact” social insurance
1
, After 1973/79 (oil shocks and economic recession)
Fiscal austerity / increasing social needs / inactivity and poverty / …
→ Prevention and activation and (social) investment
Notion of social investment:
Rather than to remediate the impacts of social risks retrospectively, it is preferable to prevent
them from occurring in the first place.
7) Challenges for social security
“Since 2000”, the world is changing:
▪ Technology (health / communication / AI / …)
▪ Labour (situations / relations /…)
▪ Internationalisation (trade / migration / …)
▪ Culture (e.g. Family composition / labour participation)
▪ Ageing in modern economies
▪ High costs (e.g. Technology in health care, ageing, …)
▪ …
Changes → New Challenges for the “New welfare state”:
▪ More uncertainty (economic / social / political)
▪ More inequality
▪ More adaptation needed (e.g. Changing labour and skills)
▪ Employability is important (keep “in touch” with the changing labour market /
with the changing world in general)
▪ More flexibility
▪ …
Note! In the meanwhile, the “old risks” (sickness, pension, …) are still there
The “New welfare state” aims at
▪ Creating jobs
▪ Active labour market participation policy (ALM)
▪ Adaptation to the “new economy” (services, sharing, internet, flexibility, …)
▪ Promoting development of skills
▪ ….
→ The new welfare state is promoting “policies in favour for the market economy” (not
“policies against”)
New Social welfare state must pay attention to:
We need to avoid “Matthew-effects” = situation in which the advantages go (mostly) to the
higher income groups
What with people with less skills? People “at the bottom”?
Poverty remains a structural problem
If we are concerned for redistribution and want efficient use of resources, we need more
selectivity in the benefits, but this is in contradiction with the objective to provide insurance for
everybody
In the presence of scarcity, cost – effectiveness is an ethical obligation. There are always
people in (real) need.
Who is responsible? Is the unemployed person responsible for his unemployment situation? Is
the sick person responsible, depending on his lifestyle?
There should be a shared responsibility between the individual and society.
2
, 8) Everything has a price, also redistribution
Be aware of the incentives
→ It is not impossible that policy choices to divide the cake in a certain way also
influence the size of the cake
→ Main reason: social security can have “discouragement effects” (working less,
being more sick,…)
→ Note that there are also encouragement effects, too often forgotten (e.g.
Feelings of financial ‘safety’)
9) Efficiency-equity trade-off
About incentives: in general, this is called the “Efficiency-Equity trade-off” (developed by
Okun, 1975):
→ Tax more progressive (more equity):
▪ More redistribution
▪ More discouragement effects (less efficiency)
Be aware of these trade-offs, include these effects in policy (proposals) and in research
▪ Example: Theory of optimal taxes
= Higher tax revenue due to lower taxes rates: (‘Terugverdieneffecten’) – Principle of the Laffer
curve
2. Economic motivation: Efficiency
1) First Theorem of Welfare Economics
Theorem: a competitive equilibrium is Pareto efficient
▪ A competitive equilibrium is reflected in the price in a perfectly competitive
market situation
▪ Pareto efficiency implies that nobody can get better off (without making
someone else worse off)
→ Limitations of the first theorem show the need for a government
2) The need for a government
There are limitations to the first theorem of welfare economics → we need a correction = we
need a government
▪ “Market failures”: External effects = Externalities (people do not take into account the
effect of their decisions or behaviour on the welfare of others)
▪ Public goods
And
▪ Distribution (and Social Justice) is not addressed in the first theorem (theorem is only
about efficiency)
3) WTP for Public goods
For each consumer, the same level of public good provision.
Difficult to know what the optimal level of public good provision AND we is cannot rely on
the market for public good provision
→ Theory: The (amount of) provision of the public good should respect the rule of Samuelson:
the social willingness to pay for public goods is the sum of the individuals’ willingness to pay
→ Reality: political (democratic) decision making process
4) Free Riders
“The tragedy of the commons” = the market cannot provide sufficient amount of public goods
If you contribute for the provision of a public good (that I can use as well), I can benefit without
paying.
3
,If everyone behaves like this (free rider behaviour), there will be no (or at least not sufficient)
public good provision
We need another mechanism (this can be a government) to organize public good provision
(note: ‘organize’ does not necessarily mean ‘produce’)
5) Welfare implication
Important: if a government organizes public good provision, everyone is better off because
everyone prefers a world with the public good to a world without the public good
→ Welfare increases thanks to the public intervention
(note: this implies that coercion or taxation makes people better off !!)
Note: in reality, there are mostly quasi-public goods (with some excludability or some rivalry):
e.g. Infrastructure, public space, environment, …
6) Externalities
Externalities (basically the same challenge as for public goods): consumption or production
creates costs or benefits external to the specific consumer or producer.
So, private benefits/costs are different from societal benefits/costs and a (competitive) market
cannot produce an optimal (Pareto) solution → government needed
Example: economic analysis of environmental problems and climate change (global warming)
7) In summary
Public goods, externalities … = “market failures”
→ the market mechanism is not the best (is not an efficient) mechanism to organize society
→ Plenty of room for “other institutions”, such as governments … welfare can increase
(‘beyond’ the first theorem of welfare economics)
3. Economic motivation: Redistribution
1) Inequality and poverty
Different (re)distributions / situations are possible → influence on the (in)equality of income
(or welfare)
Inequality ≠ poverty!!! (this is subject of next section)
Well known: Lorenz curve and Gini coefficient
Most inequality measures (e.g. The Gini coefficient) are not sensitive for proportional income
changes
E.g.: incomes in Tanzania are 100 times lower than in Belgium, although the Gini coefficient (a
measure for inequality) is similar
Comparability using equivalence scales
Equivalence scale: factor which takes family composition and advantages of scale into
account (also other variables can be taken into account)
OECD:
− Additional adult: factor 0,5
− Additional child (<14 years): factor 0,3
Example: equal welfare
4
, − Single without children: €1500
− Couple without children: €2250 (scale1,5)
− Couple with four children: €4050 (scale 2,7)
Income concept in a welfare state
Market income (from labour and capital)
= Primary income
- Direct taxes
- Social Security contribution
+ Reduction in taxes
+ Social Security allowances
= Secondary income (= disposable income)
- Indirect taxes (VAT, excise)
+ Object bound price lowering subsidies
→ Redistribution using taxation (3.2) and social
security (3.3)
2) Redistribution: taxes
Taxes are the first important redistribution
mechanism
Why using taxes?:
- To change the distribution of income and
welfare
Also:
- To finance public goods
- To influence behaviour of economic agents
3) Redistribution: social security
Social Security (second redistribution mechanism)
based on two basic principles:
Insurance against risks
→ Income transfers towards ‘victims’ (= sick, old, handicapped…)
Solidarity
From rich to poor, healthy to sick, employed too unemployed …
Social insurance
Social security is organised by government and not by the market. Three important reasons:
i. Collective component
ii. Adverse selection
iii. Moral hazard
ii. Collective component: some examples
▪ Unemployment risk: depending on business cycle
▪ Longer life expectancy for everyone
▪ Risks of earthquakes or floods; government funds with compulsory contributions
ii. Adverse selection
“Good risks” think they pay too much → leave the market
→ Adverse selection: only bad risks remain, and the market disappears
→ Obligation by the government to pay contributions (also for those with “good risks”
Iii. Moral hazard
Risk of damage (and extent of it) not exogenous but determined by the behaviour of the
beneficiary
5
, → Taking more risk when being insured
→ Government can discourage this kind of behaviour (e.g. Unemployment prevention)
In summary
Three explanations for the choice and the size (and growth) of government activities in a
welfare state:
1. Government has a role in dealing with market failures (section two)
2. It also has a task as redistributor of income and wealth (section three)
3. Its response to claims of pressure groups, bureaucrats …in short, all kinds of
“government failures”
(1) + (2) + (3): Question: which is the optimal government (size)??
The (re)distributive role of a government in a welfare state is extremely important
(especially in times of a crisis)
- For the reduction of inequality
- To provide the ‘right incentives’
- For the prevention of poverty (!) → next section
4. Poverty in the welfare state
1) Measuring poverty
Poverty lines:
A critical line (a poverty line) below which individuals are
classified as “poor”
▪ Objective versus subjective poverty lines
▪ Relative versus absolute poverty lines
European policy measures:
▪ At Risk of Poverty (AROP)
▪ Material and social deprivation
▪ Work intensity
▪ At Risk of poverty or social exclusion (AROPE)
Absolute and relative poverty
Poverty in absolute terms:
Not reaching an absolute income level (e.g. $2,15 a day –
World Bank)
Poverty in relative terms:
Varies with the average standard of living
▪ 60% of median national equivalent
income (EU) = “At risk of poverty” when
being below the 60%
▪ Other thresholds
possible (e.g. 50% of
median income - OECD)
AROP: risks
▪ Poverty figures based on country-
specific poverty lines: adequate
for distinguishing poor groups
within single Member States, but not fully comparable cross-nationally (underestimation
of poverty in the less wealthy Member States)
6
, ▪ May either overestimate or underestimate the realities of financial strain and poverty
risks:
▪ Under-estimation of poverty risks in single parent households with more than
one child
▪ Over-estimation of poverty risks for the elderly (when not being ill and being
house owner)
→ Other indicators to be considered
Material and social deprivation
The material and social deprivation rate: share of people who
cannot afford at least 5 out of 13 deprivation items that are
considered by most people to be desirable or even necessary
to lead an adequate quality of life.
Severe material and social deprivation rate: cannot afford 7 out
of 13
The items are classified into two groups:
▪ Items at household level (such as capacity to face unexpected expenses or ability to
keep home adequately warm)
▪ Items at individual level (such as having regular leisure activities or having an internet
connection)
Aggregate to the extent of poverty in a society as a whole
Headcounts: most popular as it is easy to interpret and communicate. BUT:
▪ If the extent of poverty is expressed in terms of a headcount, then it makes sense for a
policy maker to focus on the better-off poor, as this offers the best chance of lifting a
maximum number of individuals out of poverty
▪ An unchanged headcount of people below the poverty line may conceal a sharp rise in
the extent of shortfall from the poverty line.
→ Huge (and technical) literature on alternatives (e.g. Poverty gap ratio: the average normalized
amount by which poor incomes fall below the poverty line)
When an appropriate metric and a poverty line separating the poor from the non-poor have been
selected, aggregation is required to arrive at a single measure of the extent of poverty in a society
as a whole.
2) Social security and poverty reduction
7
1. Concept, evolution and challenges
1) Welfare state, traditional definition:
A system in which the government undertakes the chief responsibility for providing for the social
and economic security of its population, usually through unemployment insurance, old-age
pensions, and other social-security measures.
2) OECD on
• Social policy
o “Social policy addresses social needs and protects people against risks, such as
unemployment, poverty and discrimination, while also promoting individual and
collective well-being and equal opportunities, as well as enabling societies to
function more efficiently. The OECD analyses social risks and needs and
promotes measures to address them and improve societal well-being at large.”
• Economy and society
o Effective social policy protects individuals and their families and helps them lead
a fulfilling life. We identify policies that help individuals and their families, and
make societies and economies work more effectively.
3) Why/what government?
Why does government produce/distribute certain goods (such as health and education) and
leave other goods (such as food) to the private sector?
→ Economic theory offers a framework to explain/justify this, the main arguments are:
✓ Efficiency (section 2)
✓ Social justice (section 3)
4) Objectives of the welfare state
Efficiency
Private sector (free markets) needs
government corrections
Social justice
✓ Supporting living standards
▪ Poverty relief
▪ Protection of accustomed
living standards
✓ Inequality reduction
✓ Social integration
5) Update – social spending OECD (as % of GDP)
“Social expenditure comprises cash benefits, direct in-kind provision of goods and
services, and tax breaks with social purposes”
6) History of social policy – for compensation to prevention
After the second world war – the ‘golden sixties’
Feelings of national solidarity (shared by all classes) + economic growth and prosperity →
generous and unconditional system of social security
→ Curation and compensation (for damage, e.g. Income loss due to social risks) using
income benefits
“After the fact” social insurance
1
, After 1973/79 (oil shocks and economic recession)
Fiscal austerity / increasing social needs / inactivity and poverty / …
→ Prevention and activation and (social) investment
Notion of social investment:
Rather than to remediate the impacts of social risks retrospectively, it is preferable to prevent
them from occurring in the first place.
7) Challenges for social security
“Since 2000”, the world is changing:
▪ Technology (health / communication / AI / …)
▪ Labour (situations / relations /…)
▪ Internationalisation (trade / migration / …)
▪ Culture (e.g. Family composition / labour participation)
▪ Ageing in modern economies
▪ High costs (e.g. Technology in health care, ageing, …)
▪ …
Changes → New Challenges for the “New welfare state”:
▪ More uncertainty (economic / social / political)
▪ More inequality
▪ More adaptation needed (e.g. Changing labour and skills)
▪ Employability is important (keep “in touch” with the changing labour market /
with the changing world in general)
▪ More flexibility
▪ …
Note! In the meanwhile, the “old risks” (sickness, pension, …) are still there
The “New welfare state” aims at
▪ Creating jobs
▪ Active labour market participation policy (ALM)
▪ Adaptation to the “new economy” (services, sharing, internet, flexibility, …)
▪ Promoting development of skills
▪ ….
→ The new welfare state is promoting “policies in favour for the market economy” (not
“policies against”)
New Social welfare state must pay attention to:
We need to avoid “Matthew-effects” = situation in which the advantages go (mostly) to the
higher income groups
What with people with less skills? People “at the bottom”?
Poverty remains a structural problem
If we are concerned for redistribution and want efficient use of resources, we need more
selectivity in the benefits, but this is in contradiction with the objective to provide insurance for
everybody
In the presence of scarcity, cost – effectiveness is an ethical obligation. There are always
people in (real) need.
Who is responsible? Is the unemployed person responsible for his unemployment situation? Is
the sick person responsible, depending on his lifestyle?
There should be a shared responsibility between the individual and society.
2
, 8) Everything has a price, also redistribution
Be aware of the incentives
→ It is not impossible that policy choices to divide the cake in a certain way also
influence the size of the cake
→ Main reason: social security can have “discouragement effects” (working less,
being more sick,…)
→ Note that there are also encouragement effects, too often forgotten (e.g.
Feelings of financial ‘safety’)
9) Efficiency-equity trade-off
About incentives: in general, this is called the “Efficiency-Equity trade-off” (developed by
Okun, 1975):
→ Tax more progressive (more equity):
▪ More redistribution
▪ More discouragement effects (less efficiency)
Be aware of these trade-offs, include these effects in policy (proposals) and in research
▪ Example: Theory of optimal taxes
= Higher tax revenue due to lower taxes rates: (‘Terugverdieneffecten’) – Principle of the Laffer
curve
2. Economic motivation: Efficiency
1) First Theorem of Welfare Economics
Theorem: a competitive equilibrium is Pareto efficient
▪ A competitive equilibrium is reflected in the price in a perfectly competitive
market situation
▪ Pareto efficiency implies that nobody can get better off (without making
someone else worse off)
→ Limitations of the first theorem show the need for a government
2) The need for a government
There are limitations to the first theorem of welfare economics → we need a correction = we
need a government
▪ “Market failures”: External effects = Externalities (people do not take into account the
effect of their decisions or behaviour on the welfare of others)
▪ Public goods
And
▪ Distribution (and Social Justice) is not addressed in the first theorem (theorem is only
about efficiency)
3) WTP for Public goods
For each consumer, the same level of public good provision.
Difficult to know what the optimal level of public good provision AND we is cannot rely on
the market for public good provision
→ Theory: The (amount of) provision of the public good should respect the rule of Samuelson:
the social willingness to pay for public goods is the sum of the individuals’ willingness to pay
→ Reality: political (democratic) decision making process
4) Free Riders
“The tragedy of the commons” = the market cannot provide sufficient amount of public goods
If you contribute for the provision of a public good (that I can use as well), I can benefit without
paying.
3
,If everyone behaves like this (free rider behaviour), there will be no (or at least not sufficient)
public good provision
We need another mechanism (this can be a government) to organize public good provision
(note: ‘organize’ does not necessarily mean ‘produce’)
5) Welfare implication
Important: if a government organizes public good provision, everyone is better off because
everyone prefers a world with the public good to a world without the public good
→ Welfare increases thanks to the public intervention
(note: this implies that coercion or taxation makes people better off !!)
Note: in reality, there are mostly quasi-public goods (with some excludability or some rivalry):
e.g. Infrastructure, public space, environment, …
6) Externalities
Externalities (basically the same challenge as for public goods): consumption or production
creates costs or benefits external to the specific consumer or producer.
So, private benefits/costs are different from societal benefits/costs and a (competitive) market
cannot produce an optimal (Pareto) solution → government needed
Example: economic analysis of environmental problems and climate change (global warming)
7) In summary
Public goods, externalities … = “market failures”
→ the market mechanism is not the best (is not an efficient) mechanism to organize society
→ Plenty of room for “other institutions”, such as governments … welfare can increase
(‘beyond’ the first theorem of welfare economics)
3. Economic motivation: Redistribution
1) Inequality and poverty
Different (re)distributions / situations are possible → influence on the (in)equality of income
(or welfare)
Inequality ≠ poverty!!! (this is subject of next section)
Well known: Lorenz curve and Gini coefficient
Most inequality measures (e.g. The Gini coefficient) are not sensitive for proportional income
changes
E.g.: incomes in Tanzania are 100 times lower than in Belgium, although the Gini coefficient (a
measure for inequality) is similar
Comparability using equivalence scales
Equivalence scale: factor which takes family composition and advantages of scale into
account (also other variables can be taken into account)
OECD:
− Additional adult: factor 0,5
− Additional child (<14 years): factor 0,3
Example: equal welfare
4
, − Single without children: €1500
− Couple without children: €2250 (scale1,5)
− Couple with four children: €4050 (scale 2,7)
Income concept in a welfare state
Market income (from labour and capital)
= Primary income
- Direct taxes
- Social Security contribution
+ Reduction in taxes
+ Social Security allowances
= Secondary income (= disposable income)
- Indirect taxes (VAT, excise)
+ Object bound price lowering subsidies
→ Redistribution using taxation (3.2) and social
security (3.3)
2) Redistribution: taxes
Taxes are the first important redistribution
mechanism
Why using taxes?:
- To change the distribution of income and
welfare
Also:
- To finance public goods
- To influence behaviour of economic agents
3) Redistribution: social security
Social Security (second redistribution mechanism)
based on two basic principles:
Insurance against risks
→ Income transfers towards ‘victims’ (= sick, old, handicapped…)
Solidarity
From rich to poor, healthy to sick, employed too unemployed …
Social insurance
Social security is organised by government and not by the market. Three important reasons:
i. Collective component
ii. Adverse selection
iii. Moral hazard
ii. Collective component: some examples
▪ Unemployment risk: depending on business cycle
▪ Longer life expectancy for everyone
▪ Risks of earthquakes or floods; government funds with compulsory contributions
ii. Adverse selection
“Good risks” think they pay too much → leave the market
→ Adverse selection: only bad risks remain, and the market disappears
→ Obligation by the government to pay contributions (also for those with “good risks”
Iii. Moral hazard
Risk of damage (and extent of it) not exogenous but determined by the behaviour of the
beneficiary
5
, → Taking more risk when being insured
→ Government can discourage this kind of behaviour (e.g. Unemployment prevention)
In summary
Three explanations for the choice and the size (and growth) of government activities in a
welfare state:
1. Government has a role in dealing with market failures (section two)
2. It also has a task as redistributor of income and wealth (section three)
3. Its response to claims of pressure groups, bureaucrats …in short, all kinds of
“government failures”
(1) + (2) + (3): Question: which is the optimal government (size)??
The (re)distributive role of a government in a welfare state is extremely important
(especially in times of a crisis)
- For the reduction of inequality
- To provide the ‘right incentives’
- For the prevention of poverty (!) → next section
4. Poverty in the welfare state
1) Measuring poverty
Poverty lines:
A critical line (a poverty line) below which individuals are
classified as “poor”
▪ Objective versus subjective poverty lines
▪ Relative versus absolute poverty lines
European policy measures:
▪ At Risk of Poverty (AROP)
▪ Material and social deprivation
▪ Work intensity
▪ At Risk of poverty or social exclusion (AROPE)
Absolute and relative poverty
Poverty in absolute terms:
Not reaching an absolute income level (e.g. $2,15 a day –
World Bank)
Poverty in relative terms:
Varies with the average standard of living
▪ 60% of median national equivalent
income (EU) = “At risk of poverty” when
being below the 60%
▪ Other thresholds
possible (e.g. 50% of
median income - OECD)
AROP: risks
▪ Poverty figures based on country-
specific poverty lines: adequate
for distinguishing poor groups
within single Member States, but not fully comparable cross-nationally (underestimation
of poverty in the less wealthy Member States)
6
, ▪ May either overestimate or underestimate the realities of financial strain and poverty
risks:
▪ Under-estimation of poverty risks in single parent households with more than
one child
▪ Over-estimation of poverty risks for the elderly (when not being ill and being
house owner)
→ Other indicators to be considered
Material and social deprivation
The material and social deprivation rate: share of people who
cannot afford at least 5 out of 13 deprivation items that are
considered by most people to be desirable or even necessary
to lead an adequate quality of life.
Severe material and social deprivation rate: cannot afford 7 out
of 13
The items are classified into two groups:
▪ Items at household level (such as capacity to face unexpected expenses or ability to
keep home adequately warm)
▪ Items at individual level (such as having regular leisure activities or having an internet
connection)
Aggregate to the extent of poverty in a society as a whole
Headcounts: most popular as it is easy to interpret and communicate. BUT:
▪ If the extent of poverty is expressed in terms of a headcount, then it makes sense for a
policy maker to focus on the better-off poor, as this offers the best chance of lifting a
maximum number of individuals out of poverty
▪ An unchanged headcount of people below the poverty line may conceal a sharp rise in
the extent of shortfall from the poverty line.
→ Huge (and technical) literature on alternatives (e.g. Poverty gap ratio: the average normalized
amount by which poor incomes fall below the poverty line)
When an appropriate metric and a poverty line separating the poor from the non-poor have been
selected, aggregation is required to arrive at a single measure of the extent of poverty in a society
as a whole.
2) Social security and poverty reduction
7
