sou · H3B353en · 2015-06-04 00:00:00 — Risk sharing and economic performance Bilaga 4 till LU15 market failures and incompleteness. If so, public intervention does not necessarily involve a trade-off between efficiency and equity. Second, important implicit or social insurance is implied by welfare arrangements. Welfare policies are redistributive deriving from society attending for the sick, those unable to work, those unable to find work etc. and financing these by taxes levied on those who are healthy, able to work and having a job. Such redistributive schemes also serve an insurance function. The redistribution interpretation of welfare arrangements refers to an ex-post situation; that is, when we know e.g. who are sick and healthy, we know who will receive from and who will contribute to the system. However, if there ex ante is some risk involved in determining the position one will have at a later point in time, the welfare scheme performs an insurance function. A given individual does not know whether he/she will become ill, but will know that if it happens, there is access to a public health care system and some income support etc.. Likewise if the ability to work is lost, there is a social safety net etc. Even tax payments include an insurance element since more taxes are paid if income turns out to be high, and less if it turns out to be low (the so-called Domar- Musgrave effect). , seen from an ex-ante perspective, welfare arrangements provide insurance in relation to various possible social circumstances which may arise. It is an implication that it is not possible to make a sharp separation between redistribution and insurance.69 There are two main reasons why social insurance may accomplish something in terms of risk sharing which private markets cannot. One is the possibility of encompassing the entire population, which eliminates possible adverse selection problems well-known to be harmful to private insurance markets, see Rothschild and Stiglitz (1976). Another is the possibility of risk sharing across time and thus generations via the public budget. 69 Hoynes and Luttmer (2010) consider the redistribution and insurance effects of taxes for the US. They focus on the effects on consumption, and thus do not consider the effects of taxes on incentives. They distinguish the role taxes have in redistributing based on ex ante perceived differences and its role in providing insurance due to ex post arising differences. They find that both effects are quantitatively important and that their relative roles depend on the income level; that is, the insurance value increases and the redistribution value decreases with income. They find that there are net-gains from the scheme at all income levels. Bilaga 4 till LU15 Risk sharing and economic performance to phrase it differently, the public sector can also diversify aggregate shocks affecting all at a given point in time, something which is inherently difficult (and in some cases impossible) for private insurance markets. The literature on the economics of the welfare state has in recent years increasingly recognized that many welfare arrangements have an insurance element (see e.g. Barr (2001), Sandmo (1998), (1995, 1996)). That is, public provisions, whether they are income transfers or services, are contingent on various circumstances which can arise in life, and therefore the schemes have an insurance element besides other possible effects. In the same vein Agell (2002) and Moene and (2001) point to insurance via labour market institutions.70 Crucial for the present discussion, social insurance may have effects beyond the obvious direct positive welfare effect when private markets offer incomplete insurance and individuals are risk averse. Social insurance may have a positive effect on economic performance, including levels of employment and production as well as productivity growth. Risk may be an impediment to adjustment, work, job search or investment in human capital, and it follows that insurance may be conducive to economic performance. Such behavioural responses released by the insurance effects of social insurance are important because they may be counteracting the distortions arising from the schemes.71 6.2Social insurance, efficiency and risk To explain how social insurance can affect both efficiency and equity, it is easiest to return to the standard labour supply problem already discussed in Section 3.1. In the standard case, labour market outcomes are deterministic. Consider a situation where all agents ex ante are alike, but they face wage risks. Real wage risk can arise from risks associated with prices, productivity, length of work etc. Their labour may thus earn a low or high wage, but this is not 70See also e.g. (1970) and (1995) on taxes, (1980) on education, and Acemoglu and Shimer (1999, 2000) on unemployment insurance. 71By distortion effects are here understood the effects on incentives arising in a deterministic setting where there by definition is no issue of risk diversification. Risk sharing and economic performance Bilaga 4 till LU15 known with full certainty when deciding on how much to work, and there is no private insurance market in which the risk averse agents can diversify this risk. Agents will supply labour without knowing what the actual real wage and thus consumption will be, and risk averse agents will in this setting choose a socially inefficient low labour supply. The reason is that while the cost of work is deterministic (disutility from work or opportunity costs of foregone home production), the return to market activities is risky. In this setting inequality arises ex-post since some turn out to obtain high wages, and others low wages. Introduce next a basic tax-transfer scheme; that is, a scheme where a proportional tax on market income finances a lump-sum transfer to all participants (see e.g. (1995) or (2013)). In an ex-post sense this scheme is clearly redistributive since agents with high market income (above average) will be net contributors, and agents with low market income (below average) will be net receivers. In an ex ante sense the scheme reduces the risk associated with income, and this may make risk averse agents choose to supply more labour to the market. , changing the tax rate has an insurance effect on top of the traditional incentive effect. The insurance effects runs in general counter to the incentive effects. This is illustrated in Figure 6.1 for the standard labour supply problem taking into account wage risk.72 The solid line shows in the deterministic case how labour supply depends on the tax rate, while the dotted line shows how it depends on the tax rate in the case of risk. First, note that without any social insurance and thus a zero tax, labour supply is lower under risk than in the absence of risk. Risk aversion has a dampening effect on labour supply. Second, this reduction in labour supply holds for any tax rate since the insurance arrangement cannot eliminate risk, only diversify it. Finally and importantly, in the presence of risk an increase in the tax rate, and thus the extent of insurance, will make labour supply relatively inelastic until the tax rate reaches a sufficiently high level. In the absence of risk the increase in the tax leads to a reduction in labour supply capturing the incentive effect. 72 Showing a calibration (US data) of the basic textbook labour supply model under standard preferences adopted in the literature but in the presence of wage risk. Bilaga 4 till LU15 Risk sharing and economic performance The reason for the inelastic response in the presence of risk is the counter-balancing insurance and distortion effects of taxation.73 A higher tax has a negative incentive effect and a positive insurance effect, and in the case illustrated the two roughly balance until the tax becomes sufficiently high, in which case the incentive effect dominates. The presence of the insurance effect thus creates a situation similar to the well-known fact that substitution effects are countered by income effects in textbook models of labour supply, cf. Figure 6.1 Labour supply and taxes – the role of risk and insurance Source: (2013). The findings illustrated in Figure 6.1 point out that by disregarding the insurance effect of public intervention, the effects of taxation on labour supply and thus economic performance may be wrongly assessed.74 Most discussions of tax distortions are conducted in deterministic settings, and this may bias the results. A further important implication of implicit insurance is that the relation between efficiency and equity need not be monotone, see 73With high risk or strong risk aversion the labour supply function may even be backward bending. 74This has the important empirical implication that low estimated labour supply elasticities may arise do to a failure to separate between the disincentive and insurance effects of taxes. Risk sharing and economic performance Bilaga 4 till LU15 (1995) and (2013). This is illustrated in Figure 6.2 where the upward sloping part (starting from a situation without the social insurance scheme) arises because the insurance effect dominates the negative incentive effect; that is, an expansion of the social insurance scheme leads not only to more equity ex post (more insurance ex ante) but also to more efficiency by overcoming a market failure.75 At some point, a further expansion would have the incentive effect to dominate the insurance effect, and a trade-off arises in the sense that more equity is achieved at the costs of more efficiency. Figure 6.2 Relationship between efficiency and equity in the presence of insurance effects76 The findings captured by Figure 6.2 have several important implications. First, two countries with different public involvement may display the same level of efficiency measured by e.g. average income but different levels of equity. This may contribute to explain the findings reported in Figure 2.1 showing that the Nordic countries have achieved about the same level of average income but 75It may be questioned whether the above arguments depend critically on an assumption that social insurance can accomplish something which private insurance cannot. Clearly, if such insurance dominance is present, it leaves a clear-cut case for the potential beneficial effects of social insurance. However, even if such dominance is not clear cut, it should be noted that if there is a political to redistribute, it does also imply some insurance, and this does in turn reduce the costs of redistribution (see e.g. Boadway et al. (2006)). 76In (2013) it is shown how such a hump-shaped relation may arise due to the effects of unemployment insurance. Bilaga 4 till LU15 Risk sharing and economic performance with much less inequality than e.g. the US. Second, while it is theoretically possible that the relation between efficiency and equity may display some upward sloping part, it is a possible more important point that insurance effects tend to counteract the standard incentive effects, which implies that the slope of the efficiency-equity locus may be rather small (a flat trade-off). Finally, even though the relation between efficiency and equity has a positive sloped part as illustrated in Figure 6.2, a policy aiming for both efficiency and equity should position the economy on the downward sloping part. The reasoning is simple, since being on the upward sloping part means that both efficiency and equity can be improved, and it is not optimal to be in such a position. Having chosen a position on the negative sloped part of the locus, we have that a marginal policy change involves a trade-off between efficiency and equity, but it is the case that policy overall has contributed to enhance both efficiency and equity. At the macro level the extent of social insurance is captured by the so-called automatic budget-effects or automatic stabilizers. This is a summary concept for the automatic response of public sector revenues and expenditures to a change in the level of economic activity in the economy (the business cycle situation). These responses arise precisely because revenues and expenditures (primarily unemployment benefits) are contingent on e.g. income, unemployment etc. A recession will therefore be associated with a deteriorating public budget position and vice versa. In this way social insurance cushions individual incomes and the consequences of changes in the economic situation are diversified across time and thus generations. On average across the business cycle the budget effects should be averaging out, but some smoothing or insurance has been achieved. Risk sharing and economic performance Bilaga 4 till LU15 Figure 6.3 Size of public sector and automatic stabilizers Size of public sector, % Note: Public sector size measured by the gross tax burden in % of GDP, 2005, and automatic stabilizers as the automatic budget response, i.e. change in budget position relative to GDP to a 1 percentage point change in GDP. Source: Internet: http:// and Girouard and (2005). There are five important facts about automatic stabilizers worth noting: –the size/strength of automatic stabilizers is closely related to the extent of welfare arrangements, cf. Figure 6.3, i.e. countries with more extended tax financed welfare states tend to have large automatic stabilizers; –automatic stabilizers cushion individual disposable income, and therefore serve an insurance function which has a direct positive welfare effect for risk-averse agents. Private alternatives for this type of insurance are highly imperfect and incomplete; see e.g. Dynarski et al. (1997); (1997); Knieser and Ziliak (2002) and and Crossley (2001)). –automatic stabilizers contribute to stabilization of the aggregate economy via its stabilizing effect on disposable income and hence private consumption and aggregate demand (, 2000); Bilaga 4 till LU15 Risk sharing and economic performance –automatic stabilizers mute the consequences of economic crises on income inequality (Dolls et al., 2010); –automatic stabilizers are rule-based, inducing an automatic response to a change in the business cycle situation. , they do not require up-to-date information on the state of the economy, and they do not require any discretionary actions to work. The properties of automatic stabilizers at both the level of individuals (insurance) and society (aggregate stability, distribution) have attracted renewed interest. In the wake of the Great Recession, it has been argued widely that automatic stabilizers are too weak and that they need to be strengthened. However, the size of automatic stabilizers is not a direct result of macro-design, but rather a by-product of policy choices in relation to tax, social and labour market policies. The automatic stabilizers are the net outcome of these choices, and therefore they vary substantially across countries, cf. Moreover, since policy reforms in recent years have had a strong focus on incentive effects without much concern for the implications for insurance, it may be a consequence that automatic stabilizers have been weakened.77 Somewhat paradoxically, automatic stabilizers have been praised at the aggregate level, but disregarded at the micro level in relation to structural reforms. In the case of reduction of taxes and the real value of social transfers have in recent years contributed to a reduction in the automatic stabilizers.78 For automatic stabilizers to work, it is important that public finances are in a position to absorb the implied budget changes. A precondition for well-functioning automatic stabilizers is a fiscal policy ensuring consolidation in good times, to create the absorption capacity in bad times. It is a necessary condition for the 77Using estimates of automatic stabilizers (see van der Noord (2000) and Girouard and (2005)), the average size across countries is unchanged between 2000 and 2005. However, there seems to be a systematic pattern since countries with initial weak automatic stabilizers have tended to get stronger automatic stabilizers, whereas they have been muted for countries with initial strong automatic stabilizers. 78According to estimates by (2013) the budget sensitivity has been reduced from about 0.8 over the period 1996-2006 to about 0.4 over the period 2007-2012. Risk sharing and economic performance Bilaga 4 till LU15 public sector to provide a buffer function muting the consequences of business cycle fluctuations for private actors. It is also an important corollary that if a situation with low employment becomes persistent, then the budgetary consequences will be dire; cf. Figure 3.7 showing how the budget is affected by variations in employment. Persistence – failure to adjust It has been argued that the short-run stabilization ensured by automatic stabilizers comes at the costs of a reduced adjustment capability, which in turn produces more persistence in business cycle fluctuations; that is, they become more long-lived. and Sargent (1998) describe a generous welfare state as a “time bomb” in the sense that it may operate efficiently in tranquil times, but be vulnerable to turbulence which easily translates into persistent unemployment.79 The latter is caused by weakened job search activities and higher reservation wages due to a generous social safety net. In particular, shocks tend to depreciate skills and thus require workers to accept a wage cut to find a new job, but unemployment benefits depending on past wages tend to create inertia in the adjustment of reservation wages. As a consequence, the safety net the process of restructuring the economy. It is also asserted that a generous tax financed social safety net reduces mobility across jobs (and Sargent, 1995). This may contribute to reduce frictional unemployment, but induce higher structural unemployment in a situation with turbulence. A different explanation of persistence has been advanced by pointing to the role of norms in counteracting the incentive effects of a generous social safety net (see e.g. (1995) and et al (2003)). A strong norm to be self-supporting counters the economic incentives created by a generous scheme. 79 A possibility of multiple equilibria also arises when taking into account the financing of the safety net. Similarly, if incentive problems are countered by costly monitoring, the effectiveness of such monitoring is higher at low levels of unemployment reinforcing this situation, and oppositely in a situation with high unemployment (and Sargent, 1995). Bilaga 4 till LU15 Risk sharing and economic performance Allowing for the norm to be endogenous and depending (possibly with a lag) positively on the number of individuals being selfsupporting imply that a generous social safety net can be maintained if the employment rate is high. However, if employment falls due to e.g. a severe business cycle downturn, norms may be eroded, and the welfare state is caught in a situation with persistent non-employment and fiscal problems. However, evidence does not support that business cycle fluctuations are more persistent in the Nordic countries with stronger automatic stabilizers, see e.g. (2012). The evidence thus point to important effects of automatic stabilizers both at the individual level and for macroeconomic stability. type of insurance – private or social – suffer from potential problems due to moral hazard and adverse selection. The problems basically arise due to lack of information about individual characteristics or behaviour80 which is a source of market failures in private insurance markets which in some cases leave an argument for public or social insurance. However, both problems are also important for social insurance, and are therefore important in policy design. The selection problem is that insurance may attract particular groups e.g. with a high probability of an event occurring, while those with low probabilities opt out. Consequently it may be difficult to establish an arrangement diversifying risks. For social insurance selection is not possible for insurance arrangements running via the tax side since it mandatory81 (enforced pooling equilibrium). However, for use of other arrangements there may be selection effects. As an example social transfers may be more attractive to individuals with a strong preference for leisure. 80In the case of moral hazard the insurer may perceive the behavioural consequences, but it is difficult (costly) to condition the insurance contract on behavioural variables since they are difficult to monitor and thus to verify. 81Strictly speaking there is an exit option in the form of migration. This is of importance for the scope of social insurance, but it is beyond the scope of this paper to discuss this aspect in detail. Risk sharing and economic performance Bilaga 4 till LU15 Moral hazard problems arise when insurance makes individuals change behaviour either by not taking sufficient action to prevent a given event happening or affecting the consequences if the event happens, e.g. insufficient job search, neglecting advice on life style etc. Moral hazard problems arise for both private and social insurance, in the latter case they are often termed tax distortions. It is worth observing that the debate often stresses the incentive problems arising under social insurance without noting that the same problems would in principle arise if the insurance is organized in a private market. The moral hazard problem arises due to a common pool problem and is in this sense generic. This does not, however, imply that one should not take moral hazard problems seriously, but only that the incentive problems arising under social insurance should be evaluated under realistic assumption of the alternatives. Policy designs are important for the incentive problems arising from insurance. Such design issues are reflected in actual policy schemes. Much attention has been attached to the generosity of the transfer levels in extended welfare states like the Nordic, and they are sometimes portrayed as paying people for not working (Rogerson, 2007) or as making work unnecessary (Esping- , 1990). This effectively amounts to assuming that there is a basic income or demo grant, implying an unconditional minimum income for everybody. This is a poor characterization of social insurance in the Nordic countries, which includes numerous conditionalities; that is, although eligibility is in the sense that all have a formal right, there are conditions to be fulfilled to qualify for the transfers. These conditions apply both to the situation in which the person or family finds itself (selection), but also to behavioural variables like job search, participation in education programmes etc. (moral hazard). The gateway into more permanent types of support like disability pension is narrowed by screening of conditions, external monitoring etc. Obviously, this does not completely eliminate all incentive problems, but it does point to important design issues, which are crucial in striking a balance between insurance and incentives. As an example, it may be worth to highlight two important dimensions of social insurance in the Nordic countries. First, as in most countries, the basic social transfer (social assistance) is means Bilaga 4 till LU15 Risk sharing and economic performance tested on a family basis. Second, there are crucial workfare elements in the design of social insurance; that is, the right or entitlement to a transfer is accompanied by a duty or requirement to participate in certain activities to receive the transfer. Such conditionalities serve to reduce both moral hazard and adverse selection problems.