sou · H3B353en · 2015-06-04 00:00:00 — to all22, ii) a public sector activity which does not affect marginal utilities of individuals, or iii) a public activity like day care affecting the marginal utility of leisure (spending). As is seen the effects are very different. When the tax finances a lump-sum transfer to all citizens, the income effect is neutralized and only the substitution effect is at play. If the tax finances a general public activity which has no influence on individual decision making23, the counteracting income and substitution effects determine the outcome. As discussed below, a large share of public consumption is individual in nature, implying that this case poorly represents the workings of the welfare state. Figure 4.1 Employment and taxes Note: Numerical illustration based on simple textbook model of labour supply where a proportional income tax either finances transfers, general public activities or spending reducing the marginal disutility from work. General public activities are defined by not affecting marginal utilities from consumption or leisure. 22When tax revenue is handed back as a lump-sum transfer to all individuals, only the substitution effect is released. An expansion of this system will lead to a higher tax, and thus unambiguously a lower labour supply. 23Usually modelled by separable preferences where the utility derived from general public activities is additively separable to utility derived from private activities. As noted below this is a poor approximation of a large part of public activities. Welfare state arrangements and economic performance Bilaga 4 till LU15 If public spending affects individual decision making, there are additional effects, and some tax financed activities may boost labour supply or imply a non-monotone response to the tax rate. As a case in point, the expansion of public day care and old age care facilities in the Scandinavian countries are often mentioned as preconditions for the increase in female labour force participation rates (see e.g. Rosen, 1996).24 It can also be interpreted in the sense that economies of scale in child and old age care are exploited, which makes it possible in net terms to expand labour supply25 and therefore strengthen the financial basis of the welfare model. The public provision of child care has also been motivated in terms of learning and socialization as well as gender implications by shifting a traditional task for which women have traditionally been mainly responsible out of the family sphere. The arrangements help account for the fact that female labour force participation rates in the Scandinavian countries are high in international comparisons. Likewise health activities may have an effect on labour supply. This underlines the point that statements on the effects of taxes on labour supply and employment cannot meaningfully be made without taking into account what the taxes are financing. It also points out that care has to be exerted in interpreting estimates of labour supply elasticities. If the estimates do not explicitly account for what taxes are financing, the estimates implicitly reflect how tax revenue historically has been spent on various purposes (see also Section 4.3. below). These estimates may be misleading when used to evaluate the effect of tax changes financing a different composition of public activities. Evidence on the marginal effect of changes in taxes – other things being equal – is useful for some purposes, but not when addressing the big question of taxes and economic performance in a cross-country perspective. In short, theoretical work on labour supply distortions is often misused in policy advice, and empirical evidence on labour supply elasticities may be highly problematic inputs to evaluations of policy. 24And a reason why fertility rates are relatively high in the Nordic countries. 25Jaumotte (2004) finds that policies which stimulate female participation include a more neutral tax treatment of second earners (relative to single individuals), tax incentives to share market work between spouses, childcare subsidies, and paid parental leave. Bilaga 4 till LU15 Welfare state arrangements and economic performance The cradle-to-grave property of the welfare state depicted in Figure 3.4 is a core element of the welfare model. The design of the welfare state implies a clear age dependency in the netcontributions; that is, the average person is a net beneficiary when young and old and a net contributor when in the working age group. This arrangement is in its nature Pay-As-You-Go (PAYG); that is, the net contributions of those in the working age group26 cover the expenditures to the young and old.27 This interdependence may be termed a social or implicit contract across generations embedded in the welfare state.28 The traditional family responsibilities of the parents to take care of their children and their own parents have been institutionalized in the welfare state. Is there any efficiency gains associated with this arrangement, or does it only serve a capital market purpose? To answer this question it is useful to start by considering the expected present value of the net transfer received by a newborn. In this case the net-contributions shown in Figure 3.6 are weighted by the survival probabilities, and the present value is computed under various assumptions on the discount rate, cf. A newborn Swede has an expected present value of net benefits from the arrangement equal to or more.29,30 Simple intuition would have that such a gain should not be possible. If newborns are net-beneficiaries receiving more than they are contributing in expected present values terms, how can the welfare arrangement be financially viable? Actually it is, as can be seen from assessment of fiscal sustainability (, 2014). 26The larger share of revenue financing the welfare state accrues from the direct or indirect taxation of earnings while in the work age group, cf. Some taxation may be delayed, e.g. taxation of consumption. 27Clearly the system does not have a strict balanced budget constraint, and deficits/debts are possible. However, the nature of the system is PAYG. 28There is an issue of political support for this contract which has been addressed in a large literature, see e.g. (2003) and Kaganovich and Zilcha (2012). 29Similar computations for show that the expected net present values of the net benefitsfor a newborn are about , see and Bhattacharya (2015). 30This is of the same orders of magnitude as found in generational accounting analyses, see Haigst et al. (2012). Welfare state arrangements and economic performance Bilaga 4 till LU15 Expected net present value of social contract, newborn, Expected net present value, Note: The relevant discount rate is the growth corrected real rate of interest. Computed based on population forecasts from Statistics and age-dependent net contributions to the public sector from (2011). The number should be interpreted as the expected present value of net contributions of an average newborn in 2008 with survival probabilities as in the forecast and the present welfare arrangements. To explain these findings consider a very stylized case where the population is stripped down to consist of two age groups only, labelled young and old, respectively. Each period young are born, and the old disease. Make the two groups equal in size, implying that the population size is . Assume that each young contributes in taxes, and all old receive a pension of 100 SEK. Clearly the budget balances, the PAYG constraint is met, and the system is financially viable. The present value of net transfers for a newborn is -100+100/(1+r)<0 for any discount rate r>0; i.e. in present value terms the newborn will be a net contributor for any positive discount rate. If instead each young receives education of value when young paid by taxes of levied on the old, the present value of the net transfers received is 100- 100/(1+r)>0 for r>0; i.e. the individual is a net beneficiary from the system in present value terms for any discount rate. This simple example brings out two important points, namely i) even under a strict PAYG condition ensuring financial viability of the system, the present value of net contributions/transfers of a newborn can be different from zero31, ii) if the present value of the net contribution is negative, cf. Table 4.1, it suggests that the implicit contract is front loaded; i.e. the net-benefits received early in life matter more than those received later in life. The front-loading of the social contract is crucial. Consider Figure 4.2 which gives a very stylized version of the social contract in Figure 3.6 to point out that it can be interpreted as being composed of two contracts, a forward and a backward (implicit) 31 Clearly the reverse does not hold. A non-negative expected present value of net transfers need not be consistent with a balanced budget. Bilaga 4 till LU15 Welfare state arrangements and economic performance By forward is understood that something is received before contributing, and oppositely for the backward contract. The forward contract thus has a borrowing element, while the backward contract has a savings element. The social contract implied by the Swedish welfare model includes both the forward and the backward contract, c.f. Figure 3.6. The computations reported in Table 4.1 show that the forward part of the contract is dominating. Figure 4.2 The elements of the social contract The fact that the social contract can be seen as a combination of a borrowing and a savings element is sometimes interpreted in the sense that the welfare state is basically performing a capital market function shifting resources over the life-cycle. This interpretation raises two questions, namely whether there are imperfections in the capital markets justifying public intervention, and whether there are any systematic return differences between the PAYG system and capital markets. These two arguments are considered in turn. An important contribution by Boldrin and Montes (2005) demonstrated that the social contract can overcome capital market imperfections. If capital markets are incomplete, perhaps in the Welfare state arrangements and economic performance Bilaga 4 till LU15 extreme form of not making borrowing possible at all, then clearly educational investments are suboptimal. Boldrin and Montes (2005) showed that an implicit contract where the young receive education, the middle-aged pay taxes while the old receive a pension can replicate the allocation arising under complete capital markets.32 The reason why both education and pension should be in the package is that introduction of tax financed education would benefit inaugural generations receiving education but would harm the first generations financing this (paying taxes but receiving no education). To ensure that no cohort is made worse off by the investment in education, the middle-aged tax payers can be compensated by a pension when old (to be paid by the then middle-aged having received public education), and thus be made indifferent to the introduction of the implicit contract of the welfare state. This is a striking result. An implicit welfare contract including both education and pension overcomes market failures and can be implemented without making any cohorts worse off and some better off and thereby release long-run gains. An immediate corollary is that an economy with such a contract obviously has a larger public sector, but also higher output due to the higher investments in education. An obvious comment to this finding is that while capital markets may have been very incomplete historically, it is less clear that this is so today. This seems to diminish the gains from the social contract. Moreover, if there are problems in financing education, it may seem more obvious to address this problem directly (e.g. state guaranteed borrowing arrangements) rather than via a complex social contract.33 Finally and crucially, while the result by Boldrin and Montes (2005) is striking, it does not fully capture the essence of the welfare state. The social or implicit contract in Boldrin and Montes (2005) has a zero present value to the newborn, stressing that it serves a capital market function only. But as shown above the actual social contract in has a positive expected present value of net transfers, suggesting that the contract is doing more than replacing missing capital markets. 32For a discussion of how this result depends on the source of capital market imperfections, see Andalfatto and (2006) and (2013). 33Note the difference to the discussion on welfare accounts which usually focuses only on the savings (and insurance) aspect, see e.g. Bovenberg, and Sørensen (2008). Bilaga 4 till LU15 Welfare state arrangements and economic performance To explore this further, note first a well-known result in the economics of pensions. The implicit return in a PAYG arrangement is basically the growth of the wage sum.34,35 In a dynamically efficient economy this return is below the market return. An immediate implication is that implicit saving in a PAYG arrangement has a lower return than explicit savings in the market. Therefore public PAYG pensions are return dominated by funded pensions.36 This implies that PAYG public pensions lower longterm welfare.37Turning this argument on its head, it implies that implicit borrowing in a PAYG arrangement takes place at a lower return than explicit borrowing in the market. This suggests that the forward part of the implicit contract is potentially welfare improving, while the backward part is not38 (for a formal demonstration see and Bhattacharya, 2015). In economies with finitely lived agents, the market allocation (even in the absence of market failures) does not reach the Golden Rule allocation (or modified Golden Rule) where steady state utility is maximized, see e.g. and (1989). The capital stock is too low; that is, savings are not sufficiently high. Finitely lived agents do not take into account the future welfare gains a higher capital stock will induce. This result generalizes when considering not only investments in real capital but also other forms of investments like human capital or health. The suboptimal levels of investment potentially leave a room for public intervention to move the economy closer to the Golden Rule, that is, to increase long-run or steady state welfare. This holds even if capital markets are perfect and public and private activities in e.g. education and health are perfect substitutes, implying that the public activities on a one-to-one basis crowd out private activities 34The revenue base is in reality somewhat broader, but this does not change the thrust of the argument. 35The Swedish Pension system is also build around this principle, since the growth of the wage sum is the basis for regulation of the income pension. 36This is the well-known Aaron (1966) result and underlies arguments for transition from PAYG to a funded pension system, see e.g. Feldstein (1995). 37This result may be modified taking into account non-diversifiable risk as well as distributional concerns. 38This is a fundamental issue in pension reforms. The Swedish pension reform ensures that the system can cope with demographic changes and align pension to labour income (consumption smoothing), but it is effectively a PAYG system and thus return dominated by a funded system. A shift to a funded system would, however, create a transition problem. Welfare state arrangements and economic performance Bilaga 4 till LU15 (see and Bhattacharya (2014) for the case of health). This is thus a qualitatively different argument than when public intervention is rationalized in overcoming market failures. It is pivotal that public intervention leads to a higher level of education or health investments than in the laissez-faire situation where it is sub-optimal. Steady state welfare improvements are associated with the forward part of the contract, and thus the fact that borrowing in the PAYG system takes place at a lower return than in the market. It is an implication of this, that public intervention and thus a larger public sector may be associated with higher output and consumption. Public intervention may move the economy closer to the Golden Rule allocation even when markets are complete but agents have finite horizons. Notice an important difference between the forward and backward contract. The backward contract is easy to implement since some inaugural generation benefits without having to contribute, and oppositely for the forward contract. Releasing the potential long-run gains from the forward part of the contract may be associated with losses to current generations. Therefore the backward contract may play a crucial role in implementation since it can be used to compensate those financing the first increments in public investments. In and Bhattacharya (2015) it is shown that it may be possible to propose policy packages which release long-term improvements in welfare moving beyond the laissez-faire under the demanding constraint that no cohorts are worse off than in the absence of the intervention. These packages include both the forward and the backward parts, but it is an implication that the backward part can be phased out eventually. Crucial for this implementation result is the presence of some externality from education or health which produces sufficient gains to compensate for the higher taxes needed to finance the investments. The nature of the cradle-to-grave model is thus not only that it redistributes across the life-cycle and in this way performs a capital market function. This role is important in itself, but in addition it may release gains from investments in the young which are not feasible even under complete private markets. Welfare state arrangements may in this way be associated with welfare gains, and Bilaga 4 till LU15 Welfare state arrangements and economic performance this helps explain why countries with extended welfare states display favourable economic performance indicators. 4.3Empirical evidence on public sector size and growth What is the impact of the public sector (size and structure) on the composition, level and growth rate of economic activity? A controversial question39 with obvious policy implications. The preceding discussion brings forth the complexity between the size and structure of the public sector and economic performance. Taxes distort incentives40, but public activities may through various routes overcome market failures or in other ways improve economic performance. Ultimately it is an empirical question how these various effects interact. There is a vast empirical literature exploring how the public sector size and its composition affect economic performance usually captured either by per capita income levels or growth rates. Growth effects imply level effects, but not vice versa. Therefore growth effects are potentially of much larger potential effects since they accumulate over time. The level versus growth divide is mirrored in the difference between exogenous and endogenous growth models. In exogenous growth models population growth and technological progress determine the growth rate. Fiscal policy may via various channels affect the level and composition of economic activity, but in general not the growth rate (of course it may affect population growth and technological growth, but this is usually taken to be of secondary importance). In endogenous growth models policy may affect growth rates. The endogenous growth models stress external effects and spillovers, implying that factors of production which can be accumulated (e.g. physical and human capital) are not displaying decreasing returns to scale. If policy affects the accumulation of these factors of production, they affect growth 39See the exchange between Fölster and Henrekson (1999) and Agell, and (1999) as well as between Korpi (2004) and and (2005). 40In some cases this is desirable e.g. in relation to environmental regulation, withso-called Pigou taxes addressing various forms of market failures. Welfare state arrangements and economic performance Bilaga 4 till LU15 Obvious examples include public investments in infrastructure which may increase the marginal product of private capital, and therefore release the endogenous growth mechanism (see (2008)). A similar mechanism may be generated via human capital (Barro (1990) and Barro and Sala-i-Martin (1992)). Since the public sector is heavily involved in the accumulation of human capital via education, it follows that the public sector size and structure may matter for growth rates (for a survey see e.g. Zagler and Dürnecker (2003)). The effects of policy may be direct via e.g. human capital or infrastructure which enters the production function, but also indirect via influences on factor markets (labour supply) and thus accumulation of various forms of capital. These effects have to be weighed against the distortionary effects of the taxes financing these activities. Both the level and structure of government expenditures are thus of importance. This opens for a variety of channels through which public sector activities can affect growth rates in the upward or downward direction both from the expenditure and revenue side. This reasoning suggests a distinction between /productive and passive/non-productive expenditures, cf. Figure 3.5, and distortionary and non-distortionary forms of revenue. In the simple form productive expenditures enter directly into the production function, while non-productive expenditures do not. Distortionary forms of taxation affects savings-investment decisions, while non-distortionary do not (see e.g. Barro (1990)). While the distinction between the two forms of expenditures and revenues helps explaining the mechanisms, it is often blurred since it is model-specific and it is ultimately an empirical question41. Still it makes the point that one cannot make inference on how economic performance depends on the public sector from aggregate measures of revenues and expenditures. The composition of both sides of the budget matters. Productive expenditures42 may thus enhance growth if they are financed by non-distortionary 41Under some assumptions e.g. consumption taxes may be inconsequential for growth, in others they are not (see e.g. Zagler and Dürnecker (2003)). 42In empirical work (see e.g. Kneller et al. (1999), Bleaney et al. (2011) and Gemmell et al. (2011)) productive expenditures include general public expenditures, defence, education, health, housing, transport and communication. Distortionary taxation includes taxes on income and profit, social security contributions, payroll taxes and taxation of property. Bilaga 4 till LU15 Welfare state arrangements and economic performance taxes, and distortionary taxes reduce growth if they are financing non-productive investments, cf. If productive expenditures are financed by distortionary taxes, a non-linear relation may arise where growth is at first increasing and later decreasing in the level of productive expenditures. The reason is that the initial marginal impact of such expenditures may be large, while the distortions are increasing in the tax level. This produces a so-called “growth hill”, see e.g. Bania, and (2007). Notice the observational equivalence between this distinction and the forward/backward distinction pertaining to the implicit social contract. The front-loaded expenditures like education and parts of health expenditures are examples of or productive expenditures, while e.g. pensions belong to the passive or nonproductive expenditures. Whether the empirical findings are to be interpreted as reflecting a growth effect or a static efficiency gain is open to debate. Table 4.2 Growth effects of public expenditures and revenues