Social transfers and the welfare state

The points made in the previous post on net contributions paid and entitlements received got me thinking on the whole debate regarding transfers and their outburst during the recent crisis. As the quote from Makiw has shown, accounting for net transfers while calculating the progressiveness of the tax system paints a more precise picture of the US redistribution of income (amid all the controversies over how those numbers were calculated). Even though the number for transfers to the bottom quintile group is biased upwards, it is still nonetheless true that on average lowest quintile groups receive more from the government than what they contribute to. And this is fair in some instances where people are disabled or for other reasons unable to work (retired or children). But the escalation of transfer payments towards a rising 'army' of unemployed can have negative long-term consequences as well. 

The following graph shows an expected inverted relationship between rising unemployment (i.e. at declining employment population ratio - red line) and increasing transfers (blue line). An obvious interpretation would be that as more people lose their jobs, the state has to divert more resources to unemployment benefits and other welfare programs which is increasing the pressure on the budget (engage into counter-cyclical policies). 

Source: St. Louis Fed, FRED Database

Short-term spikes in transfers (such as the 2008 tax rebate) didn't do much to stop rising unemployment (or in the case of the E-P ratio, to stop the increase of discouraged workers), a point that was proven earlier on this blog by comparing spikes in temporary income and its effects on consumption. 

Looking at the graph, one can't help at wonder does the argument go the other way since the E-P ratio puts a stronger emphasis on people leaving the workforce. In particular, did the people quite the workforce to live off entitlements? In this case, certainly not. In a crisis people don't typically chose to quit their jobs to end up on social benefits. But the problem starts to arise if this increase in social transfers becomes permanent. From the looks of the graph, this is becoming more and more likely as both variables, transfers and discouraged workers, seem to be stabilizing. 

The graph further shows that (1) the employment-population ratio is a much better labour market indicator than the unemployment rate (a point made on this blog many times before) since it perfectly depicts the strength of the labour force, and (2) the gap between those who work and those who receive transfers (not in scale) is far too unsustainable at the moment. This draws implications on another important debate - the fiscal deficit and public debt unsustainability. With a severely distorted labour market, lack of incentives, and  ageing baby-boomers, the deficit will become unsustainable even in the short run.

Does this mean that the US is turning into a European-style welfare state? It is true that a lot of blame for an escalating budget deficit is due to the crisis, but large entitlement programs and war spending started way before the crisis and the current administration. The accumulation of Medicare, Medicaid and Social Security programs inspired Alex Tabarrok from George Mason University to call the US a Warfare-Welfare state (he adds to the three biggest spending programs expenditures on defence, the second largest budget outflow), in opposed to what it used to be - an innovation state.

Source: Alex Tabarrok, "The Innovation Nation vs. the
Warfare-Welfare State", The Atlantic , January 26th 2012. 

The following graph shows what he aims at. He compares the warfare-welfare expenditures to those on innovation (science and medical research for example). Even though some funds in defence spending are allocated towards R&D, this is highly unlikely to have spillovers beneficial to the rest of the economy. The urban myth that the internet was created by a state funded defence agency is proved to be untrue. On the other hand, innovation and research in fields like health care can go a long way into solving the US health care issues. Tabarrok makes a clear case: 

"From an innovation perspective, two facts about health care are of importance. First, a huge amount of health care spending is wasted. A strong consensus exists on this point from health care researchers along the political spectrum. Hundreds of billions of dollars are spent on health care today with little or nothing to show for it in terms of improved health. Second, although spending more on health care today doesn't get you much, spending more on health care research gets you a lot. The increases in life expectancy from fewer deaths brought on by cardiovascular disease over the 1970-1990 period, for example, were worth over $30 trillion... In other words, the gains from better health over the period 1970-1990 were comparable to all the gains in material wealth over the same period."

The essential point from creating a welfare-warfare state is constant fighting over how the pie should be divided. But the true challenge is to try and make the pie bigger - that's the point of innovation. And that's the real issue average Americans should think about - why is the US becoming less and less competitive and less and less innovative. The substantial increase in transfer payments during the current crisis certainly didn't help. And while the argument that transfer payments caused the people to drop work is certainly false, it may keep them out of work for much longer. As soon as they get used to living off the state, a lot will "become discouraged" and continue to do so, which will seriously undermine the country's competitiveness, not to mention what it will do to the budget deficit. In short, they will turn into a European-style welfare state, very vulnerable to outside shocks and very far away from the innovative forces that drove the US forward all these centuries.