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Institutions and government spending in 20 th century 17 th December 2012.

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1 Institutions and government spending in 20 th century 17 th December 2012

2 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

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

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6 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

7 Examples of such spontaneous development Changes to taxes Changes to expenditures

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12 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

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14 Expenditure: spending on welfare Biggest items as a % of GDP of OECD countries: – Year – Public pensions – Unemployment benefits1.8 – Basic assistance (welfare)2.9 – Healthcare – Public housing1.0 – Public education

15 Life expectancy and retirement in Europe

16 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

17 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

18 Education

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20 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

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22 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)

23 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

24 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

25 Deficit as % of GDP in OECD

26 Same stats, PIIGS

27 Same stats, chronic offenders

28 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

29 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)

30 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

31 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”, 17 th March 2011, The Economist OECD website


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