The Welfare State Must Be Designed To Take Account Of Private Incentives

Many of the accusations made against the welfare state, in Sweden and elsewhere, are exaggerated. The lesson from the Swedish experience is not that the welfare state does not work nor that it should be dismantled. Rather, it is that the institutions of the welfare state must not be designed in a way that neglects the role of private incentives. These are the conclusions of Professor Jonas Agell, writing in the latest issue of the Economic Journal. Agell notes that supporters of the welfare state used to take comfort in the Swedish experience. By the early 1970s, Sweden was one of the richest countries in the world, unemployment was spectacularly low, and the income distribution was equitable by any standard. Now all that has changed. Sweden has recently suffered its most severe economic downturn since the 1930s. According to many observers, Sweden is now paying the price for an obsession with income equality and social protection.

It is surprisingly hard to substantiate the popular claim that countries with high aggregate tax burdens and public spending levels have a poor aggregate growth performance. Over the period 1970-90, Swedish growth was below the OECD average. At the same time, the public sector was very large.

But there is no easy way of proving that there is a causal link from the latter observation to the former. Economic growth depends on many factors besides the public sector, and it is not meaningful to make simple correlations between growth and indicators of public sector involvement. This point is borne out in recent work on cross-country growth: evidence from aggregate OECD data allows no conclusion on whether the relationship between
growth and the public sector is positive, negative or non-existent.

In spite of this, even a sympathetic observer had reason to worry about certain features of the Swedish welfare state. A careful reading of the kind of microeconomic and econometric evidence that belongs to the bread and butter of a public finance economist suggests that some parts of the welfare state had expanded to the point where they risked imposing significant efficiency losses at small or no gains in equality:

  • First, the behavioural responses reported in recent studies of labour supply are consistent with the view that the very high Swedish marginal tax rates had far from trivial negative effects on economic efficiency.
  • Second, the non-uniform tax treatment of the returns on different assets produced tax arbitrage and distributional inequities, and led to an inefficient allocation of scarce investment resources.
  • Third, the extensive system of social insurance contained hardly any mechanisms to discourage misuse.
  • Fourth, the government''s way of subsidising unemployment benefits gives unions a strong incentive to strike excessive wage deals.

Agell believes that in most of these cases, recent reforms to the Swedish welfare state have
restored the balance.

''Why Sweden''s Welfare State Needed Reform'' by Jonas Agell is published in the November 1996 issue of the Economic Journal. Agell is Professor of Economics at Uppsala University, Sweden.