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Cut the Spending, Spare the Poor

PARIS – Why do some governments spend more than others? The question is more complicated than it appears, especially in the case of European governments. The answer may look obvious when comparing, say, Denmark (where public spending, excluding interest payments on debt, amounted to 58% of GDP in 2012) and the United States (where the same number was 35%). Extensive public services and a comprehensive welfare state appear to be the indisputable explanation. The data seem to vindicate German Chancellor Angela Merkel’s famous statement that Europe’s problem is that it accounts for 7% of the world’s population, 25% of its GDP, and 50% of its social spending.

From this perspective, European governments face an uncomfortable choice. Most are seeking ways to contain public indebtedness, trim deficits, and cut spending without making their poorer citizens worse off. But, judging by the experience of the US and other non-European countries, they may have to choose between insolvency and inequality. Having reached the point at which taxes can scarcely be increased further, these governments cannot both repay their debts and keep welfare spending at current levels.

The answer, however, is less obvious when comparing European countries to one another. Most share a preference for socializing risk and an aversion to inequality – the pillars of the “European social model.” Yet their public-spending levels differ significantly.

The highest spender is Denmark, with its 58%-of-GDP mark, which is a whopping 13 percentage points higher than in Spain. Even more striking perhaps, French public bodies spend 12 percentage points of GDP more than those in Germany, with no significant difference in outcomes in terms of health, education, or poverty. This suggests that some countries are more efficient at social welfare than others.

Furthermore, some countries have succeeded in reducing their public spending significantly without changing their social model altogether. Swedish public spending is nine percentage points lower than it was in 1995. There were welfare-spending cuts along the road, yet the country still ranks at or near the top of most development indicators and continues to be perceived as a social-democratic role model.

This is not to say that all European countries provide the same social safety net. Unemployment benefits or public pensions are not identical in, say, Ireland and Finland. But differences in public-spending levels are not matched one for one by differences in social outcomes.

There are several explanations for that. One is the sheer cost-effectiveness of public programs. Some health-care systems are simply better managed than others, because expensive equipment is used more intensively, patients are provided with generics instead of premium drugs, and timely prevention helps contain treatment costs. More efficient health care does not presuppose higher inequality; on the contrary, it may reduce inequality.

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A second reason for the significant differences in European countries’ spending levels is that public and private expenditure can be highly substitutable. Contributions to a public pay-as-you-go pension system are very similar to those made to a mandatory private insurance system. For example, one reason why France spends a lot on public pensions is that there are virtually no private pension schemes in the country. If employees were mandated to subscribe to a company or industry fund, public spending would mechanically drop, but not much would change.

True, public pension schemes generally involve some degree of redistribution. But they mostly take money from employees when they are active to redistribute it to them when they retire. The difficult question is whether employees in fact regard these contributions as their own savings or merely as taxes – in which case they may discourage labor or create incentives to work in the black economy. In any case, if desired, substitution of private for public pension schemes may help reduce government spending without major distributive effects.

A third reason for the disparities in European public-spending levels is that governments often aim at alleviating the consequences of market inefficiencies – and miss the mark.

Consider housing. Public programs are necessary to provide affordable housing to the poor and the young and to help foster energy saving. But they often do much more: they provide unnecessary support to middle-class households – or, worse, subsidize landlords indirectly by helping tenants pay the rent. The same applies to labor-market or enterprise policies.

Public spending in these cases does not serve its stated aims; rather, it finances middle-class welfare or even capital owners’ welfare. Cutting such spending may be difficult in the short term, but it can be achieved without adverse social consequences in the medium term.

In the end, it is difficult to disentangle the various causes of higher public spending in some countries relative to others. Clearly, some social models are more generous than others, and some are more efficient than others. But, though some governments have no choice but to cut inequality-reducing programs, and others may find it more politically expedient to change the distribution of income than to enforce efficiency, much can be done to improve the cost-effectiveness of public spending before reneging on a social contract. Europe’s governments can still trim public spending without undermining the European social model.

Jean Pisani-Ferry teaches at the Hertie School of Governance in Berlin, and currently serves as Commissioner-General for Policy Planning in Paris. He is a former director of Bruegel, the Brussels-based economic think tank.

Copyright: Project Syndicate, 2014.

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