111

Ec426 Public Economics

2Can welfare states compete in a

global economy?

222

1. Globalisation as threat to the welfare state2. Impact of globalisation on non-welfare state

(“US”)3. Impact of globalisation on welfare state

(“Europe”)4. A richer model5. Importance of institutional structure:

unemployment benefits

Plan of lecture

333

“The panoply of social programs, benefits and protections designed to cushion Europeans from the harshest effects of their capitalist economies have become enormously expensive and, in some cases, their consequences extremely perverse” (Newsweek, 20 December 1993).

1. Globalisation as threat to welfare state

Two different argumentsArgument A: Tax Cost

That welfare state has too high a tax cost.

Argument B: Specific effect

That welfare state benefits have negative effects on economic performance.

4

Tax as % GDP =

Replacement rate x dependency rate

+

Other government spending/GDP

+

Cost of tax expenditures/GDP

+

Cost of debt interest/GDP

Tax cost argument

5

Globalisation (G) Economic performance (EP)

Welfare state (WS)

∂EP/∂G < 0

and

∂2EP/∂G∂WS < 0

Need to examine economic impact of globalisation, first in absence of WS.

Specific cost argument

666

Open economy:

Assume goods and services traded (with zero transport costs), but that factors immobile. Immobility reasonable first assumption for labour, on which focus to begin with, as literature has highlighted labour market and the differential impact on skilled and unskilled workers. Cause of increased wage dispersion in US.

2. Impact of globalisation on non-welfare state (“US”)

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X/Y

pX/pY

wS/wU

Assume small country: facing given world relative price for output

Pricing

wS/wU

Re-label GE two factor model:

skilled and unskilled labour

Assume X more intensive in unskilled labour

pX = cX(wS,wU); pY = cY(wS,wU)

Eg Cobb-Douglas case

pX= wUα wS

(1-α) ; pY = wUβwS

(1-β)

pX / pY = [wS/wU]β-α

X is intensive in use of unskilled labour if α > β

Domestic demand

Production

Trade: import of X, export of Y

88

X/Y

pX/pY

wS/wU

Effect of globalisation

Pricing

wS/wU

Effect of increased competition in production of X by NIC

Skilled wage premium rises and trade increases

99

X/Y

pX/pY

wS/wU

Pricing where both goods produced

wS/wU

Different where specialisation.

Cobb-Douglas case

“Supply” curve

Effect of globalisation

wS/wU =

[(1-β)/β

/LS/LU]

unaffected by global competition

●

●●■ ■

1010

X/Y

pX/pY

wS/wU

Export X

Pricing

wS/wU

Country faces offer curve

Trade in balance

Import X

Domestic demand

Domestic + Foreign demand

1111

X/Y

pX/pY

wS/wU

Effect of globalisation on final demand (domestic + foreign)

Pricing

wS/wU

Effect of globalisation where country faces offer curve

Skilled wage premium rises and pX/pY falls

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Implications for personal income distribution

It is not just a matter of ws/wu. The personal distribution depends on the numbers of skilled and unskilled workers. There are LS with wage wS, LU with wage wU. Denote ratio wS/wU by ω, and ratio LS/LU by ℓ. Then total income is wU (ωLS+LU) and share of unskilled is 1/[1+ωℓ].

Gini coefficient is equal to the difference between population share and income share, which is

[ω-1]ℓ/[(1+ℓ)(1+ωℓ)]

Depends on ω but also on ℓ.

“Trade” explanation of

increased earnings dispersion.

Lorenz curve

131313

Krugman (1994 and Brookings Papers on Economic Activity, issue 1, 1995) argued that Europe differently affected by globalisation on account of welfare state.

Welfare state here represented by unemployment benefit at rate b (in real terms), financed by a payroll tax levied on workers at rate tS or tU, so that the net wage becomes w(1-t).

BUT

First have to ask: why is there unemployment?

3. Impact of globalisation on welfare state (“Europe”)

14

Unemployment benefit and reservation wage

In the textbook Krugman model, the only cause of unemployment is that unemployment benefit causes there to be a reservation wage that is (1+η) times the benefit level. In particular,

(1-t)wU ≥ (1+η)b π

where π is an index of consumer prices. If we assume that demands are Cobb-Douglas, with all income (and all government revenue) being spent a fraction μ on good X and a fraction (1-μ) on good Y, then price index

π = pXμ pY

(1-μ)

With Cobb-Douglas cost functions (see slide 7), and ω = wS/wU

pX = wU ω(1-α); pY = wU ω(1-β) Hence π = wU ωζ where ζ= μ(1-α)+(1-μ)

(1-β)

The ceiling on the skilled wage premium therefore becomes

(1-tU)wU ≥ (1+η)b wU ωζ or ω ≤ [(1-tU)/(b(1+η))]1/ζ = ω*.

1515

X/Y

pX/pY

wS/wU

wS/wU

Effect of wage premium ceiling

Cobb-Douglas case

Wage premium ceiling

Effect of globalisation

ω = ω* =

[(1-tU)/(b(1+η))]1/ζ ●

●●

Supply where full employment

Higher unemployment

1616

X/Y

pX/pY

U/LU

Determination of unemployment rate

Effect of globalisation

●●

Unemployment rate of unskilled workers

● ●

Determined by ω*

How to cut unemployment in this model?

• allow ω* to rise by cutting b

• allow ω* to rise by cutting tU

• raise LS/LU

Unemployment rises

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Implications

Globalisation causes increased wage dispersion in US but unemployment in Europe.The distributional consequences need to be analysed with care.

In the “European” case there are LS with wages (1-tS)wS ,(LU –U) with wages (1-tU)wU, and U with benefit income b. Need to distinguish between:

• distribution of earnings

• distribution of market income

• distribution of disposable income

Earnings: mean rises, causing both

slopes to fall, and proportion of

unskilled workers falls.

What happens to the distribution of

market income and disposable income?

Lorenz curve

Effect of globalisation in “European” case

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• (1) Underlying model is Arrow-Debreu (perfect competition and fully clearing markets), with no unemployment in absence of unemployment benefit;

• (2) Economic model is inconsistent and omits key features (Section 4);

• (3) Treatment of unemployment benefit ignores important institutional aspects (Section 5).

BUT

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• Inconsistent: Do not have parallel universes; Europe and US are trading in same world, so cannot have both pX/pY fall (and increased wage dispersion in US) and pX/pY constant (and European unemployment); need as a minimum 3 country model (US, Europe and NIC);

• Need to relax tight link between product prices and factor prices; introduce non-traded sector (e.g. personal services, sector Z).

• Model lacks capital and intermediate goods

• 2 country x 2 good x 2 factor model not adequate.

4. A richer model

2020

Capital Labour Intermediate good (X)

Sector X(intermediate good)

Input Unskilled

labour

Output

Sector Y(final good)

Skilled labour

Input

Sector Z (non-traded personal services)

Unskilled

labour

A richer 3 country (Europe, US and NIC) x 3 sector (intermediate good, final output, and personal services) x 3 factor (skilled labour, unskilled labour and capital) model

A B Atkinson, “The economics of the welfare state in today’s world”, International Tax and Public Finance, 2008, vol 15: 5-17.

212121

• In this model, wS/wU may be fixed in Europe, but not determine wage ratio in US;

• Globalisation can lead to unemployment of unskilled workers in Europe but increased wage dispersion in US;

• Effect of globalisation is moderated in both cases by expansion of service sector employment;

• Globalisation may cause de-localisation of capital from X sector in Europe to either NIC or US;

• Welfare state is less exposed the higher the LS/LU ratio; investing in skills is advantageous.

Main conclusions from richer model

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The standard treatment by economists assumes that unemployment benefit is paid unconditionally to all those unemployed. Such a treatment ignores important institutional features.

Hypothetical Typical real-world UI(unemployment insurance)

Typical real-world UA (unemployment assistance)

Benefit paid irrespective of reasons for entering unemployment.

Benefit refused where a person enters unemployment voluntarily or as a result of industrial misconduct.

As UI.

Benefit is paid for all days of an unemployment spell.

Benefit may not be paid for an initial period.

As UI.

Benefit is unlimited in duration.

Limited duration and rate of benefit may decline over time.

As hypothetical.

No condition of job search is imposed.

Benefit conditional on being available for work and engaging in job search.

As UI.

There is no penalty for refusal of job offers.

Refusal of job offers may lead to disqualification from benefit.

As UI.

There are no contribution or income conditions.

Benefit depends on satisfaction of contribution conditions.

Amount of UA depends on other income and on assets via a means test.

Eligibility for benefit is not affected by income of other family members.

As hypothetical. Amount of UA is affected by income and assets of other household members.

5. Importance of institutional structure

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• Some of the unemployed may not receive benefits: in 2005 in the EU 40 per cent of those unemployed 1-3 months did not receive any benefit (UI, UA or sickness benefits), 29 per cent of those unemployed for 4-6 months, and 42 per cent of those unemployed for 7-12 months.

• Benefit conditions need to be taken into account in economic models: for example, job search models of unemployment assume that a person can reject job offers without any risk of losing benefit, whereas they may be disqualified;

• The “shirking” model of efficiency wages assumes that a person dismissed for shirking would receive benefit, whereas they may well be disqualified;

• Contribution conditions mean that new entrants cannot receive UI;

• Contribution conditions mean that there is a link between payroll taxes paid and benefits received.

Implications of institutional structure

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• Distinguish two concerns: (a) tax cost of welfare state and (b) its impact on working of the economy;

• In absence of unemployment benefit, globalisation can lead to widening wage dispersion, but not where economy specialised;

• Unemployment benefit leads to restricted wage flexibility, and hence unemployment, intensified by globalisation;

• But we need a model where there is rationale for unemployment benefit (e.g. search model);

• Analysis needs to be extended to allow for 3 countries (and 3 goods and 3 factors);

• The standard treatment of unemployment benefit by economists assumes that it is paid unconditionally to all those unemployed. Such a treatment ignores important institutional features.

Conclusions