Social safety nets … at what cost?

Posted on February 23, 2010 by

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Public provision of private goods comes at a great cost to our living standard.  The notion that social spending has a negative effect on economic activity has been the center of many public policy debates for nearly four decades.  The results of many academic research papers have consistently shown that public spending on social safety nets such as social security, healthcare, and even public spending on education come at the high price of slower economic growth.  To name a few, Devereux and Love (1995) on “The Dynamic effects of government spending policies in a two-sector endogenous growth model” conclude that government spending may raise growth rates but only if the spending policy is financed without tax distortions.  In the more realistic case, when spending is financed by an income or wage tax, like it is the case for social security and healthcare, these taxes have a negative effect on long-run growth rates.  The key feature driving these results is the responsiveness of labor supply to higher taxes.  Another important study published in the Federal Reserve Bank of Minneapolis Quarterly Review in 2004, that of a prominent economist, Edward C Prescott entitled “why do Americans work so much more than Europeans?” Prescott (2004) demonstrates this notion that higher taxes on labor income have a negative effect on labor supply, output and productivity therefore affecting the unemployment rate and slowing economic growth in the long run.  Any increase government spending funded by labor income taxes reduces the incentive to work or to hire, resulting in a higher unemployment which would slow the US economy on its path to recovery from what was labeled by many as the worst economic downturn since the Great depression. A slowdown in economic activity could have devastating effects on our economy in the current global economic climate.

The real question that arises is how government spending on social safety nets, more specifically on education, health, the pension system (a form of retirement insurance), have affected private savings, private expenditure for these basic services and the quality of life of the American people.  Public spending on social security, education, healthcare, welfare programs reduce the incentive to privately invest in one’s self.  Unfortunately government provided programs also often fail to match the service offered by the private provision of such basic services therefore reducing our quality of life.

Social security vs. private savings (self-insurance for retirement)

Empirical evidence, starting from Feldstein (1977), suggests that Social Security wealth crowds out private savings.  According to his study, social security was partially responsible for lowering private savings by 50% in the United States.  In Italy for example in 1992, the government introduced sweeping reform, reducing the social security benefits for young workers in the public sector, while reducing much less the benefits of older workers and those in the private sector.  This change set up a natural quasi-experimental analysis.  Comparing the change in savings of young public workers (the treatment group) to the change in savings of older public sector workers and private sector employees (the control group), and using the difference-in-difference estimation method, allowed researchers to shrink any bias from any time series changes in savings.  The results in Italy indicated that 30-40% of the reduction in social security benefits was offset by an increase in private savings.  Similar results were also found in the UK.

In addition to the tax burden put on the young working age generation, Bernheim, Skinner and Weinberg (2001) found that all types of consumption fall by 30% in retirement supporting the fact that social security has a negative effect on private savings and our living standard.

 

Public vs. Private investment in education

            When referring to this very important issue, there is not one economist familiar with the issue who does not mention Dr Gerhard Glomm’s groundbreaking academic research on the public vs private provision of education and on inequality.  One study worth mentioning is Glomm and Ravikumar (1992).  The main finding in this theoretical approach suggests that although income inequality declines more quickly under public education, private education yields greater per capita incomes unless the initial income inequality is sufficiently high clearly not as much the case in the United States and the developed world as it is in most of the developing world. 

A more statistical approach, Private Schools in the United States: A Statistical Profile with Comparisons to Public Schools by Peter Benson and Marilyn Miles McMillen draws the conclusions that private school students have a five percent higher graduation rate than public schools students and are 1.5 times as likely to apply for entrance to post-secondary education.  Private school students are more likely to graduate from college. Roman Catholic school students are twice as likely to graduate from college as public school students, while students of other private schools are 2.5 times as likely to graduate from college. Hispanic and African-American private school students are three times as likely to graduate from college (both Roman Catholic and other private school students).  Private schools cost less per student on average; yet, performance on standardized tests is higher in private schools than in public schools, although some may argue that average differences may be in part also not solely related to socioeconomic and home factors.

            When examining the data closely, it is easy to see that despite our public spending for education and retirement insurance increases, our standard of living has deteriorated.  The United Nations Human Development Index (HDI) indicates that the United States has fallen from the top 5 less than a decade ago to a less than stellar 13th place in 2007.  The HDI looks beyond GDP to a broader definition of well-being. The HDI provides a composite measure of three dimensions of human development: living a long and healthy life (measured by life expectancy), being educated (measured by adult literacy and gross enrolment in education) and having a decent standard of living (measured by purchasing power parity, PPP, income).

To be continued…

References

Benson Peter and McMillen Marilyn Miles.  “Private Schools in the United States: A Statistical Profile with Comparisons to Public Schools.” Washington, DC: U.S. Department of Education, Office of Educational Research and Improvement, National Center for Education Statistics, 1991.

Bernheim B. Douglas & Skinner Jonathan & Weinberg Steven “What Accounts for the Variation in Retirement Wealth among U.S. Households?.” American Economic Review, American Economic Association, vol. 91(4). 2001

Devereux Michael B. and Love David R.F. “The Dynamic effects of government spending policies in a two-sector endogenous growth model.” Journal of Money, Credit and Banking Vol 27, No 1. 1995.

Feldstein, Martin S. “Social Security and Private Savings: International Evidence in an Extended Life-Cycle Model.” The Economics of Public Services an International Economic Association Conference Volume, Boston, MA: Harvard UP, 1977.

Glomm Gerhard and Ravikumar B. “Public versus Private Investment in Human Capital: Endogenous Growth and Income Inequality.” The Journal of Political Economy, Vol. 100, No. 4. 1992.

Prescott E. “why do Americans work so much more than Europeans?.”  Federal Reserve Bank of Minneapolis Quarterly Review Vol. 28, No. 1. 2004.

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