Is the welfare state good for growth?

It’s not as simple as you might think. First, let us start with the bad news:

Whatever one might have thought, the smaller-government countries such as Japan, the United States, Switzerland, Canada, and Australia tax capital and private property at least as heavily as the welfare states of Scandinavia, Germany or the Netherlands.

That’s Peter Lindert, writing in a recent research paper. Now the plot thickens. It turns out that welfare state spending does not diminish economic growth, drawing from a sample of OECD countries. This result, however, requires qualification. If you spend more on welfare, your other policies are more favorable for growth:

…the welfare state choice of a large overall tax burden to support transfers is usually accompanied by the political choice of taxes that promote growth and environmental quality…This is not just a temporary condition captured by our 1995 snapshots. It has been the case over the last third of the twentieth century…

Lindert suggests the following principle: “The higher the social budget as a share of GDP, the higher and more visible is the cost of a bad choice.

So when it comes to growth-damaging policies, governments can only get away with so much. Many interventions will appear in the data to be growth-neutral. Yes you do something bad, but the system reacts by kicking something good back to you. Or vice versa. In a true ceteris paribus thought experiment, however, more social spending still damages growth.

If you are a policy advisor, what is the correct perspective? Say John Kerry calls you up and asks you about social spending. Should you answer the ceteris paribus question, and look at the increase in welfare spending alone? Or should you answer the general equilibrium remixing question, and consider what other good policies will come bundled with some more welfare spending? If you opt for the latter, does it mean you should be indifferent toward inefficient policies? After all, you will find a way to make up for the loss (a bit like being a writer and having part of your day’s work crash; your second draft is usually better). Do you still get the favorable general equilibrium remixing if everyone advises that anti-growth policies do not matter at the margin? Does this mean that we should complain less about Bush’s fiscal irresponsibility?

Read the Lindert paper, it is sure to provoke your thinking. I just ordered his new book on the same topic.

The bottom line: These questions should make everyone uncomfortable. Let’s say you favor free markets. Perhaps you only get some of the goodies you want (i.e., trade) because the government is allowed to spend the resulting surplus in ways that it wants (i.e., welfare). You can’t always simply pick and choose policies a’ la carte. By the way, is it an accident that Bush boosted social spending but also cut taxation on capital?