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Unbundle the Welfare State
From the December 20, 2010, issue of NR.


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America is a very different place than it was in the first half of the 20th century, and this has led to severe dislocations between the original design of our welfare programs and today’s needs. For one thing, we are vastly wealthier. The simple lack of available food and shelter that in America persisted into the Great Depression is extremely rare today for any physically and mentally competent person who is willing to abide by the most basic social norms. Individual conduct is the primary driver of contemporary deprivation. Further, the ratio of old to young is crucially different. The money to pay for retirement spending (including late-life health care) must either come from one’s own accumulated savings or be taken from somebody else. When the latter approach takes a tiny bite from many younger people’s paychecks, it is not a critical political problem, but if the cost becomes an appreciable share of income as the ratio of workers to non-workers rises, it becomes politically unsustainable.

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We are fast approaching that point in the United States today. What are often called “promises” to workers are in fact merely current entitlement rules changeable at any time by any future Congress, and they cannot go unaltered without massive tax increases. As the private sector has already realized, we are moving from a “defined benefit” to a “defined contribution” world. 

Another important development is greater diversity in the population, across many dimensions. There is far less agreement on how people should live their lives today than there was among the politically relevant population 50 years ago. In practical terms, this has meant the dissolution of the traditional family model for large swathes of American society. 

A final relevant change is that Americans, especially the middle class, are far better educated than they were decades ago, and are used to having and managing many more choices enabled by information and technology. 

What hasn’t changed is the basic rationale for the welfare state: It is a way of managing the tension between human nature and capitalism. All of the major elements of the welfare system — pensions, health care, education, and welfare payments — share a common architecture that combines them. Unbundling these five components — and understanding each one separately — can open up the path to achieving the goals of the welfare state in a modern environment. 

First, welfare programs provide a safety net: a fail-safe provision of important goods that represents some roughly agreed-upon minimum baseline of subsistence for any member of the society. Second, they incorporate some element of risk pooling (and, more generally, economies of scale) beyond what is implied by the safety net: spreading out the costs of falling victim to some horrible disease in old age, for example. Third, these programs also may require prudent behavior on the part of beneficiaries. For example, Social Security requires that wage earners forgo some consumption today in order to provide funds for retirement. Fourth, the programs may redistribute wealth beyond what is required by the first two goals. Fifth and finally, they may be a mechanism for the government to provide certain goods directly, as in the case of traditional public schools.

Even if it made sense to bundle these functions in 1935, does it today?

The first two components — provision of a safety net and the exploitation of economies of scale, such as risk pools — are legitimate government functions. But bundling them has an enormous drawback: It hides the transfer of wealth from the prudent to the imprudent. This is especially problematic in the modern environment. The safety net and risk pools should be different programs.

For example, Social Security provides a safety net for old people who have been extremely unlucky, unwise, or unproductive. It is also a mechanism to force almost all workers to save for retirement — prudently consuming less today — and pool their savings. These two components were bundled to build a political coalition for the program, but the bundling obscures the income redistribution from richer workers to poorer ones that is embedded in Social Security’s benefit schedules, which provide higher returns on the first dollars of worker earnings and lower returns on the last dollars. This, in turn, exacerbates the moral hazard of the program. 

Instead, we should have a defined-contribution pension program requiring individuals to contribute a reasonable proportion of their income (though some flexibility should be allowed) to an array of investment vehicles to which they hold property rights. In addition, the government should offer a safety net specifically for those who end up destitute in old age. Unlike a safety net for people of working age, it should not have a work requirement. It should also not attempt to guarantee for all the income of those who have prudently saved for retirement but instead be a true minimum safety net. This is welfare for old people, and should not be conflated with a pension scheme.



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