Politics & Policy

The Leaner Welfare State

From the Aug. 30, 2010, issue of NR.

Should American workers fear the economic future? As recently as the early 1990s, many academic and political elites were convinced that the United States was doomed to become a backwater, an economic also-ran. From 1973 to 1995, average labor productivity increased by 1.4 percent a year, a marked decline from the 2.7 percent annual growth rate that drove post-war prosperity from 1948 to 1972. Because Germany, Japan, and a number of other industrial economies had surpassed the United States in productivity growth over that period, it seemed likely that our country would slowly slip behind in the economic league tables.

That’s not what happened. Between 1995 and 2000, productivity growth increased to 2.6 percent as heavy investments in information technology began to pay off. The American economy had, by any objective standard, made an extraordinary comeback. The recession that followed was short and shallow, but it offered a glimpse of the wrenching change to come. From 2001 to 2003, productivity growth reached a white-hot 3.6 percent.

Yet the 2000s were no one’s idea of an economic Golden Age. Even before the Great Recession, the last decade had been characterized by a pervasive if ill-defined sense of economic unease. Many on the left have exploited this unease, yoking to it an expansion of the existing welfare state that threatens to stifle growth and innovation.

Before we can offer an alternative, we have to understand the source of our economic woes.

During the post-war era, the United States was without peer as the ruined economies of Europe and East Asia struggled to recover from the ravages of war. The years from 1973 to 1995 saw those regions flourish, creating a market for U.S. goods and services as well as competition for U.S. firms, most strikingly in the manufacturing sector. Now, as workers in China and India upgrade their skills, the global economy is entering a new phase. Harvard economist Richard Freeman has warned of a global surplus of skilled labor. “As the low-income countries catch up with the advanced countries,” Freeman writes, “the pressure of low-wage competition from the new giants will battle with the growth of world productivity and the lower prices from goods produced in low-wage countries to determine the well-being of workers in higher income economies.” There is good reason to believe that growth in low-wage countries will prove overwhelmingly beneficial to U.S. workers overall, not least by creating a wave of low-cost, innovative goods. Yet there is also no question that it will continue to increase downward pressure on the wages of workers in tradable economic sectors, from manufacturing and programming to legal services and perhaps even education.

Another source of our economic discontent lies in the subtle difference between the two most recent productivity booms, which economists Erik Brynjolfsson and Adam Saunders describe in their book, Wired for Innovation. The 1990s boom can be directly traced to IT investments, particularly in the retail sector, which had seen sluggish productivity growth for decades. The productivity surge from 2001 to 2003 was driven by investments in organizational capital, a catch-all term for productivity-enhancing business practices.

Many U.S. firms invested heavily in technology. But the most successful firms — which Brynjolfsson and Saunders call “digital organizations” — also embraced incentive systems and decentralized decision-making to allow their most talented, driven, and well-trained workers to use new technologies effectively. To put it simply, digital organizations reward workaholics and weed out weak performers. Suffice it to say, the workers who flourish in these firms are not replaceable cogs. Rather, they are valuable assets, and they demand and receive generous compensation. While digital organizations tend to be culturally egalitarian, they are a major driver of wage dispersion. Google and Facebook, for all their progressive bona fides, spend far more on top-flight engineers than on custodial staff, and they always will.


The rise of digital organizations is one reason productivity growth has continued during the Great Recession. One of the most striking facts about this downturn has been that employment has declined far more than output. As jobs evaporated throughout 2009, productivity increased by 3.8 percent, the largest increase in seven years. Comparatively few productive workers were let go, and many of those who were worked in firms that simply discovered a way to do without them, in part by offshoring a range of tasks.

As Dirk Pilat, an OECD economist, observed in 2004, these developments “are part of a process of search and experimentation, where some firms succeed and grow and others fail and disappear.” Countries that allow this process of creative destruction have an edge, Pilat suggests, in reaping the full benefits of technology investment.

The job losses we’ve seen over the last few years have affected American workers unevenly. Those with some college, 26 percent of the adult population, have an unemployment rate hovering around 8.3 percent. For the 30 percent with only a high-school diploma, the unemployment rate is 10.1 percent. And for those without a high-school diploma, 13.4 percent of the population, the unemployment rate is 13.8 percent.

Meanwhile, the 30 percent of adults over the age of 25 with a college degree or more have fared well, with an unemployment rate around 4.5 percent as of July. These are the workers who — a handful of brilliant dropouts aside — staff the digital organizations that are driving the economy forward. This is also the group that tends to outsource household labor — by buying meals outside of the home, day-care services, and much else — providing employment opportunities for large numbers of less-skilled workers. For better or for worse, all of us depend on the success of digital organizations. The value they create spreads throughout the wider economy. America’s economic mission should thus be to attract, retain, and develop talent, and to guarantee that the barriers to grassroots entrepreneurship are as low and as few as possible.

Viewed through this lens, the Left’s effort to expand the existing social contract, rooted in the industrial relations of the mid-20th century, looks short-sighted at best. Citizens rely on employers and the state to provide a range of benefits, which have come to include comprehensive health insurance, pensions and retirement-savings vehicles, and unemployment insurance. But this arrangement creates a number of economic inefficiencies that the United States can no longer afford.

For one, it prevents the personalization of benefits and restricts the choice of providers. Employers approve only a limited number of benefit providers, which in turn provide only a limited number of plans. Governments, attempting to reduce inequality and promote solidarity, typically mandate baseline benefit levels and restrict the ability of beneficiaries to tailor benefits to their liking or to trade off greater risk for greater reward. This inclination also requires governments to impose strict regulation on providers.

The liberal social contract also obscures the link between benefits and costs. When employers negotiate deals with insurance providers and “pay” the premium, employees fail to connect greater benefit use with lower take-home pay. And even if they did, there would still be a free-rider problem: Why should I be cost-conscious if I’m going to have to pay for my coworkers’ profligacy next year through higher premiums?


This moral hazard is worse with public benefits. In Social Security and Medicare, population dynamics have allowed a large base of workers to finance benefits for a relatively small number of retirees, permitting the benefits to grow. But this arrangement worked only while fertility was high and life expectancy low, and the retirement of the baby boomers will reverse this alchemy. The federal government can also pay for public benefits by selling bonds to investors — up to a point. Because legislators try to buy votes, the political dynamics push toward benefits of ever-increasing generosity combined with low taxes — a toxic mix when use of entitlements by beneficiaries is high. Debt levels eventually explode and tax levels explode soon after, crippling firms and driving away talent.

Even employer benefits have unintended consequences, as demonstrated by the “job lock” workers stuck in poor-fitting positions experience because they are afraid they will lose their health-care coverage. The system made great sense in earlier decades, when lifetime employment was the expectation of employer and employee alike and when few married women worked. Today, however, employer benefits can impede the smooth functioning of labor markets and thwart worker efforts to develop their skills in new jobs and industries, undermining the central advantage of the U.S. economy.

What we need is a leaner, more flexible welfare state founded on the principles of personalization and choice, but one that protects those who hit a patch of bad luck or whose marginal productivity lags behind the level demanded by digital organizations. To that end, we favor a program of what we call “citizen benefits.” Americans would have access to a range of benefits sponsored not by their employer, but by a federal exchange. Just as workers today have employer-sponsored retirement plans and health-insurance policies, all citizens would have access to exchange-sponsored benefits.

But citizen benefits would be entirely voluntary — there would be no mandates imposed on individuals or employers — and employers could continue offering benefits to their workers (but without receiving preferential tax treatment). There would be subsidies to the disadvantaged, but they would be much more transparent than they are under today’s arrangements. And tradeoffs between greater pay, higher benefits, different benefit mixes, and greater costs would be much more transparent than they are today, too. A federal safety net would continue to exist to catch those who fell through the cracks of the citizen-benefit system.

To see how such a system would work, consider health insurance. To switch to a system of citizen benefits, two large tax expenditures favoring employer-sponsored insurance — the deductibility of insurance-related health expenses by employers and the exclusion of employer-provided health benefits from individual income taxation — would be repealed. The primary effect of this change would be that many employers currently providing health insurance would drop their coverage and instead increase the pay of their workers. Workers could use the higher take-home pay to purchase insurance.

Or not purchase it. The individual mandate imposed by the Democrats’ recently passed health-care reform law, the Affordable Care Act (ACA), would be repealed, and employers would not be required to provide coverage or endure new taxes to support citizen benefits, meaning the ACA’s play-or-pay penalty for not covering workers would also be repealed. For workers whose employers continued offering coverage, very little would change under citizen benefits.

But for those whose employers dropped coverage, those who never had employer coverage, and those who simply prefer an alternative to their employer’s coverage, one or more public insurance pools would be open to everyone. Private insurers would offer different coverage options and benefit packages in the pool and compete on price. Plans participating in the pool would be subject to guaranteed-issue and renewal rules, and they would be community-rated. Insurers could still offer coverage outside the exchanges without facing these federal requirements, meaning that ACA’s regulations would be repealed. A federal reinsurance program would help offset insurers’ costs for the most expensive subscribers they cover.

The federal government would subsidize, on a sliding scale, the premiums of families earning less than 200 percent of the federal poverty line, rather than the 400 percent ceiling established under the ACA. Subsidies would be fairly transparent in this system — federal revenues would redistribute toward the poor through premium support and toward the very sick through reinsurance and risk adjustment.


Ultimately, the system would not offer tax subsidies for health insurance; but to allow health-care and insurance markets to adjust, tax subsidies could be temporarily offered — with incentives for enrollment in (lower-cost) catastrophic-coverage plans. It would also move us toward a system where insurance actually functions as insurance, protecting enrollees from the risk of unforeseen expensive services rather than paying for relatively inexpensive and predictable costs. Finally, for the system to bring down future federal deficits, it would ultimately have to replace Medicare and the services to seniors that that program provides — a change that would clearly need to happen gradually in order to be politically viable.

Retirement-savings benefits could be delivered in a similar way. The federal government would sponsor IRA-style plans, and existing IRAs and similar individual accounts would be rolled into them. Individuals could contribute to these new plans but would not be required to. Employers could match their employees’ contributions but would not be required to. They could also continue to sponsor their own retirement plans and match employee contributions to them. The federal government would provide its own match for contributions made by individuals in households earning under 200 percent of the poverty line. All income-tax refunds would automatically be placed in an individual account unless the taxpayer specified otherwise. Also by default, 3 percent of earnings would be transferred by his employer from each employee’s paycheck to an individual account, if the employee did not participate in an employer-sponsored plan or opt out of the default.

Social Security would continue to exist, but over time it would shrink to become more of a safety-net pension program (while retaining its other functions, such as providing disability benefits). As with health-insurance tax subsidies, in the long run the goal would be to eliminate tax incentives for savings entirely, a move that could be coupled with lower marginal tax rates, but this, too, would require a transition period.

A third type of citizen benefit would be an income-loss insurance program that would replace the state/federal unemployment program. It would do so by allowing holders of retirement-savings accounts to take qualified distributions from them in the event of unemployment, divorce, death of a spouse, or short-term disability. What is more, accountholders could borrow, up to some limit, against future savings if existing savings are depleted. For periods of unemployment lasting longer than 16 weeks, individual “re-employment accounts” would be given to those still out of work, providing them with $5,000 to use for income support, job training, or employment services. Holders of re-employment accounts could keep however much of the $5,000 was left upon finding a job. After 20 weeks of unemployment, a traditional social-insurance program, similar to today’s government unemployment insurance, would provide an additional safety net. This approach would give workers the flexibility they need to seek training or to relocate to a more promising labor market.

Everyone from policymakers to entrepreneurs to parents wants to know about “the jobs of the future.” But just as no one in 1800 could have predicted the extent to which the railroad would reshape the American landscape, there is no way to know exactly what the economy will look like in 2050 or even in 2015. What we do know is that a dynamic market economy demands openness and flexibility. Trade, offshoring, and the global sourcing of jobs are not just a quirk of history. As transaction costs decline, successful firms focus on their distinctive internal capabilities while mobilizing the resources of other specialized firms, wherever they are based. Rather than fight this powerful tendency, we need to embrace it. The citizen-benefits model would build on American strengths. It has the potential to give the United States the world’s most modern, flexible, and cost-effective social contract, an essential competitive advantage in a shrinking world.

Reihan Salam is a policy adviser at Economics21 and blogs at The Agenda on National Review Online. Scott Winship is a recent graduate of Harvard’s social-policy doctoral program and analyzes economic trends at his blog, The Empiricist Strikes Back.


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