Harmonizing Social Welfare and Economic Growth: Case Studies of European Countries

and Implications for Korea

Yoo-Duk Kang, Tae Hyun Oh, Cheol-Won Lee, Hyun Jean Lee and Junyup Kim

Debt crisis in some European countries have created a controversy in Korea, which has managed to achieve a relatively sound fiscal position. However, with welfare spending continuing to garner a bigger chunk of the national budget, this has become a key economic issue that has attracted much public attention. Fiscal conservatives call for tighter controls on welfare spending, because once spending starts growing, it tends to become hard to reduce and reverse. On the other hand, some are calling for greater welfare spending in order to temper the effects of economic polarization, social unrest, unemployment and an aging population. In this context, this paper aims to examine the relationship between welfare spending and economic growth and propose a direction for welfare policy which can actually contribute to economic growth.

Discussion over the proper size of welfare spending is based on the argument that large governments tend to be inefficient. It is often said that large government distorts resource allocation and economic activities, not to mention that big welfare spending decreases incentives to work, leading to chronic low growth and high unemployment. However, there are also opinions that cite positive effects of welfare spending on economic growth. First, welfare spending can make up for capital and labor market failure. As income inequality may inhibit investment for human and physical capital, redistribution policy can remedy this capital market failure and promote growth. Second, welfare spending can contribute to social integration, allowing for stable growth. Widening income gap aggravates discord and conflict between classes, becoming a factor for social unrest that leads to negative impact on economic growth. According to various empirical studies, there is generally a negative correlation between government spending/welfare spending and economic growth rate, although the correlation has not been fully confirmed. However, while it may be very difficult to find causality, it is relatively easy to prove a correlation. Against these arguments and previous studies, this paper reviews the correlation between government spending/welfare spending and economic growth rate, and finds a number of variables that may affect the correlation. Many studies have pointed out negative correlation between big government spending or large welfare spending and economic growth rate, which this paper confirmed as well. However, we have shown that the impact of welfare spending on economic growth rate varied depending on its characteristics. Of special note, countries with higher education and R&D spending displayed high economic growth rate despite large welfare spending as a percentage of GDP. This finding can be interpreted as investment in human capital and productivity increase having a big impact on the growth rate in the long run.

Even though there have been many research on the classification of the European welfare models or regimes, Esping-Andersen (1990)'s tripartie-regimes is the most significant amongst them. He argues that European Welfare models consist of Liberal (the Anglo-Saxon), Conservative (Continental) and Social Democratic (Nordic) models according to decommodification and social stratification. However, some experts and researchers, in particular Ferrera (1996) and Sapir (2005), put weight on the distinctive importance of the Southern European model which is different from the Continental model. As a result, our research makes use of four European welfare models: the Anglo-Saxon, the Continental, the Nordic and the Southern European.

The Nordic model is well known for the high level of social expenditure based on citizenship rather than on contribution. In this model, the role of government is more important than that of the market. Also the Nordic model tries to enhance the linkage between work and welfare by active labor market policies. On the other hand, the Anglo-Saxon model regards welfare not as a social right but as distribution, focusing on low income households as social assistance based on means-test. Therefore, the requirements for beneficiaries are very strict even though the level of welfare is not higher than that of other Welfare models. In the case of the Continental model, it reflects key features of both the Nordic model and the Anglo-Saxon model. While the Continental model contends that the role of the government is more important as the case of the Nordic model, it sets up complex pension systems that reflect occupation, resulting in wider economic polarization. Lastly, the family-centered Southern European model is known for its high level of employment protection. And cash benefits are more important than other methods. However, as many experts point out, the structural problems of the Southern European model have to be addressed with respect to welfare sustainability.

After analyzing the European welfare models by the OECD Social Expenditure Database (1994~2007), we can find an array of results. First, the improvement of income inequality and the rate of poverty are more effective in the Nordic model than in other three European models. Second, the welfare sustainability is even higher in the Nordic model and the Anglo-Saxon model in terms of the efficiency. Third, the Anglo-Saxon model and the Nordic model display high level of GDP per capita as the measure of economic performance. Lastly the Southern European model can be estimated to be less effective than any other European Welfare models. However, there are some critiques on the classification of European Welfare models. For instance, countries classified within the European Welfare models display disparate performances and features. This is the reason why case-studies on major countries' welfare systems are needed.

For more detailed analysis, we selected four European countries, Denmark, Sweden, Germany and Netherlands, which are regarded as successful cases of welfare reform since the 1990s. In case of Denmark, the Danish government has focused on improving labor participation to account for the mid and long-term demographic changes (i.e. population aging) and strengthen the sustainability of the Danish welfare system since the 1990s. In this context, some examples include raising the retirement age to 67 for receipt of pensions and reforming voluntary early retirement pension (VERP) that delays retirement age, providing more incentives to work. In the meantime, welfare reforms in Sweden have been initiated as a response to the negative business cycle shock and sequential crises in its welfare system. While Swedish public spending is under the control of strong fiscal regulations, the Swedish government has tried to make for a more predictable and sustainable welfare system. For instance, through the pension reform in 1998, it is possible to reflect real wage, inflation rate, economic growth, and life expectancy in the calculation of the amount of pension entitlements improving the overall sustainability of the Swedish pension system. In Germany, “Hartz reform” in 2003-2005 formed the foundation of the current German welfare system, focusing on the promotion of employment and the flexibility of the labor market. This brought about new forms of labor such as dispatch working and mini-jobs. Moreover, education and financial assistance is provided to encourage the elderly and women to actively participate in the labor market. Especially, in order to cope with the aging society, the age level of persons benefiting from the pension system has been raised. In the German welfare system, all policies acknowledge that welfare and growth influence each other. The Netherlands has long been the model of traditional and generous welfare state in Europe. After the Wassenaar Agreement in 1982, the Dutch welfare system has developed a tendency to focus on lightening the tax burden in public expenditure, control over wage increase, and reducing the level of social security by practicing flexicurity. In order to maintain female and elderly citizens within the labor market, various policies were implemented. Upward adjustment of the retirement age occurred within the same context. However, after the global financial crisis and European financial crisis, the Dutch government is seeking methods to secure financial stability by efficient allocation of welfare as well as increasing productivity by invigorating the labor market.

Today, welfare state models face numerous challenges. Many developed countries in Europe are experiencing worsening fiscal sustainability with narrow room for economic stimulus, and more sluggish economic growth. Austerity measures were put in place to recover fiscal stability, but making cuts in large spending budgets has proven difficult and painstaking. Raising tax rates, which represents an alternative, is difficult for possibility of its negative impact on economic activity. As for semi-developed countries, the likelihood of increases in future welfare spending due to low birth rate and aging populations looms over already-existing demands for more welfare. We can find some implications from the above cases toward a future direction of Korea's welfare policy. First, it is necessary to maximize existing welfare policy, but also develop ways to raise taxes in growth-friendly way. Also, in the coming years, it is necessary to decide on the time for increasing tax rates. Second, we have to create an atmosphere conducive to policy innovation. Mindful that high tax rates, an essential feature of welfare regimes, may put burden on business activities and employment, it would be necessary to ease unnecessary regulations and reform the business environment in order to encourage economic activity. Third, we must establish growth-oriented welfare regimes with special focus on strengthening human capital and employment rates. It is helpful for long-term growth to raise productivity through robust R&D investment. Welfare reforms reviewed in this paper focus also on increasing retirement age in order to cope with population aging. It is required to raise productivity and employment rates to sustain economic growth, and use the fruits of that increase on raising growth rates for sustaining the welfare regime.