System transformation and social protection / [Alfred Pfaller] - [Electronic ed.] - Bonn, [2002 - 2] Bl. = 24 KB, Text . - (Policy information / International Policy Analysis Unit)
Electronic ed.: Bonn : FES Library, 2002

© Friedrich-Ebert-Stiftung


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Social Protection was Built into the Old System

The centrally planned economies of the pre-1990 socialist world did not need formal welfare-state arrangements of social protection because „social welfare" was woven into the central processes of production, distribution and income generation. All productive resources, including labor of various skills, were mobilized by the planning agencies of the government to contribute to social production. In turn, participation in the production process entitled people to share in the consumption of the product both while they were still active producers and when they were no longer able to work, due to old age, illness, disability or child birth. The state-run economy produced what the planners considered as desirable for current individual and collective „consumption" (including military build-up) and for future economic growth. And it was the state planners who decided on the distribution of consumption rights – by determining money incomes and prices. Goods and services considered as essential were made available at very low prices or even for free. Education was accessible to everyone who qualified with regard to age, aptitude and to some extent political loyalty. Similarly, access to medical services was completely independent of individual purchasing power. Basic housing was provided for a token.

Typically, access to many social services such as day care for children or recreation as well as to consumer goods was organized through the firm or institution that people worked for. Firms could be generous in these respects because their financial capacity did not depend on the balance of production costs and sales revenues but on allotments by the government for the purpose of workers’ salaries and „welfare". Part of the „social" task assigned to the firm was the employment of people to a large extent independently of productive needs. In this way, unemployment was practically not allowed to materialize, everybody willing and able to work was kept in the job-based distribution system of individual and collective consumption rights.

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Liberated Markets Need Political Intervention

With the transition to a market economy, consumption rights have to be earned in the market, subject to the price formation process determined by supply and demand (including the fluctuations of aggregate demand due to changes in the balance of savings and investment as well as the shifts in demand and supply structures). The unmitigated market process carries several risks for people’s standard of living and basic life chances:

  • There is no guarantee that people who have no other productive asset but their ability to work will earn – for themselves and their dependents – an income that is somehow in line with the nation’s per capita income. There is the real danger that at times they will not find a job at all or that the jobs available offer a salary very much below the national average.

Those who are not able to work can either consume to the extent that they have accumulated or inherited wealth that yields returns or can be turned into cash; or, they depend on income support by the larger community (at state or local level), the family or some charitable person or organisation.

  • Certain goods and services that are essential for human well-being, such as shelter and medical treatment, or that are decisive for life-time income chances, such as higher education, will not be available to those whose income cannot pay for the costs of those goods and services.

In other words: the market carries the risk of significant social exclusion. But society can decide politically not to tolerate exclusion, i.e. to secure for every citizen a standard of living that is not too far below the national average – which, in turn, depends on the productive capacity of the national economy. In this case, arrangements are required to correct ex post the results of the market process and perhaps to intervene ex ante in the market process so as to make it produce as few „casualties" as possible. Without some sort of welfare state, significant segments of the population run a substantial risk of having to live in outright misery or even not to live long at all.

Under the central planning regime, most allocation of economic resources was subject to political decision-making (as opposed to decentralized decision-making by buyers and sellers in the market). Thus, the decision to avoid large-scale economic exclusion could be integrated easily, like any other collective goal (such as the quest of military might), into the overall economic planning process. In the market economy, most of the resources to be dedicated to collective goals have to be extracted from the „private sector", although state enterprises might generate some market income for the „caretaker of the collective will". That is to say, political command, which ideally represents the will of the citizens’ majority, has to overrule individual spending (or saving) preferences. This political command can oblige citizens and residents to pay a certain part of their income directly as taxes to the government or as contributions to special funds such as a collective pension system or a health insurance.

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The Limits to Taxation

The new method of securing collectively desired patterns of resource allocation (in our case: avoidance of exclusion) by means of taxation gives rise to a general problem. In the political arena, people might well support decisions in favor of welfare-state arrangements that protect them against poverty or outright misery in various contingencies of life. But at the same time they might resist and resent the necessary taxation. They might assume a free-rider position, trying to avoid taxes, but at the same time claiming the benefits of the system whenever the need arises. We should expect such free riding to become a generalized phenomenon, as the state is not readily perceived as the collective agency of the citizens for the citizens, but rather as an unloved disciplinary agent, suspected, in addition, of being wasteful or even corrupt. Moreover, the very practice of successful tax avoidance creates and reinforces a culture of „legitimate" cheating (with those who do not being regarded as fools).

Explicit taxation (rather than implicit resource allocation by central planners) also raises overtly the issue of the distribution of the tax load. People might support the magnitude of tax-financed government spending but resent the particular tax which is levied on their income, assets or consumption. One such group of tax „resenters" and avoiders even has the endorsement of an influential school of economics: business people. „Excessive" taxation of businesses is said to harm national prosperity on two grounds:

  • It stifles entrepreneurial initiative, the very engine of wealth-creation, and

  • it diminishes the national economy’s competitiveness, making it more difficult (a) to sell national products in internationally contested markets and (b) to attract foreign investment.

If, in addition, the relatively low administrative capacity of the transformed state apparatus in transition countries is taken into account, it becomes clear that there are economic limits to a welfare-state system of social protection even if the citizens of transition countries and their elected representatives opt for it politically. We should expect a strong tension between the politically articulated desire for protection and the political system’s ability to mobilize the necessary resources.

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The Logic of Insurance: Mobilizing Individual Self-interest

In view of the new limits to collective action that result from the limits to taxation, solutions to the various needs for social protection should

  • be designed so as to rely as much as possible on individual incentives to make provisions for the risks of life;

  • give priority to the most pressing needs for protection and for avoiding exclusion, leaving other goals – that might be politically popular as well – unattended;

  • avoid hinderingbusiness incentives to invest and employ people, thus reducing the need for welfare-state income support.

In order to extend the limits to tax-financed protection, a clear link should be established, wherever possible, between a person’s payment into a protection scheme and his/her entitlement to the scheme’s benefits. This applies to people who do earn a taxable income in the market, most commonly – but not exclusively – as employees. For this group, the relationship between payments and benefits is most readily established for old age pensions and for income support during temporary unemployment. But it can be done as well for income support during times of illness. It would be a matter of establishing – public or adequately controlled private – insurance systems which offer the corresponding benefits in relation to the contributions paid. Contributors themselves have an incentive to pay in order to maintain their claims.

However, it is important that cheaper ways to reap the benefits are excluded. Moreover, in order to avoid a taxation-of-labor effect, which would harm employment in times of labor abundance, it would be best if contributions were paid not by employers, but exclusively by the prospective beneficiaries – as is the case with an ordinary private insurance. But, employers could be instrumental in pooling risks and collecting contributions, thus reducing „dead-weight" transaction costs.

A certain complication is posed by the continuing cash-flow needs of pay-as-you-go pension systems, on which the current generation of pensioners depends. This is one strong reason for compulsory membership, which, in turn, re-introduces to some extent the problem of tax resistance (especially if the benefits of the system are not valued highly in comparison with alternative ways of providing for old age).

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Insurance Cum Solidarity: the Health System

Not all elements of social protection can follow the pure logic of insurance. Take provision for medical treatment in the case of illness: defining benefits in relation to contributions would exclude those who earn too little to pay for the costs of adequate protection (disregarding „non-essential" benefits such as private rooms in hospitals, aesthetic surgery etc. as well as extremely expensive treatments with verylimited health benefits). If the restoration and maintenance of good health in accordance with the possibilities of medical art and technology is not to become a privilege of the well-to-do – which would be a gross violation of social justice when defined as absence of social exclusion – health insurance must charge contributions in relation to income while handing out benefits in relation to need. Such a system is immanently unattractive for those whose households have above average incomes per person because they have to subsidize the health services for their poorer compatriots with their relatively high contributions. For them, private insurances with strictly cost-related contributions would be more advantageous. Therefore, opting out of the public system with its income-related (rather than level-of-benefit-related) contributions would have to be precluded for them. If they pay their contributions but still prefer to buy medical treatment in the free market no harm would be done. But, of course, this would raise the problem of tax resistance by those who do not really benefit from the system to which they have to contribute.

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Tax-financed Redistribution

There are parts of welfare-state protection for which no individual self-interest can be mobilized via appropriate financing methods. They include all sorts of income support – in cash and kind – for the poor who do not earn an adequate market income and who did not have the chance of making provisions in earlier times.

In the highly developed welfare-states of the western industrialized world, these types of pure redistribution schemes have traditionally claimed only a small part (seven to ten percent) of the overall welfare-state bill. Lately, however, this percentage has been increasing. The reason is that the market economy has been producing more „casualties" than it used to in the hey-days of welfare capitalism. A larger part of the labor force has found itself unable to earn a decent wage income, either due to protracted unemployment (for which the first tier of unemployment insurance no longer provides) or due to very low wages for many jobs.

In the transition countries, the problem of insufficient wage income during working-age has much larger proportions. For the transition shock has led to large-scale destruction of jobs as protected former markets vanished and large parts of the production structure proved unable to survive in contested markets, or as companies, in order to survive, took to large-scale labor-shedding. On the other hand, in quite a few transition countries, the problem has not yet unfolded to its full magnitude because large state enterprises have continued their old labor-hoarding practice precisely in order to avoid even more unemployment. In this respect, remnants of the old socialist welfare-state system have been kept alive.

Income support for those unable to provide for themselves over the life-cycle cannot be financed by contributions in the same way protection against the contingencies of life is. It must rely on taxes, to which the above mentioned limitations apply. The same holds, to a significant extent, for education. If it is – above a certain base level – not to become a privilege of the well-to-do, it has to be financed by all citizens, those with children and those without. This, in turn, makes it a „natural" candidate for tax-based financing, even though the well-to-do could, in addition, be asked to pay for their share of education.

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Optimizing Outcomes Under Tight Resource Restrictions

Part of the overall welfare-state package corresponds to the logic of insurance. Its financing is relatively unproblematic. This part caters to those who cannot be considered „casualties" of the market economy, i.e. those who earn a „decent", albeit modest, income in the market. But we also have – varying significantly from country to country – a need for relatively large sums of tax-financed redistribution, for both income support and public goods like education. And we have states with relatively low taxation capacity. This combination of challenges and constraints would suggest the following strategy:

  • Organize the insurance part, which caters to the protection needs of the employed and reasonably well remunerated members of society (including their families), in a way that does not absorb precious tax revenues. Establish a firm sense of „ownership" for the protection which is being bought by individual contributions. At the same time, implant the idea of social contributions as part of the wage rather than something granted in addition to the wage. Otherwise a conflict is bound to emerge between social protection (which raises labor costs) and employment (which should be by far the most important source of income).

  • Do not hand out public goods to those who can pay for them. This applies, for instance, to education. But make sure, at the same time, that those who cannot pay have equal access. Avoid a second-tier, lower-quality supply for the less well-to-do.

  • Preclude the possibility that the well-to-do opt out of the public health system, at least as far as contributions are concerned.

  • Give priority in re-distributive tax spending to those items which imply the biggest effect in lifting poor citizen’s and their children’s standard of living. In pratice, it might be better to offer „essentials" as public goods rather than top up low incomes with public transfers so as to enable every citizen to buy these essentials in the market. This overrules private spending preferences, which offends liberal sentiment but also protects children’s rights and limits self-destructive irresponsibility. Perhaps more importantly for transition countries, it saves the high administrative costs of pervasive and repeated means-testing. „Essentials" should include high-standard health services and the full range of education. Low-cost housing and free (or low-cost) public meals could come next in line.

Alfred Pfaller

Friedrich-Ebert-Stiftung, 5310 Bonn, fax: 0228 / 883 625, e-mail: PfallerA@fes.de

© Friedrich Ebert Stiftung | technical support | net edition fes-library | Februar 2002