Thought Paper: A Comment on F.W. Scharpf's Strategic Options for the Sustainability of European Welfare States

Thought Paper: A Comment on F.W. Scharpf's Strategic Options for the Sustainability of European Welfare States

In this article F.W. Scharpf calls for exploring “whether and how it is still possible to pursue the aspirations of the welfare state “ in the current international economic setting and suggests five “strategic options” still available at the national level. As will be seen, these proposals seek to accommodate the welfare state to the functioning of the market. Since each proposal is spelt out very briefly professor Scharpf does not address the potential problems associated with each one. The purpose of the following pages is to comment on each proposal’s viability and limitations. Even if a critical tone is maintained throughout the paper, one must praise the effort of advancing policy alternatives, which is not an easy task.

If wage and tax cutbacks seem unacceptable as a competitive strategy, unions and governments must concentrate their efforts on helping to raise business profitability in other ways. That implies industrial policy and industrial relations efforts that will increase productivity and the capacity to innovate, rather than protect existing jobs and firms against the market.

Scharpf addresses here a key problem: how to maintain international competitiveness while at the same keeping the wage and tax levels associated with the welfare state. Indeed, in the last decades the advanced industrial countries have faced increasing competition from the newly-industrialized countries as well as among themselves, and this has led to a race for reducing production costs.At first glance, Scharpf’s argument is very sensible: if European industries are to survive low-wage international competition keeping fixed labor costs, they must increase productivity — and this is done through the introduction of enhanced technology and product innovation.

It is indeed possible to implement this strategy in some sectors of the economy. To be sure, Europe has at present very profitable industrial firms based on the high quality and the uniqueness of its products and highly productive information, communication, financial and business services. However, these industries with high added-value are either capital-intensive (high capital inputs per worker) or reflect high qualifications of workers (human capital). Therefore, as opposed to traditional industry that absorbed masses of unqualified workers, these sectors demand less workers and/or provide jobs only for a highly qualified labor force. The result is that demand for unskilled workers falls and the problem of unemployment is compounded.

Governments can resort to industrial policy to stimulate the movement of resources (capital and labor) to particular sectors of the economy, which are considered as key for future economic growth (because are more productive). This will increase aggregate national wealth and can directly benefit workers in those sectors whose wages are less exposed to downward pressures. But it is a partial solution; in the end this raises skill requirements and shrinks employment opportunities for the low-skilled.Furthermore, not all sectors of the economy are susceptible of benefiting from technical innovation to keep production costs low. The productivity of many labor-intensive service jobs (which absorb less skilled workers) is not easy to increase (e.g. services in retail trade, restaurants, hotels as well as personal and household services), so here high labor costs cannot be offset by gains in marginal productivity. And if kept, leads to job losses because management resorts to greater automation. Here it seems that wage and tax cutbacks are inescapable if employment opportunities are to be expanded.

Unless extreme specialization of the economy in these highly productive sectors takes place (which is improbable) we are left with the present situation: a differentiation between white-collar and blue-collar workers, as well as between highly productive and low productive workforce. In this context the demand for wage differentials arise. In the past these differences existed but were smaller and through the institutions governing industrial relations, the more productive branches subsidized wages in the less productive branches. Now this is more difficult to achieve because highly productive firms exposed to international competition argue that they have no surplus to redistribute if they are to keep competitive standards. Moreover, in present circumstances they can play the card of moving to less regulated environments if they are forced to accept smaller economic rewards.

In summary, given international competitive pressures, in order to maintain the level of wages and taxes associated with the welfare state, productivity and innovation capacity must be enhanced. This allows capital to receive returns that are competitive by international standards while still absorbing high labor costs. In principle, this allows to maintain employment and social protection in these sectors for the workers that command the necessary high skills associated with those jobs. So it seems that, as Scharpf argues, here it is possible to squire the circle of combining economic efficiency and social protection.

However, there are less productive manufacturing and service sectors that are not capable of resorting to this productivity-based competitive strategy. Here the price paid for maintaining high labor costs or firm taxes for the sake of redistribution is the shrinking of labor demand, generating unemployment precisely among those low or unskilled workers that were not absorbed by the value-added leading sectors of the economy. Finally, high levels of unemployment compound the fiscal strains of the welfare state. Note that the above paragraphs are in fact equivalent to a succinct description of the current situation in Continental welfare states. So in fact, as briefly stated as it is, this is not a strategy that signals a way out from present problems, unless we interpret that Scharpf is advocating an extreme specialization in those high-tech sectors matched by an analogous specialization of the working force. However, this is not likely to happen, particularly in the larger countries with larger populations. Therefore, Scharpf turns to another crucial aspect: how to remedy the unemployment problem. Employment is one of the pillars supporting the future of the welfare state, for it keeps state welfare systems financially sound and combats emerging forms of poverty, exclusion and marginalization.

If the welfare state is bankrupted by high and rising rates of unemployment, governments could attempt to increase the “employment content” of welfare expenditures – for instance, by subsidizing low-wage employment instead of financing full-time unemployment. In a very limited form, this is achieved by the “earned income tax credit” in the United States. (…) More attractive from a fiscal and labor market point of view would be a targeted scheme in which a degressive income subsidy would be paid to all workers in jobs paying wages at or below the poverty level (…). Income subsidies would permit their utilization without allowing the emergence of a large population of the working poor who are compelled to work full time to achieve incomes that remain below the poverty level (…) and they pay for themselves in terms of reduced outlays for full time unemployment.

Here Scharpf argues that the solution to unemployment is to admit the development of a low-wage labor market that currently does not exist in Scandinavian and Continental welfare states or, put it differently, to follow the path of Liberal welfare states that have come to accept wage differentials combined with targeted transfers for those in the lowest levels of the wage scale. The “earned income tax credit” scheme has an additional advantage: the subsidy is less visible because it is included in the paycheck and therefore it carries none of the stigma or social control associated with traditional means-testing. In the Liberal welfare states this strategy has been successful in terms of producing job growth for the young, unskilled and non-unionized workers in the private service sector. Why not replicate this strategy in the Continental and Scandinavian welfare states? There are problems both in terms of principles and of immediate feasibility.

Beginning with the question of principles, in the Liberal welfare states the low-wage labor market strategy has been relatively easier to implement because it suits well this system’s underlying logic: the state should only step in when the market fails to produce satisfactory results. Therefore, within this logic it is sensible to allow the labor market reach its equilibrium and provide means-tested support to the very disadvantaged.
In the Scandinavian and Continental welfare states the acceptance of market clearing wages is not so forthcoming because this strategy tends to undermine their original goals: an egalitarian society in the former and a differentiated society but without severe income polarization in the latter. Why is this the case if in principle regressive income subsidies are meant precisely to level out market outcomes? Isn’t it even more socially just in that it helps those that are really needy?

If subsidies were high enough to cover the gap between actual pay and average wages this would be indeed the case. However, we are departing from the assumption that governments face financial constraints.– which in the first place led us to search for alternatives to the financing of full-time unemployment – and this very fact also rules out the possibility of a generous scheme of income subsidies. Thus, this strategy requires that targeted wage subsidies are kept low in order to contain costs. Therefore, redistribution in the form of wage subsidies is to be kept at a minimal level: just right to avoid poverty. Consequently, above the poverty line, income differentials and social inequality are bound to be large and, at any rate, larger than before . The United States exemplifies the case of growing income polarization and rising poverty rate under this scheme.
Ultimately, the role of the welfare state in this particular aspect changes: instead of providing income security for average workers its task is reduced to alleviating the situation of the working poor. The European welfare states would thus be required to “re-specify their original goals”, as Scharpf puts it.

The negative income tax strategy presents another problem in terms of economic efficiency that affects equally all welfare states. Since low wage and (forced) part-time employment are undesirable, the best industrial policy – as commented above – is one that promotes economic activity in highly productive sectors. However, the subsidization of labor costs in low wage sectors introduces negative incentives for employers that will tend to expand or at least keep their activities in these areas.

Finally, we should consider the relevance and feasibility of this strategy in the Scandinavian and Continental welfare states in relation with the intrinsic characteristics of their labor markets. In the present economic setting, the opportunities for a meaningful expansion of employment are located in the service sector. To be sure, in the Liberal welfare states this strategy served to expand employment in the private sector and, more specifically, in services that demand low-skilled labor. However, the Scandinavian welfare model is largely based on the provision of public services, which is the reason why they perform as well as the Liberal welfare states in terms of employment. These services provide jobs for highly trained professionals as well as for a large number of persons with relatively low levels of formal training. In terms of services, the state crowed out the market and prevented the viability of low-wage service jobs in the private sector. Therefore, at present this strategy is not truly relevant for the Social-democratic welfare states: here the state is the main employer, so wage subsidies that are thought for private sector employment make no sense.

The vulnerability of Scandinavian welfare states is, of course, that public employment growth already reached its limits and in the last decade there was a tendency towards controlled privatization of service delivery. Since existing jobs in the public service sector will be defended, this strategy may apply for newly created jobs in the private sector. The more they rely on this employment strategy, the more wage differentials will be demanded and wage subsidies could start to be a response. This proposal can be very relevant for Continental welfare states. These countries do not have a large public service sector (because the welfare state is transfer-intensive rather than service-intensive) so there is much to room to develop a market for private services. However, the precondition of labor market deregulation is toughly contested by unions, as Scharpf admits. To be politically feasible, it would be necessary to offer relatively generous levels of income support and, as has been already suggested, this may not be financially viable.

Scharpf addresses the problem of welfare financing in the following proposal.

If financing welfare expenditures through taxes on business and non-wage labor costs leads to capital flight, dis-investment and job losses, a larger part of the welfare burden must be shifted to taxes on consumption. Again very sensible: if a government cannot rely as much as before on corporate income taxes or employers’ social contributions in order to finance welfare benefits, then it can resort to its other source of revenue, namely consumption taxes. The greatest advantage of this proposal is that since all citizens are consumers and it is safe to assume that they will not move all together to another country, consumption taxes are relatively isolated from international tax competition. However, there are problems and not least for firms, which are supposed to be the beneficiaries of this burden-shifting strategy. If applied through out the economy so as to be meaningful as an alternative revenue source to finance welfare expenditure, the effect of high consumption taxes is to shrink aggregate demand. Thus, the positive investment incentive could be offset by the negative effect of taxes and result in a general slow down of economic activity. This again goes against job creation or, in the worst scenario, could bring about job losses.

Furthermore, high consumption taxes have the same effect as non-wage labor costs on low productive services: a high consumption tax will price them out of the market and there will be a tendency to substitute them with self-service or will stimulate the consumption of services provided in the informal economy. Moreover, this is not very convincing in terms of redistribution. The most used consumption tax, the value added tax (VAT), has regressive effects (all consumers pay the same rate irrespective of their income so this means a heavier burden for those with lower income). This negative effect could be mitigated with a selective application of VAT to non-basic or luxury goods and services. It could also be applied to imported goods that do not have employment effects in the national economy. But again, with these constraints consumption taxes may not constitute a sufficient tax base to compensate for the elimination or significant reduction of taxes on business and employers’ social contributions.
From the political point of view, the strategy goes against the current tax-cutting discourse. One should remember that the political campaigns of the 1990s were frequently based on tax-cut offers. In the Continental welfare states it may be easier to raise workers’ social contributions – that are mentally directly linked to welfare benefits – than taxes (as the French case has shown).

Coming to the particular case of Denmark, it is true that contributions in the form of taxes on goods and services as a percentage of GDP (16.7%) are high for the average OECD level (11.2%), but personal and corporate income taxes are also high (29.7% of GDP). So competitiveness at present is not so much attributed to a tax-friendly structure for employers, but – as Goul Andersen explains – to a progressively more flexible labor market that was accepted because the replacement rate of unemployment benefits is very high (near 90% of former wage). Moreover, Denmark has come to finance an increasing share of social services for families and for the elderly (social assistance) through means-tested co-payments.

An even more radical solution would generalize the Swiss model of health care finance. Here the role of the state would be reduced to requiring everybody to take out private insurance against typical social risks, and to subsidizing the premium payments of low-income groups. Since this would shift the major burden to private consumption, the overall size and cost of the welfare state would cease to be a major public or economic issue.

Here Scharpf seems to argue that welfare states could move in the liberal direction in terms of the health care system and, not by chance, chooses the Swiss model. This model is based on private provision and, to a large extent (but not totally), is privately financed; however, in contrast to the American system, at the same time it guarantees universal access and high quality services for all. The secret is that market forces are not left to work alone: on the contrary, Swiss healthcare is highly regulated. Indeed, one of the main objections to private healthcare systems is that coverage is very unequal and, within those insured, outcomes also tend to be very unequal since individuals that can pay higher premiums will get better and more comprehensive care. Moreover, the market will tend to absorb only the good risk individuals, while leaving out the bad risk. Usually, in the liberal welfare states the very poor (those who cannot really afford to contract a private health insurance) can qualify to receive public health services but – as in the United States – they receive a demonstrably lower standard of care.

The Swiss model has some interesting features that counteract these problems. It is not only that health insurance is mandatory (all Swiss residents must have basic health insurance), but even more important is the fact that the Health Insurance Law defines the scope of the basic benefits package under compulsory insurance and guarantees a high standard of care. Moreover, the state ensures that the price of basic premiums is kept at an affordable level for the average citizen and that they are not risk-related. For those who still cannot afford the basic insurance there are government subsidies: the Health Insurance Law states that premiums for the less well off and certain families must be reduced. Thus, means-tested tax-financed subsidies from the state and cantons are paid directly to the insured whose premiums comprise more than 8-10% of income.

The final component of the Swiss health insurance system comprises compulsory sickness, old-age and disability insurance. These are funded through mandatory income-based employer and employee contributions according to the social insurance model. What stands out of the Swiss model is that it manages to uphold the principle of universality. On the one hand, the system ensures universal coverage and, on the other, people dependent on government support are not condemned to a low quality service. Through the use of targeted subsidies on private insurance premiums Switzerland guarantees a standard chosen by people on middle incomes who are spending their own money. That standard is very high and, therefore, the system makes certain that the most disadvantaged people in society enjoy the same level of care as the middle classes.
Some elements of this system – e.g. basic benefits package, government regulated premiums – may be appealing for Scandinavian welfare states now that they are moving more in the direction of private delivery in order to allow services to vary more in accordance with differentiated client demands.

The other side of the coin is that the Swiss model is very expensive (around 11% of GDP) and arguably it can only be sustained in a very affluent society like that of Switzerland (with a GDP per capita 15%-20% above that of the big West European economies) where the average citizen can (and chooses to) spend a lot on health care. It could be in any case a good model to be replicated in the United States where the health system is even more costly (14% of GDP) but provides very unequal quality of services and, most importantly, leaves about 40 million people excluded from the system. Finally, the Swiss welfare state may be leaner in this respect because it is not engaged in service provision, but in terms of cost it does absorb around 25% of total health expenditure. Even if the major financial burden here is shouldered by private consumption, state intervention in the form of comprehensive regulations and, ultimately, to redress negative market outcomes is very relevant.

If terms of trade between capital and labor have irreversibly shifted in favor of capital, political parties and unions still committed to egalitarian goals would finally need to shift their attention from wage and tax policy to the distribution of capital assets. In collective bargaining agreements, a part of the “normal” wage settlement could be used to “buy” equity in the firm, title to which would then be transferred to investment funds. (…) over the medium term income from work would be supplemented by income from capital.

It is indeed interesting to think in new ways of redistribution based on capital assets. Even if I lack the necessary knowledge to judge the technical feasibility of this proposal, one comment is in order. This is possible to implement in large firms that are in the competitive sector. Here wages are sufficiently high so that workers can afford to receive a smaller paycheck monthly (liquid and certain money) and leave the other part of income linked to variable returns (i.e. returns that depend on the performance of the investment fund in the market).
On the other hand, I wonder if this can be implemented in small and medium size firms that work with modest capital assets and where most of the labor force is employed.

Final Comments
The limitations of Scharpf’s strategic options illustrate the difficulty of putting forward proposals to reform the welfare state and still have the same level of good results (social protection) as before. When he addresses the problem of competitiveness, unemployment comes to the fore; when he deals with unemployment, income differentials and the need for generous subsidies arise; when he looks for an alternative source of financing, we come back to the unemployment problem. And we should not forget that here he did not refer to the other types of challenges arising from population ageing and changes in the family structure. This hints to the fact that it is easier to criticize reform proposals than to come up with innovative solutions.

My impression is that from the economic viewpoint, the difficulty to find a new sustainable equilibrium for the state welfare system lies ultimately on the fact that where in the past there were three social partners shouldering the burden of social protection – capital, labor and the state – now the burden is increasingly being shifted to the latter two. If we are to accept that this situation is irreversible the new goals set for the welfare state have to be necessarily less ambitious.

However, Scharpf correctly points out that these constraints were brought about by political choices, that they are not empirically inevitable and that they could still be changed by concerted political action (p.28). In this sense, it is worth stating what would be the ideal path for the future, dispensing for a moment the ‘reality principle’.

In an increasingly globalized market of capitals, investment and entrepreneurial decisions, the inexistence of political regulating bodies that operate at that same level determine that the rules are imposed by capital itself. Therefore, there should be a re-regulation of transactions at the supranational (EU) or global level to recover the primacy of politics over economy.
This is not likely to happen in the foreseeable future, but two things – which are not novel proposals but that I find feasible – can be done at present:
• Introduce the harmonization of corporate taxes at the EU level so as to diminish the competitive pressure at least within the Single Market. Moreover, this does not necessarily entail a capital outflow from Europe since there are other factor important factors that firms consider when deciding where to invest new capital (i.e. whether to 'exit' or 'enter') like the quality of workforce, access to markets, quality of infrastructure and political stability, among others.
• At the global level, extract resources to finance welfare expenditure from non-productive financial capital. There is an exponential growth in capital movements and the financial economy, which does not correspond to the growth in real transactions or investments over periods longer than a week. Over 90% of world capital flows is accounted for by operations effected over periods shorter than a week. These transactions should be taxed uniformly around the world and the potential revenue could be extraordinarily high.