Can We Stop the March To Fifty Percent? Facts on Why the Tea Party Is Right to be Alarmed

The European welfare state is a boogeyman for conservatives and a panacea for the left. It is defined differently by different people, but it has distinctive features on which most agree:

1) The state’s share of the economy (as captured by spending) is fifty percent or above,
2) The major portion of this spending is for welfare programs,
3) Regulation of the labor market is pervasive, and
4) The welfare state is largely paid for by taxes on labor.

Public spending in France, Italy and Sweden is in the mid fifties and half or more of that spending is for social welfare. The traditionally frugal Germany is currently at a “modest” 48 percent of GDP. Payroll taxes as a percent of labor costs are 39 percent in France, 33 percent in Germany and 31 percent in Italy. In these countries, unemployment benefits are an entitlement for the long-term unemployed, health care is paid for out of payroll taxes but is an entitlement for those not working, and there are extensive protections against firings and layoffs.

The European welfare states rank among the world’s richest. They are rich because of past economic growth. For the past three decades, they have been among the slowest growing nations of the world, and their populations are shrinking.

Using these measures, how far away is the United States from the European welfare state?

Our government share of spending (federal, state and local) last year was above 41 percent. Of this 40 percent was for social welfare spending. Payroll taxes were 14 percent of labor costs. Most health care costs are paid for by insurance at the place of work, but the non employed are not covered by insurance unless they are retired or poor. President Obama’s health care reform is supposed to change this latter feature. The unemployed are offered unemployment insurance whose duration is limited but which tends to be extended during periods of high unemployment.

The U.S. would therefore share the characteristics of the European welfare states if the current government share of GDP were to rise another ten points, if the share of social welfare spending of total spending would also rise another ten points, if social security taxes were to more than double, if our labor market were as strictly regulated as Europe's, and if unemployment insurance became an entitlement.

What are the chances of these things happening?

Of this list, the doubling of social security taxes appears the most unlikely given our political aversion to social security reform. However, credible economists have warned for more than two decades that substantial increases in payroll taxes must inevitably come about given the Ponzi-scheme nature of our social security system. If and when this happens, U.S. workers will suffer along with their European counterparts the competitive disadvantages of bloated labor costs in a world of cut throat competition.

The conversion of the U.S. into a European-style labor market with highly-restrictive firing restrictions, shop-floor worker rights, month-long mandated vacations, and short work weeks is also unlikely. In Europe, such labor market protections have a long history, going back to Bismarck’s Germany, to Europe’s codetermination laws, and to organized labor as a quasi political party. Another peculiarly U.S. factor that makes the Europeanization of our labor market unlikely is the declining labor-market share of labor unions, which are now largely restricted to public employees.

The conversion of unemployment insurance into an entitlement is more likely, especially as long-term unemployment rises to European rates. The entitlement nature of unemployment insurance may never be recognized in legislation, but legislators will lack the political will to cut off benefits for the chronically unemployed. By lowering the personal cost of long term unemployment, the U.S. unemployment rate will rise, hopefully not to European levels.

If we look at the history of government spending as a share of the economy over the past forty years, we see an increase from one third or below in the 1970s to the mid to upper 30s after 1980. We had only one noticeable decline in the government’s share (during Clinton’s second term with a Republican congress). Public social spending rose between 1980 and the present at a similar rate (from 13 to 16 percent).

The government share of spending is a race between the growth of government spending and of nominal GDP. Just to keep the government share from rising, nominal GDP must rise at the same rate as government spending. The growth of nominal GDP equals the inflation rate plus real GDP growth.

In this race, it is difficult to stay even. Over the past half century, government spending has risen, on average, 7.5 percent per year. Were it not for the incredibly slow government growth of the period 1990-2000, the growth of government would have been more than eight percent per annum. Political economists have devoted considerable research to explaining this inexorable growth of government spending, and past history says it can be reduced only during exceptional circumstances. Just to keep the government share constant with such growth of government (assuming a two percent inflation rate), the real growth of the economy has to be a remarkable five and a half percent per year! Such growth is highly unlikely to say the least. Even with a three percent inflation, we would still have to have a sensational 4.5 percent real GDP growth!

Thus, we either have to reduce the growth of government spending or face continuing increases in the share of government.

The Congressional Budget Office’s projections do not inspire confidence. They project a miserly three percent growth of nominal federal government spending over the next five years, with a projected decline (!) in 2012. Under this rosy scenario, the federal government’s share of GDP will decline from 24.2 to 22.3 percent between today and 2015.

In government spending, the past is usually a better guide than rosy projections of austerity, especially during a period when a vast new entitlement program is being put in place.

If we replace the CBO’s unrealistic projections with the rates of past history (and use their own projections for nominal GDP), we get the alarming result that the federal government expenditure share of GDP alone will rise by 2020 from the current 24.5 to 32 percent – an almost eight point increase. With this accomplishment, the US by 2020 would almost reach the spending levels of the European welfare states, even if state and local level spending does not increase its share of GDP.

As measured by spending, the United States will be a European-style welfare state without a historic permanent shift against spending growth. We will be a European welfare state, however, without its funding base of payroll taxes more than double our current levels. The only option will be to seek new funding sources, such as a national value added tax.

These figures sound the alarm for those who do not want the United States to become a European welfare state. They explain why we have a Tea Party movement, whose motto is “it’s the spending stupid” and the vociferous opposition to the new health-care entitlement. It also shows the crucial role of the Republican house freshmen in holding the line on spending. These figures show that we are at a turning point at which those who wish for a European welfare state for the United States see it in sight within a relatively few years.

Most of our attention has been focused on the deficit, and rightly so. However, it would be a mistake to overlook the effects of the spending component of the deficit on the way our economy is organized and functions.

Data sources: The data used in this report are from the OECD Factbook 2010, The Economic Report of the President, and the CBO’s Baseline Budget Outlook.