Does Social Welfare Spending Reduce Inequality? New research says NO

NARRATIVE: Redistributive measures, such as social welfare spending, are necessary adjustments to “fix” wealth inequality.

REALITY: Politicians and pundits often advocate for policies to “fix” a supposed ill. More often than not, these policies are supported without consideration for the unseen, unintended effects.

Economists from the European Central Bank examined private wealth accumulation across 13 European countries to determine the role of inheritance, income, and welfare state policies in explaining the differences in household net wealth. They use extensive survey data from over 60K households, regression analysis, and control for household variables.

Their findings on inheritance confirm past literature. Heir households hold substantially higher net wealth levels than their non-heir counterparts. On average, intergenerational transfers lift a household by 14 net wealth percentiles. These transfers are a higher contributor to net wealth than welfare state policies – specifically, increasing inheritors wealth by 35%.

The results of welfare state spending on inequality, however, are quite surprising to a single stage thinker. Welfare state expenditures are substitutes for private wealth accumulation. The more insurance provided by the state against contingencies of life, the less a household has to accumulate wealth for precautionary reasons.

That translates to relatively lower average net wealth for households in countries with higher welfare state expenditures. The analysis, however, is still not complete.

The substitution effects impacts each wealth percentile differently. On the lower end, households are able to consume more and avoid accumulating private wealth because it is subsidized by the state. On the higher end, welfare programs, such as social security, substitute low risk assets in investment portfolios. Thus, wealthier households can take higher risks in their portfolios and therefore experience higher returns.

As a result, the negative reduction of net wealth is relatively more for lower income households than higher income. This implies that given an “increase of welfare state expenditure, wealth inequality measured by a standard relative inequality measure, such as the Gini-coefficient, will increase.”

Their findings quantify these effects. For one, there is a stronger negative correlation between social expenditures and net wealth for lower income households (25th percentile) than mean wealth.

The effect [on net wealth] of a 1 percentage point increase in state pension expenditures as a share of GDP is a decrease about 20% less wealth for households in lower wealth percentiles. For wealthier households, that effect is just above 10%.

Moreover, an additional euro spent in public security wealth correlates to a decrease in private wealth between .41 and 1 euro. This “displacement effect” varyingly impacts different households in terms of net decreases in total wealth – 47% for lower wealth households, 16% for middle, and 8% for higher.

In the words of researchers, “the estimates obtained here are conservative. Had we assumed higher pension wealth for the low wealth household, a larger increase in expenditure, or higher displacement rates, we would have seen a stronger effect for the low wealth household and the declining effect for wealthier households would have been even more pronounced.”

CONCLUSION: These findings are contrary to the political narratives surrounding wealth inequality. Moreover, they show the importance of thinking beyond stage one and considering what else might happen besides what is intended.

Whether or not low income households are “better off” from these programs is entirely subjective – consuming now versus savings or saving now versus consuming. It is evident, however, that social welfare spending reduces household wealth disproportionately for lower income households and favors high income household.

If lower income households were able to make their own decisions with money, it stands to reason that their inheritance levels would increase from the resulting wealth accumulation. Thus, as presented in these findings, their future generations would be wealthier.

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