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The Means to European Prosperity by Sven R. Larson

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The Means to European Prosperity

In my commentary “The Hurdles to European Prosperity” I explained how Europe is trapped in economic stagnation by the large welfare state and the Stability and Growth Pact (SGP). The welfare state redistributes income, consumption, and wealth from citizens with higher incomes to those who earn less. In doing so, it disincentivizes entrepreneurship, workforce participation, and productive investments. 

The SGP adds insult to injury, forcing welfare states to do their economic redistribution without running excessive budget deficits. This has pushed Europe’s taxes to the top of the world. 

By combining the welfare state and the SGP, the European Union has designed its economy for stagnation. This design was, of course, not intentional: the economists and politicians who drafted the EU Constitution three decades ago believed that the structure they were building would encourage economic growth. Yet the outcome has been the exact opposite: from 2000 to 2019, the euro-zone economy grew by an average of 1.4%, adjusted for inflation. 

The need for spending reform

This is half or less of what most European countries experienced in the post-World War II part of the 20th century. 

Europe developed its welfare state during the post-war period. We can see this clearly in the OECD’s database, on taxes as share of GDP. The database goes back to 1965, but only covers 15 current EU member states and the United Kingdom (due to differences in data collection methods). Nevertheless, the numbers are compelling: 

  • In 1965 the tax-to-GDP ratio for these 15 countries was 26.9%; 
  • By 2018 that ratio had risen to 39.2%. 

This growth in government is the most prominent change that Europe’s economy has undergone while its economic growth has slowed down. It is simply irresponsible to overlook it as the main factor behind the decline in growth. 

It is easy to point to what Europe must do to get its economy growing again: smaller government spending and lower taxes. The hard part is to formulate specific policy reforms that structurally reduce government spending.

A good place to start would be the scholarly literature on economics. Unfortunately, academic economists are not very interested in welfare-state spending reductions; compared to the literature on tax cuts, there is almost nothing written that can help us here. 

This is understandable to some degree: formulating reforms that permanently shrink the welfare state is both economically challenging and ideologically controversial. Above all, it is not an easy sell to politicians. 

Yet spending reform is the only path forward if we want to bring Europe out of its current state of stagnation.

There are two ways to move forward. The first is to give welfare-state spending “annual haircuts.” In American parlance this is known as the “penny plan” which cuts one or two pennies or cents off every dollar/euro spent by government. 

Trimming the budget on the margin is relatively common. Most legislators do not even think twice about doing it. However, while it is being widely used and therefore seems to be working, it has two disadvantages that essentially make it useless as a tool for reinvigorating the economy:

  • It does not actually reduce the size of government, but only holds back its expansion; and
  • It gradually eats into the entitlement promises that underlie the spending programs of the welfare state. 

We saw examples of the second point during the austerity crisis a decade ago, when many welfare states across Europe slashed entitlement programs and deprived primarily the poor and low-income families of the government help that they had been promised—and had adjusted their lives to. 

In other words, government had made promises it could not keep. You don’t make promises you can’t keep. Nor do you keep an economic structure that can’t promise growth and prosperity. Therefore, Europe is better served by the second path to welfare-state reform, namely structural spending reductions. 

The current definition of poverty

Our laws define the structure, and the purpose, of the welfare state. This purpose is economic redistribution: the welfare state exists to redistribute income, consumption, and wealth from “the rich” to “the poor.” It has been assigned this purpose for ideological reasons, which means that a structural reform of the welfare state must begin with giving it a new ideological purpose.

To identify this new purpose, let us look at how the current welfare state is defined ideologically. This purpose is manifested in the official EU definition of poverty: it spells out the purpose of all tax-paid entitlement programs. They are designed to alleviate poverty. But as a result of how poverty is defined, spending for alleviation does not stop at simply providing basic help to those who have nothing else. 

On the contrary, in fact.

The European Union defines poverty as follows:

People are said to be living in poverty if their income and resources are so inadequate as to preclude them from having a standard of living considered acceptable in the society in which they live. 

If we weed out the verbal filling of this definition, its content boils down to something rather simple: a person who makes less than most people, is considered poor. However, whenever politics is involved, things do not stay simple for very long. The authors of this reform decided to throw some normative gravel into the definition: you are poor because you are “precluded” from an “acceptable” standard of living. 

The normative meaning of this definition is as follows: a poor person ought to have the same standard of living as non-poor persons enjoy, without having to work his or her way out of poverty. In other words, someone else is responsible for raising the poor person’s standard of living to an “acceptable” level.

In the next leg of the definition, the duty of this “someone else” is spelled out with more clarity: 

Because of their poverty they may experience multiple disadvantage [sic] through unemployment, low income, poor housing, inadequate health care and barriers to lifelong learning, culture, sport and recreation. They are often excluded and marginalised from participating in activities (economic, social and cultural) that are the norm for other people and their access to fundamental rights may be restricted. 

The first sentence proposes a bizarre causality. It says that:

a) A person is poor;

b) Because a person is poor, he or she has low income, is unemployed, etc.

When we normally talk about poverty, we consider low income to be the cause of poverty. 

Logic notwithstanding, this—the second part of the EU’s poverty definition—reinforces its purpose: to provide an ideological imperative for the redistribution of income, consumption, and wealth. Now: since a person’s status as poor is defined by the relative size of his or her income, the poverty limit rises whenever median household income increases. As a result, the welfare state is forced by its own very design to expand spending. 

Plainly: the better the economy does, the bigger government grows. That, however, does not mean that a stagnant economy shrinks the size of government: when the economy is sluggish, more people fall into poverty and become eligible for the welfare state’s entitlement benefits. 

In other words, the welfare state is asymmetric: it can grow, but it cannot shrink. Since its size gradually brings about economic stagnation, it becomes a trap in which the economy gets stuck and from which it cannot get out.

Unless we reform the definition of poverty. 

A new definition of poverty

In order to create a welfare state that contains its own outlays over time, we need to remove every reference to relative income or living standards from the definition of poverty. In their place we employ a simple statement: “A person is considered poor when he or she, for involuntary reasons, cannot cover his or her most basic needs of nutrition, health care, shelter, clothing and transportation.” This definition specifies the welfare state as a last-resort entity, the role of which is to step in and help when there is no other help to be had.

It is important to note that this absolute definition of poverty does not confine government to the role it had under the British Elizabethan poor laws of half a millennium ago. The core of this definition, “most basic needs,” does not confine those who seek government help to undignified subsistence. The point is instead to limit government aid to where economic self determination is more rewarding. 

Since this poverty level is not tied to work-based income (unlike the current definition which puts poverty at 60% of median earnings) it automatically keeps welfare-state spending in check. Once we have given “most basic needs” a practical meaning, per-person government spending, on the benefits covered, would increase only by inflation. 

As an example of how this definition would work in practice, let us apply this reform to unemployment benefits. Those benefits are usually tied to a person’s income history; under this new definition the benefits would be equal for all unemployed, regardless of previous earnings. 

It is important to note that this example is purely hypothetical, meant only to illustrate the economic mechanics of this reform. The example is not meant to suggest any particular level of unemployment benefits. 

Suppose that in 2004 all countries in the euro zone had adopted an unemployment-benefit system that paid out the equivalent of the income for the lowest-earning 10% of the workforce. That year, the first decile made €6,609. If all the 13.6 million unemployed individuals in the euro zone had been paid this amount, the total outlays for unemployment benefits would have been €92 billion. This is a 35.5% reduction compared to the actual cost of those benefits in 2004.

But what about the effect of inflation on benefits? In the current model, benefits rise with growing workforce income, which by and large protects benefits against inflation.

Putting the new definition to work

We need to make sure, of course, that the benefits that cover “most basic needs” are also protected against rising cost of living. The simple way to do this is to tie benefits to inflation, such as a standardized consumer-price index. In our hypothetical example with the new poverty definition implemented in 2004, this would have increased per-person benefits by just a hair over 2% through 2010. On average, the benefits paid out would have been 40% lower than they actually were.

Let us, again, note that by using these benefits levels, I am not at all proposing that they be the actual levels used in any practical reforms. The point is instead that when this “benefits” definition is put to work over time, while the level of benefits keeps up with inflation and therefore maintains a steady level of last-resort help, the gains from taking a job increase:

  • In 2004 our hypothetical benefits are 47.7% of median income;
  • In 2011 they equal 44.6% of median income; and
  • In 2019 they were 42.7% of median income.

Due to the rise and fall in unemployment, savings to taxpayers would vary from one year to the next. Assuming that the number of unemployed individuals remained unchanged, the savings would vary anywhere between 14.6% and 41.3%. However, since over time income grows relative to benefits, it is likely that this absolute-benefits system would incentivize workforce participation, even if benefits were higher than the earnings of the lowest-paid income decile. Therefore, unemployment would likely shrink over time compared to a trajectory under the current system.

An absolute definition of poverty obviously has repercussions for other benefits systems as well. Our purpose here was simply to identify the point of origin for a reform to government spending that will reduce government, and keep it limited over time. 

Furthermore, it is worth noting that our experiment assumes a blanket reform for all euro-zone member states; the exact layout of any reform in the spirit of our discussion here would be contingent upon the extent to which legislators believe reforms are feasible, and what reforms are politically, culturally, and morally acceptable in each individual country. 

Sven R. Larson is a political economist and author. He received a Ph.D. in Economics from Roskilde University, Denmark. Originally from Sweden, he lives in America where for the past 16 years he has worked in politics and public policy. He has written several books, including Democracy or Socialism: The Fateful Question for America in 2024.