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France Is Right to Cut Runaway Social Spending

by | April 24th, 2014 | 11:25 pm
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Prime Minister Manuel Valls of France recently announced details about where he intends to cut public spending to lower business costs and also reduce the government’s deficit. This is long overdue in a country where the government already spends around 56 percent of GDP, or more than 10 percentage points above the Organization for Economic Cooperation and Development (OECD) average [pdf]. To the surprise of some, he also included nominal freezes of public pensions and welfare benefits for the next year, targeting two spending priorities that have long been politically sacrosanct.

Now—in these near deflationary times in the euro area—is ironically an opportune time to freeze the benefit levels. France’s low inflation of 0.9 percent [pdf] in the 12 months prior to March 2014 protects recipients against some of the real decline in the value of their government transfers.

That a socialist prime minister is tackling this sensitive issue is good news politically, even if the projected savings remain to be seen. In the absence of a crisis forcing cutbacks in welfare programs, European welfare states are generally best overhauled by reformist center-left governments. When center-right governments propose such cuts in welfare payments, center-left parties tend to be able to block them.

Because deficits remain a problem even after France raised taxes on the wealthy, trims in public spending on social issues are necessary. Informed choices depend on the clarity of information, however, and the complexity of advanced economies’ welfare states often masks the true levels of social spending and redistributive government actions. The measures often focus on direct government social expenditure, neglecting tax policy and private social spending. For example, France devotes more resources toward social needs than many measures suggest and cannot likely return to solid long-term economic fundamentals without curtailing this allocation.

Take gross public social expenditures from government budgets, which include cash and/or in-kind benefits on old-age/survivor/disability pensions, health care, families, active labor market policies, unemployment, housing, and other social spending. Figure 1 uses data from the OECD Social Expenditure Database (SOCX) showing the level of gross public social spending as a share of GDP in 2009 for available EU countries.

figure1-20140424

According to figure 1, French public social expenditures are 32 percent of GDP, the highest in Europe, two percentages points higher than Scandinavia, more than 5 percentage points higher than the rest of the EU-13 average, and 7 percent higher than the non-France euro area average.

Even so, figure 1 does not account for the full effect of tax systems. Two main types of taxation benefits are relevant:1

Direct Taxation of Cash Benefits Many European governments levy income tax and social security contributions on cash transfers, reducing the size of the benefit.

Indirect Taxation of Consumption by Benefit Recipients Consumption taxes in the European Union vary greatly, but they also reduce the value of gross benefits.

Figure 2 illustrates the effect of different direct and indirect taxation systems and computes net after-tax public social expenditures for available EU members.

figure2-20140424

Thus Scandinavian countries and many other governments claw back a share of gross social expenditures through direct and indirect taxes. Hence the variation among EU members in public net after-tax social spending is smaller than indicated by gross spending data. But at 28.1 percent of GDP on an after-tax basis, France spends 2.5 percentage points of GDP more than the next highest public social spending in the European Union, Belgium, at 25.6 percent of GDP in 2009.

Social spending is also magnified by specific tax breaks for social purposes, or TBSPs. The OECD Social Expenditure Database (SOCX) defines TBSPs as “those reductions, exemptions, deductions or postponements of taxes, which: a) perform the same policy function as transfer payments which, if they existed, would be classified as social expenditures; or b) are aimed at stimulating private provision of current benefits.

For example, many EU countries have an earned income tax credit (EITC) similar to the one that effectively transfers cash through the tax system to poor families in the United States. France also has a family support (quotient familial) tax break. TBSPs are also often employed to subsidize private health, unemployment, and other social insurance coverage by individuals and/or employer-based plans.2

Figure 3 illustrates what happens when the unrecorded costs of TBSPs are added to the public net after-tax social expenditures for EU members.

figure3-20140424

Figure 3 shows many differences among EU countries on this score. Germany implicitly spends around 2 percent of GDP on TBSPs, while France, Portugal, and Spain spend around 1 percent of GDP. This type of spending is trivial in most other EU countries.

Overall, the tax system as illustrated in figure 3 equalizes social expenditures in EU countries. But France still spends 3 percentage points of GDP more than Belgium, the second highest spender in the European Union, and 3.5 percentage points more than Germany. It spends 4 percentage points more than Spain, 5 percentage points more than the Scandinavians and the EU-14, 6 percentage points more than other old members of the European Union, and more than 7 percentage points more than the rest of the euro area on average.

From the perspective of a recipient household, or when comparing the ultimate outcomes of social spending, it does not really matter so much whether the resources for social expenditure originate in the public or the private sector. Accordingly, private sector spending should be considered part of the welfare state, in two ways:

Mandatory Private Social Spending This category includes legal mandates for individuals or employers to provide cash benefits for worker incapacity, occupational accidents, sickness, or pension plans.

Voluntary Private Social Spending Depending on the EU member, this category can include many of the same things that are mandated elsewhere.

The value of TBSPs for private social spending should be subtracted from the data to avoid double counting.

Figure 4 takes the net public after-tax social expenditure from figure 3 (blue bar). To this it adds EU members’ mandatory (grey bar) and voluntary (yellow bar) private social spending, while subtracting direct and indirect taxation income for the government from private social spending, as well as the government cost of TBSPs towards its provision.

figure4-20140424

Figure 4 shows sizable country differences in EU spending levels for voluntary private social spending. In gross terms, this category accounts for more than 5 percent of GDP in the United Kingdom and the Netherlands, and 2.5 percent of GDP on average for the euro area and the European Union. At around 3 percent of GDP, France’s gross private social spending is slightly above the European average. At the same time, France has few offsetting government revenue items to yield lower net total costs of social spending, so it has about the same high level of net total social spending as gross public social spending in figure 1, or 32 percent of GDP.

The conclusion to be drawn from these comparisons is that France’s net total social spending is more than 4 percentage points of GDP higher than the second highest social spender in Europe, Belgium, and 4.5 percentage points higher than Germany and the United Kingdom. France also spends a total of 7 percent of GDP more on social issues than the Nordic countries and the other old EU members on average. When compared to the rest of the euro area, the additional net total social spending in France reaches 8.5 percent of GDP, or fully a quarter more than the other members of the common currency on average.

It is hard to argue that the social outcomes in France are materially better than in other EU countries. Prime Minister Valls is therefore right to tackle the overdue issue of reducing aggregate French social spending. Unless he succeeds, France’s economic revival seems unlikely.

Notes

1. Fiscal adjustments measures included here consist only of “first-round effects”, related to the net value of benefits. Second-order effects derived from social expenditure, like the direct taxation of the earnings of those who provide social services (e.g., staff in hospitals or childcare centers) is not included here.

2. Another and arguably more important tax break of this type is the one aimed at stimulating private pension savings, e.g., a private benefit provision beyond the current year. However, lack of comparable data across all OECD countries means the cost of TBSPs to spur the private pension provision is only available for some OECD countries, and they are consequently not included here.