A Crisis in the Making: Europe's Welfare Burden
Will Welfare Reform Restore Economic Incentives?
SEPTEMBER 01, 1994 by NICHOLAS ELLIOTT
Mr. Elliott is a financial journalist in London, England.
Europe’s welfare states face a profound crisis because aging populations mean growing numbers of benefit recipients and dwindling numbers of taxpayers to fund the entitlements.
Prolonged recession has highlighted these dangers as high unemployment has meant higher welfare payouts and reduced tax revenues. As a result, wide budget deficits have developed in most countries of Europe, and there has been a sharp build-up of debt.
This has awakened the governments of some European nations to the fact that maintaining “cradle-to-grave” welfare states is impossible in the long term, and reforms are already being undertaken to limit eligibility to benefits. As privatization was partly a response to the inefficiency of industry in the 1970s, so welfare reform is being forced by inexorable demographic strains. In years ahead, economic growth rates in the countries of Europe are likely to depend heavily upon their differing welfare burdens.
Comprehensive welfare states have become standard across Western Europe since 1945, providing—variously—unemployment benefits, sick pay, disability benefits, maternity benefits, child care, health care, and pensions. In the early stages it appeared affordable to extend these benefits, paid for by young taxpaying populations.
However, there was always a fine line. Sweden illustrates the economic consequences of unrestrained welfarism. From 1960 to 1990, as an extensive welfare state was erected, government spending grew from 31 percent of gross national product to 60 percent. But the increase in taxes required to pay for this blunted incentives disastrously. For instance, because of higher taxes, real after-tax wages for Swedish industrial workers fell 0.6 percent from 1980 to 1987 despite a 72 percent increase in gross wages.
As a result, Sweden has tumbled from being the third wealthiest in 1970 to 12th place among rich countries, reflecting an average growth of only 1.1 percent in the past 20 years. The government of Carl Bildt was elected in 1991 with a program of welfare reform to restore the economy.
Pensions and Aging
The largest spending increases in welfare states have been on pensions, and without reform the future costs are potentially explosive. Only about a quarter of the increase in pension spending among Organization for Economic Co-Operation and Development (OECD) countries between 1960 and 1984 was due to aging populations; the rest resulted from widened entitlements and larger benefits. Because such a major aging is now underway, this largess will have to be reversed.
Greater longevity means that by the middle of the next century there will be 190 million over-65s in the OECD, up from 61 million in 1960. The disparity this will cause between earners and pensioners is highlighted by the age-dependency ratio, which shows the number of over-65s in proportion to 15-64 year-olds. This is set to rise from 19 percent in 1990 to 28 percent by 2020 and 37 percent by 2040.
To give some individual examples, the over-60s made up 11.75 percent of the British population in 1961, but that’s expected to rise to 22.44 percent by 2011 and 26 percent in 2026. At the same time, the proportion of 15-64 year-olds—roughly speaking those of working age—is forecast to drop from 65.3 percent in 1990 to 62.3 percent by 2026. Similarly, in Germany the proportion of 15-64 year-olds is forecast to fall from 69 percent of the population in 1990 to 67 percent in 2011 and to 64.5 percent in 2023, while the portion of over-65s is projected to increase from 14.94 percent in 1990 to 20 percent in 2011 and 23 percent in 2023.
The fiscal stress of this aging will be exacerbated by some pension schemes reaching maturity—paying out the maximum benefits—around the time that the number of pensioners peaks. When pension funds are first established there are many contributors and few claimants, but as time goes on there are fewer payers and more recipients. For example, Britain’s State Earnings Related Pension Scheme (SERPS) will mature in 2020.
Many government schemes are unfunded; they are simple transfers from the young to the old. Whereas funded schemes can be managed with a view to future liabilities, unfunded schemes are laid bare to the ravages of demographic swings.
Also, older people make greater demands on health care, which adds to government spending where the system is publicly operated. For example, the over-75s cost Britain’s National Health Service nine times as much each year as 16-64 year-olds.
The Necessity of Reform
There is a crisis in the making across Europe, to which most governments are now alert. The extent of their reforms now—consisting principally of reducing government entitlements and encouraging private provision—will be a key determinant of economic growth in years to come.
Several countries have raised the age at which government pensions are paid. The British government recently announced that the pensionable age for women, currently 60 years, will be raised to 65, equal to that of men. The Italian government plans to raise the pensionable age from 60 years to 65. Bildt’s government in Sweden intends to raise it from the current 60 years to 61. In France the government plans to lengthen the period over which contributions must be made to qualify for a full pension. Outside Europe, Japan’s pension age for women will be raised in the year 2000 from the present 60 years to 65, equal to that of men. The U.S. government took a similar step in 1983, scheduling a gradual increase in the pension age, from 65 to 67 years, beginning in the year 2003.
Another move has been to encourage opting-out of government pensions into private plans. The British government did this with SERPS in 1988, prompting 4.5 million to exit the government scheme. This shrinkage in membership of the government scheme should greatly curb any increased costs to the taxpayer arising from its maturing.
The most significant reform is to update pensions with prices rather than incomes, as earnings typically outpace prices over time. The U.K. did this in 1980, and France did so in 1984. A British government actuarial report estimates that tax rates would have to be eight percentage points higher by 2030 if pensions had continued to be linked to earnings rather than prices.
Differences in welfare burdens and in the rigor of reforms among the countries of Europe are already being reflected in their respective economies. Despite the demographic trends described above, Britain is in a relatively good position; her reforms will contain future costs. Also because much of the aging of her population has already occurred, the size of the emergent mismatch won’t be as great as in other countries. The age dependency ratio is set to rise by 31 percent in Britain by 2040, as compared with 66 percent in the United States and 73 percent in Germany.
By contrast, Germany’s welfare costs are potentially explosive, with the admittance of new claimants from the former East Germany, placing further strains on a system that was already bloated.
German government pensions are linked to earnings and the retirement age—58 years—is relatively low. Proposals to reform a sprawling system of welfare benefits are already meeting with vociferous protest: 100,000 building workers recently converged on Bonn to object to plans to curb payments for being left idle by bad weather. The government may raise the pensionable age, but at the same time it is planning to extend government nursing care.
Welfare costs are recouped in Germany through taxes on employers and employee earnings, not through general taxation as in Britain. As a result of higher welfare spending, these costs are expected to reach 40.2 percent of wages next year, up from 26.5 percent in 1970. With such a burden it’s not surprising that 36 percent of western German industries are planning to relocate investment abroad in the next three years.
In the short term a welfare state may be an affordable luxury for a wealthy and prospering country, but in some European countries wealth and growth have been dissipated by the taxation needed to pay for it. Maintaining a welfare state is not simply a question of producing the wealth and then redistributing it, because the process of redistribution itself hinders wealth creation. The extent to which this point is understood will determine whether or not Europe remains a rich continent. It’s an open question whether welfare reform will be far-reaching enough to restore economic incentives. Otherwise some European countries risk becoming economic backwaters. 
- 1. See S. G. Warburg Securities, Weekly International Bond Market Review, November 25, 1993.
- 2. Peter Stein, “Sweden: From Capitalist Success to Welfare-State Sclerosis.” Policy Analysis, Cato Institute, September 10, 1991.
- 3. Organization of Co-Operation and Development, “Reforming Public Pensions,” OECD. Paris, 1988.
- 4. Financial Times, October 25, 1993.
- 5. Office of Population and Census Studies.
- 6. Federal Statistics Office.
- 7. Paul Johnson and Jane Falkingham. Aging and Economic Welfare (London: Sage Publications Ltd., 1992), p. 133.
- 8. Cited in Johnson and Falkingham, op. ctt., p. 142.
- 9. The Sunday Telegraph, November 28, 1993.
- 10. Financial Times, November 19, 1993.
- 11. Cited in Gerard Lyons, The Outlook for the European Economies and Financial Markets in 1994, DKB International, November 1993.