Anthony de Jasay: The Vicious Circle of Social Kindness, in: Financial Times, April 29, 1994

Unemployment in the industrialized west is now clearly endemic and not cyclical as in the past. No reversal appears in prospect. At best the next few years will bring a minor rise in employment, at worst a further fall.

In the search for an explanation and cure, many old – but unsatisfactory – chestnuts are trotted out: a deep technological transformation is taking place (it always is); world trade has become too free and not fair enough (but freer trade, surely, brings greater riches?); or labour markets are too rigid and training inadequate (but did not the same apply 20 years ago?)

There may, however, be a different explanation for high unemployment in modern, redistributive democracies.

This is best illustrated with a simplified example. Imagine an economy where income comes from only two sources – profits and wages. Rents are negligible, and there is full employment. If the government wished to redistribute income in favour of wage earners, it would tax employers’ profits and add the money raised to wages.

The natural response would be for employers to put the wages they offer – and for employees to demand less. Consequently, the impact in terms of redistribution would be negligible and harmless: there would be no unemployment created and after-tax, after-subsidy incomes would remain unchanged.

But imagine that instead of transferring money, the government offered employees a basket of “social protection” – insurance against illness, unemployment, or destitution in old age. If we make the (large) assumption that collecting the tax and distributing it in the form of social protection are costless, the effect on the demand and supply of labour would depend on the difference between the cost of the package and the value attached to it by recipients.

At first sight, it would appear that employees would attach great value to social protection: reaction to proposals for curtailing benefits is usually virulent. But that is because most wage-earners are under the illusion that the greater part of the “insurance premium” is being paid by someone other than themselves.
The point is `social protection’ costs more than it is worth to at least some of those that it protects.

If wage earners understood that, ultimately, the cost had to be borne out of their own wages, would they prefer to have the “social protection” on offer – or would they rather buy some private insurance, save some, and spend the rest?

There is a strong paternalistic argument for saying that wage-earners should not be given such a choice – improvidence would make many take the money and “blow it”. But the important point is that “social protection” costs more than it is worth to at least some of those that it protects.

The result is that, at the margin, employment is taxed more than the subsidy is worth to workers. The two no longer cancel out and there is a net extra burden on the economy. Enterprises have to “restructure” and unemployment is born of “social protection”.

Worse, a vicious circle comes into operation. The initial unemployment created by the tax-subsidy inequality increases the amount of “social protection” that has to be handed out.

That extra cost results in a further increase in the tax on employment, widening the gap between the non-wage costs of labour and the value of the benefits in kind. Demand for labour is further depressed relative to its supply, more unemployment is created and the cycle is repeated.

Under an optimistic scenario, non-cyclical unemployment would stabilize, at some point, at a level that society would have to support indefinitely. But under a pessimistic scenario the rise in unemployment would prove inexorable.

There is empirical evidence to lend weight to such a theory. Comparisons across countries show a high correlation between cyclically corrected unemployment and “social protection” expressed as a share of national income. Unemployment in Europe, where the welfare system is more costly per head, is twice as high as in the US and many times higher than in east Asia.

Within post-Maastricht Europe, unemployment is worse in the centre than on its periphery, and the more “social” the country, the more it is plagued.

Democracies, we are told, cannot relax social protection. Are they, then, condemned to smother the young and the long-term unemployed with their caring kindness?