The argument that cutting social spending is an essential part of necessary fiscal adjustments is pervasive. That slashing welfare does not harm economic growth while tax hikes do is treated as received wisdom by many academics and policymakers. Georg Wenzelburger deconstructs the argument in favour of welfare cuts, writing that we need a much more nuanced understanding of the underlying mechanisms which distinguish successful from unsuccessful adjustments

Wenzelburger, Georg

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blogs.lse.ac.ukhttp://blogs.lse.ac.uk/usappblog/2014/02/15/the-policy-advice-that-adjusting-public-finances-by-cutting-welfare-is-the-best-way-to-proceed-is-far-too-simplistic/The policy advice that adjusting public finances by cuttingwelfare is the best way to proceed is far too simplisticThe argument that cutting social spending is an essential part of necessary fiscal adjustments ispervasive. That slashing welfare does not harm economic growth while tax hikes do is treated asreceived wisdom by many academics and policymakers. Georg Wenzelburger deconstructs theargument in favour of welfare cuts, writing that we need a much more nuanced understanding ofthe underlying mechanisms which distinguish successful from unsuccessful adjustments.“Any fiscal adjustment hoping to be successful cannot avoid dealing with cuts in the welfare stateand in government wages and employment”. This statement by economists Alberto Alesina andRoberto Perotti (see p.227 here) is just one example of the advice commonly given to policy-makers that budgetconsolidations are only successful (i.e. lead to economic growth) if welfare benefits are slashed. Over and over,think tanks and policy advisors have put forward this relationship between cutting welfare and successful fiscaladjustments in their policy recommendations. And indeed, a vast body of econometric research, including thework of Alesina and Perotti, has shown that fiscal adjustments which mainly rely on spending cuts do not harmeconomic growth (the criterion for success), whereas budget consolidations by means of tax hikes have negativeconsequences (for example, see here and here).However, for political scientists in general and scholars of social policies in particular, the simplicity of thisargument is puzzling in two respects. First, in welfare state research, much has been written about the“dependent variable problem” which means that reductions of social spending do not necessarily equal cuts inbenefits (see here, here and here). If unemployment increases, for instance, social spending will increaseautomatically as more people are entitled to unemployment benefits. Hence, even a small cut in benefits may wellbe offset by this development. Consequently, recent studies on welfare state retrenchment tend to usereplacement rates or indices of welfare state generosity instead of social spending (see here and here). Incontrast, the empirical foundation of the “cutting welfare” advice is built on analyses of social spending cuts.Second, scholars of welfare state retrenchment have pointed out recently that there is no such thing as thewelfare state. Instead, the term covers many different programs which follow different dynamics and differentlogics. Recent analyses have for instance shown that governments cut unemployment benefits much more easily(and more frequently) than pensions (see here and here). From this perspective, it would therefore be important todisaggregate the welfare state into its components and see which program matters most for successfuladjustments instead of looking at the overall aggregate measure of social spending. Summing up these twopoints, the policy advice that adjusting public finances by cutting welfare is the best way to proceed seems far toosimplistic.Empirical results corroborate this claim. If one uses the two said insights from welfare state research and refinesthe analysis of fiscal adjustments accordingly, the relationship between “cutting welfare” and “successfuladjustment” looks very different: First, the statistical relationship between welfare cuts and the success of fiscaladjustments completely disappears when generosity measures are used (measured inter alia by replacementrates or eligibility criteria) instead of social expenditures. Second, whereas reductions of unemployment insurancebenefits have no effect on the success of fiscal adjustments, cuts in pension generosity have an effect (see mywork for more on this).How can we make sense of these results? The first point, namely that there is no statistical relationship forgenerosity measures but such an association exists for spending, underscores the significance of the “dependentvariable problem”. Rising demand for social benefits is a non-negligible factor which impacts on spendingindependently of governmental decisions on benefit levels or eligibility criteria. Hence, policy recommendationsCredit: Fibonacci Blue (Creative Commons BY)about benefit levels based on empirical results for social sending are highly problematic. In addition, the secondfinding on the difference between unemploymentand pension cuts also contributes to understandingthe non-relationship between overall generosityreductions and successful adjustments: As overallgenerosity covers many different components ofthe welfare state, looking for correlations at thislevel of abstraction does not uncover therelationships further below. As the retrenchment ofunemployment benefits and pension benefits followdifferent logics, throwing both programs togethertherefore blurs the underlying causality. Inconclusion, the empirical results therefore suggesta more nuanced interpretation, namely thatreductions of pension benefits are an importantingredient for successful fiscal adjustmentswhereas cuts in unemployment benefits are not.This result makes perfect sense with regard to themajor theoretical argument which provides thecausal link between welfare cuts and successfuladjustments. Economists argue that the mainreason why welfare cuts are crucial to successful adjustments has to do with credibility. Governments that attackthe electorally most delicate parts of the budget – namely welfare entitlements which are popular with the majorityof voters – show that they are really serious about balancing the budget. This idea that cutting welfare increasesthe credibility of governments is relevant in two respects: First, international financial markets reward credibleconsolidation efforts by lowering the risk premium on the interest rates for government bonds. This, in turn,encourages investment and leads to economic growth.Secondly, citizens and entrepreneurs acknowledge the determination of the government to reduce deficits. Theyare more confident about the future, consume and invest more which, again, leads to economic growth. Thefinding that reductions of pension benefits are an important ingredient to successful fiscal adjustments whereascuts in unemployment benefits are not impotant nicely fits into this theoretical framework. Pension systems can beconsidered to be the most difficult part of the welfare state to retrench, due to the entrenched interests associatedwith them and the broad electoral support. Therefore cutting pensions is the hard case for a government’sdetermination to balance the budget. This explains theoretically why the link between cuts in pension generosityand successful adjustments is clearly present in the data, whereas reductions of unemployment benefits do notlead to said effects.These results have important consequences for policymakers and policy advisors. They show that we need amuch more nuanced understanding of the underlying mechanisms which distinguish successful from unsuccessfuladjustments. In the actual context of the debt crisis which is characterized inter alia by a special monetary policycontext, the need for nuanced arguments is even more important. Simple advice such as “cutting welfare leads tosuccessful adjustments” therefore have to be taken with a grain of salt.This article originally appeared at the LSE’s British Politics and Policy blog.Please read our comments policy before commenting.  Note:  This article gives the views of the authors, and not the position of USApp– American Politics and Policy, norof the London School of Economics.Shortened URL for this post:  http://bit.ly/1ouXVIE _________________________________About the authorGeorg Wenzelburger - Freiburg UniversityDr Georg Wenzelburger is assistant professor at the Chair of Comparative Politics at FreiburgUniversity, Germany. He received his PhD from Ruprecht-Karls-University, Heidelberg, Germany.His articles were published inter alia in the British Journal of Political Science, West EuropeanPolitics, the Journal of Public Policy, the Journal of European Public Policy and the Journal ofEuropean Social Policy. His research interests include the politics of welfare state reform, fiscalpolicy and the politics of law and order.CC BY-NC-ND 3.0 2014 LSE USAPP

The policy advice that adjusting public finances by cutting welfare is the best way to proceed is far too simplistic

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