Tuesday, 4 December 2012

70 years after Beveridge: Credible threats and the welfare state

It is 70 years since the publication of the famous ‘Beveridge Report’. The report set out a revolutionary new model for social insurance that soon led to the instigation of the National Health Service and National Insurance. One of the more interesting ‘anniversary events’ I came across was a program on BBC Radio 4 - ‘The State of Welfare’; it basically assessed social insurance 70 years on from Beveridge. The clear message I got from listening to the program was that the current system fails to deliver a core principle of the Beveridge Report. Beveridge would not have been impressed by all the elements of our current welfare system. So, what went wrong?
    The recommendations in the report were based upon three principles. I’ll skip the first two and focus on the third: ‘The third principle is that social security must be achieved by co-operation between the State and the individual. The State should offer security for service and contribution. The State in organising security should not stifle incentive, opportunity, responsibility; in establishing a national minimum, it should leave room and encouragement for voluntary action by each individual to provide more than that minimum for himself and his family.’ Our current system of social security seemingly fails this principle. The analysis of a simple game can guide us through the main issues.  
     The details of the game are sketched out in the game tree below. The game starts with a citizen choosing whether to work hard or be a slacker; working hard would involve working hard at school, searching for a job, being willing to do a job that’s not very pleasant, etc. If the citizen works hard then he can either be ‘lucky’ or ‘unlucky’; lucky would mean avoiding redundancy, disability, discrimination etc. (Because its out of the control of the citizen or taxpayer whether he is lucky we say that nature decides.) If the citizen works hard and is lucky then everyone is happy. Both the citizen and taxpayer get a payoff of 100, which you can interpret as both being 100% happy.

If the citizen works hard but is unlucky then things are not so good. Consequently, the taxpayer needs to decide whether she will give benefits to the citizen. If she doesn’t then the citizen has payoff 0 – it cannot get any worse. Because of this, the taxpayer feels guilty and so her payoff is only 50 – it’s not nice to see hard working people destitute. If the taxpayer gives benefits then the citizen has payoff 50 and the taxpayer 80. Note that the taxpayer has to pay the benefits, so her payoff is less than 100, but she does not feel guilty, so her payoff is more than 50. 
    Clearly, it pays for the taxpayer to give benefits to an unlucky, hard working citizen. More generally, everyone benefits if there is a national insurance system that helps hard working people who, through no cause of their own, fall on hard times. This is a core principle underlying the Beveridge Report. The problem, however, is that this insurance system, like any other, creates moral hazard. To see why we need to know what happens if the citizen chooses to be a slacker. 
    If the citizen is a slacker then no amount of luck is going to help. So, without benefits the citizen gets 0. The taxpayer feels guilty about this meaning she only gets a payoff of 70. Note that the taxpayer feels less guilty when a slacker gets 0 than when a hard working citizen gets 0. Even so, she feels guilty. And if you’re wondering why she should feel guilty then let me point out the slacker’s secret weapon – he has children. No one wants to see children going without and so our taxpayer feels guilty to see this citizen and, more importantly, his children destitute. 
    If the taxpayer gives benefits then the slacker gets 60 and the taxpayer gets 75. (A slacker on benefits is happier than a hard working person on benefits because he did not have to work hard.) The taxpayer is less happy giving benefits to a slacker than a hard working citizen. Crucially, however, she will still give the benefits. She gets payoff of 75 by giving the benefits and only 70 by not giving benefits; remember those children. It’s emotional blackmail – but blackmail can be effective. 
   Why should the citizen work hard if he can get benefits anyway? Well, the citizen does have some incentive to work hard because the 100 he can get from working hard trumps the 60 he can get from slacking. Everything will depend on the probability of being lucky. Suppose the probability is p. If the citizen works hard his expected payoff is 100p + 50(1 – p) = 50 + 50p. If he’s a slacker he gets payoff 60. It pays to be a slacker if 60 > 50 + 50p or p < 0.2. So, if the probability of being lucky is less than 20% it pays to be a slacker. That’s moral hazard – an unintended consequence of offering national insurance is that it lowers the incentive to work hard.
    The Beveridge Report said that social security ‘should not stifle incentive, opportunity, responsibility’. It seems, however, that our current system is doing exactly that. So, can we do anything about it? Most ‘solutions’ seem to focus on changing incentives. These solutions focus on ‘making work pay’ which puts the emphasis on the payoffs of the citizen (those highlighted blue in the game tree below). We can increase the probability a hard working citizen is lucky, increase the payoff to a hard working unlucky person, or decrease the payoff to a slacker on benefits. Doing any of these three things can tip the balance in favour of hard work.

A ‘solution’ that gets much less attention, but can solve the problem in one easy step, is to change the payoffs of the taxpayer (those highlighted brown below). As things stand, a threat to not pay benefits to slackers is non-credible. A slacker knows that the taxpayer will feel guilty watching his children starve and so he will get his benefits. If we flip things around so that not paying benefits is credible then a slacker knows that anything other than hard work will leave him with 0. Arguably, this is the kind of the system the U.S. has created. It certainly looks like the kind of system that Russia has. So, can we make it credible to give slackers no benefits?

While I said this is the easy solution – it’s not so easy to not feel guilty about those children. It requires a change in preferences – the taxpayer to feel less guilty about slackers having nothing – and a change in expectations – the citizen needs to know that the threat of no benefits is credible. Neither of these is easy to do. Note, however, that if it can be pulled off the taxpayer never needs to feel guilty: Everyone will work hard, and unlucky hard workers will get benefits. There will be no slackers! A harsher social security system can, therefore, end up harming nobody. That’s a concept that seems to be missed in the drift towards a softer welfare system which ‘rewards’ slacking.

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