The Economy of Obligation: Incomplete Contracts and the Cost of the Welfare State

Avner Offer

University of Oxford

Abstract

Western governments typically pay out some 30 percent of GDP for social purposes. This is financed by taxation on a pay-as-you-go (PAYGO) basis. How efficient are these transfers, and can market or other mechanisms do it better? The problem arises since no individual stands alone. During the life cycle there are several periods of unavoidable dependency, in which there is no earning and little to bargain with: motherhood, infancy, childhood, education, illness, disability, unemployment, old age. The problem is how to transfer resources from ‘producers’ to ‘dependants’ over the life cycle. The market solution is for individuals to accumulate financial assets and to transfer them over the life cycle by means of long-term contracts with financial intermediaries.

But law, economics, psychology, political science, and history, all suggest that long-term contracts are not reliable. People are myopic. Financial intermediaries exact high rents, and market entitlements are volatile.  Equity markets do not have sufficient capacity to support life-cycle transfers.  Governments convert private life-cycle transfers into intergenerational cross-sectional ones, financed by PAYGO. The resource base is much larger than financial markets, and is made up of the whole of the tax base.  Costs are low, transfer levels are not rigid, are fixed by political consent, and can be adjusted. The national income resource base is stable.  The constraints are (1) the demand for security (2) taxable capacity (3) integrity and competence of government (4) potential capture by finance. Because of these constraints, although government can do it better, it cannot do it alone, and the whole repertoire of transfer is required.