The system of European welfare – social insurance, social services, pensions and redistribution – is in crisis. Michael Orszag and Dennis Snower offer a proposal for reform.

The rise in European living standards over the past half-century has been accompanied by steadily increasing demand for social services (such as health and education), ‘life-cycle transfer’ services (such as pensions), and social insurance (such as unemployment and disability benefits). After all, these welfare services are not inferior goods: demand for them rises as people’s income and wealth increases.

At the same time, there is the threat of supply-side failure. The growing risks of unemployment and job loss have made it more difficult for the private sector to meet the increasing demand for social insurance and life cycle transfers. Meanwhile, though public welfare programmes remain broadly popular, governments are coming under more and more pressure to reduce their welfare budget commitments.

In a new CEPR Discussion Paper, Michael Orszag and Dennis Snower describe a potential reform of European welfare services that would both address supply-side failure and facilitate an expansion of the system in line with growing demand. Orszag and Snower propose the establishment of four ‘welfare accounts’ for each person in a country: a retirement account (covering pensions); an unemployment account (covering unemployment support); a human capital account (covering education and training); and a health account (covering insurance against sickness and disability).

This reform would replace the existing tax-and-transfer system with a system of compulsory saving: people would make regular mandatory contributions to each account, and the balances would, over time, cover their major welfare needs. When people retire, they would draw on their retirement accounts. When they become unemployed, rather than claiming benefits, they would draw on their unemployment accounts. When they wish to acquire skills, rather than seeking government subsidies or loans for education, they would draw on their human capital accounts. And when they are ill or disabled, they would draw on their health accounts.

If the balances in a particular account exceeded a specified limit, they could be transferred to other welfare accounts. For example, someone with excess funds in the health account could move them to the human capital account to purchase training. At the end of a person’s working life, the outstanding balances in the unemployment and human capital accounts could be moved into the retirement account.

The government would set mandatory minimum contribution rates depending on a person’s age and income. It would also set maximum withdrawal rates. Rates would be determined in an actuArial,Helvetica,Sans-Serifly fair manner so that for each type of account, across the country as a whole, the discounted value of the associated aggregate benefits would equal the discounted value of the aggregate contributions.

The government would be able to redistribute income across welfare accounts. But it would be constrained by a ‘balanced budget’: total taxes on each type of account would have to equal total transfers into them. In this way, the proposal meets one of the central challenges of welfare reform: enabling the government to redistribute income from rich to poor without it also using the tax-and-transfer system to finance welfare services, and hence discouraging private sector provision.

Instead, welfare services would be financed solely by what people choose to spend from their welfare accounts. As a uence, the government would have no incentive to manipulate contribution and withdrawal rates to ease fiscal pressures outside the welfare state. For example, it could not use tax receipts from welfare accounts to finance spending on defence.

Indeed, there would be two budgetary systems: one where non-welfare expenditure (on defence, transport, etc.) is financed through existing taxes, and another where public spending on welfare services is financed through payments from the welfare accounts. In effect, the welfare system would be insulated from the rest of the government’s budgetary process.

In such circumstances, the public and private sectors would provide welfare services on an equal footing, competing with one another for the custom of welfare account holders and thereby promoting more efficient provision. For example, with health services, people would pay for health insurance from their health accounts and then choose the provider of their health services, whether public or private.

Private sector pricing of insurance services would need to be regulated to prevent ‘cream-skimming’, that is, providing services only to those who are unlikely to receive large payouts and leaving the others to the public sector. As with many existing private insurance systems, providers could be required to make the prices of their welfare services dependent only on a small subset of characteristics, such as age and income, and to ignore all others.

People could voluntarily contribute more than the specified minimum to their accounts. Indeed, they would be encouraged to do so: while contributions would be taxed or subsidised according to the agreed scale of income redistribution, withdrawals and capital income from the accounts would be taxed at preferential rates (or possibly not taxed at all).

Since welfare account funds would have tax benefits relative to ordinary savings, individuals may choose to save more in their welfare accounts than the mandatory minimum. Employers too would be encouraged to contribute to their employees’ accounts at the same preferential rates. Yet the account balances would remain fully portable across employers.

To make a fiscally viable transition from the current system, the welfare accounts could initially be run on a ‘pay-as-you-go’ basis. Over time, they would eventually be turned into a fully funded system. Once the transition is under way, people could be given discretion over who manages the funded portions of their accounts, whether the government or private sector financial institutions. To guard against bankruptcy, the financial activities of the latter would need a system of regulation similar to that for commercial banks.

Adopting this new system of welfare accounts would improve incentives for productive activity as well as for the efficient provision of welfare services. For example, welfare account funds could become a key component of overall investment. Since the funds would typically have relatively long-term liabilities, they could be used to finance the long-term investments essential for future growth and competiveness.

At the same time, unemployment accounts would give people more incentive to avoid long periods of unemployment. The longer people remained unemployed, the lower would be their unemployment account balances and consequently the smaller the funds available to them later on.

For a given scale of income redistribution, unemployment accounts would generate more employment than does the current system of unemployment benefits. And while people are generally resentful of their tax burden and often find existing unemployment benefits and training programmes demeaning, they would be more willing to contribute to personalised accounts for their own purposes.

Welfare accounts would give people more freedom to meet their diverse individual needs, to respond to changing job opportunities, to finance periods of job search, to acquire skills and to provide for retirement. All this could be done without creating greater inequality or increasing government expenditure. And by removing the distortions of the unemployment benefit system, the government would benefit from extra economic activity and hence enhanced tax revenues.