(This essay was published in Hong Kong Economic Journal on 12 February 2014)

 

In the 19th Century, the rise of capitalism in Western Europe led to the rapid growth of the market economy. Productivity soared and the standard of living of the industrial working class improved significantly despite socialist assertions to the contrary. An important consequence of capitalism was that it produced an economic surplus able to support the development of a much more powerful and effective government. The size of the government grew to proportions previously not possible.

 

From Table 1 we can see that the average share of general government expenditures in GDP among 25 of the more developed economies in the world rose from 10.7% in 1870 to 22.8% in 1937. The main component of government expenditure was consumption, not transfers and subsidies for the poor and disadvantaged, even though these were rising very rapidly from a very low base. The latter constituted only 1.1% of GDP in 1870 and 4.5% in 1937. Although transfers and subsidies grew in this period from one-tenth of government spending to one-fifth – a rate that was not trivial – this was not spectacular compared to what would happen in the following decades.

 

Table 1:     Percentage Share of Government General Expenditures, Consumption Expenditures, and Subsidies and Transfers in GDP, 1870-1995

 

  About 1870 1937 1960 1970 1980 1995
Average Government General Expenditure 10.7 22.8 27.9 35.5 43.1 45.5
Average Government Consumption Expenditure - - 14.2 15.6 18 15.9
Average Government Subsidies and Transfers 1.1 4.5 9.7 15.1 21.4 23.2

 Note:  The remainder of Government expenditure is spent on investment. The economies include Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, U.K. and U.S.

 

The period 1870-1937 was an era of expansion for civil and military bureaucracies, a feat made possible only because there was sufficient surplus in the capitalist economy to be extracted. Most of the expenditures went to salaries for public employees. In the West, the rise of the modern state with its rational bureaucracy was therefore a product of the rising capitalist market economy. The main functions of government were national defense, law and public order, tax collection, and various public administrative services. In economic jargon, the functions provided by the government appeared to be primarily modern state functions, which the market was unable to supply, such as public goods, correcting externalities, and so forth.

 

The Rise of Social Welfare

 

By 1960, average government general expenditure reached 27.9% of GDP. Government consumption expenditure was 14.2% and spending on transfers and subsidies came to 9.7%, with the rest on investment. Roughly speaking in 23 years (with World War II taking up 8 of those years), government transfers and subsidies had grown from one-fifth of total government spending in 1937 to two-fifths in 1960. This was the period when the welfare state came of age.

 

By 1980, average government general expenditure had reached 43.1% of GDP. Government consumption expenditure was 18.0% and spending on transfers and subsidies came to 21.4%. Over roughly two decades, government transfers and subsidies had grown from two-fifths of total government spending in 1960 to three-fifths in 1980. This was a period when the welfare state made its presence felt even further.

 

Three points stand out. First, the average share of government consumption spending of GDP grew only modestly, roughly doubling from 1870 to 1995. This is a period of 125 years. Even in 1980, the average amount of government consumption spending was only 18.0% of GDP.  It could be argued that this share is approximately the total cost of the state provision of essential public services not supplied by the market, including national defense, law and public order, tax collection, and various public administrative services; and that it excludes welfare transfer and subsidy programs.

 

Second, the average share of welfare transfers and subsidies provided by the state grew dramatically from 1.1% of GDP in 1870 to 21.4% in 1980. This is a total increase of some 20 times and represents a very large amount of resources. If it had been given away directly to all households below the median income in the form of cash supplements, it would have been more than sufficient to guarantee every household a median income level. There would then not have been any low-income households below the median income level, let alone below the poverty line.

 

Third, although in 1980 21.4% of GDP was spent on transfers and subsidies, it was not obvious that recipients valued the benefits they obtained by the same amount. If the efficiency ratio of benefits to costs is less than 100%, then potentially a lot of resources will be wasted. Say, for example, recipients valued transfers and subsidies at 75% of their value, then 5.35% of GDP (=21.4% x 25%) was being wasted for no good reason. In general, the larger the size of the welfare state, the lower will be the efficiency ratio and the more detrimental will be the state’s effect on economic efficiency and economic growth.

 

After 1980, the size of government as a share of GDP began to slow down. Government general expenditure rose from 43.1% in 1980 to only 45.5% in 1995. The share of government consumption spending of GDP fell from 18.0% in 1980 to 15.9% in 1995. But the share of government transfers and subsidies rose slightly from 21.4% in 1980 to 23.2% in 1995. This was the era of Reaganism and Thatcherism and of the collapse of the Soviet Union. Welfare state ideas had become hugely discredited in this period. But despite all the supposed efforts to roll back the welfare state, in reality, little was accomplished other than preventing it from growing still further.

 

Tyranny of the Majority

 

Why has it been so easy for the welfare state to grow, and so difficult for it to be rolled back? Three hypotheses have been proposed to explain this: first, tyranny of the majority, second, tyranny of the minorities, and third, bureaucratic inertia.

 

The concept of the tyranny of the majority is used in discussing the problem of democracy and majority rule. It envisions a scenario in which a majority acting through the democratic process makes decisions in its interests so far above those of individuals or minority groups as to constitute oppression, comparable to that of tyrants and despots.

 

The second U.S. President John Adams was probably the first to use the phrase “tyranny of the majority” in 1788. The phrase gained prominence after its appearance in 1835 in Democracy in America, by Alexis de Tocqueville. Many thinkers have since written against the tyranny of the majority, arguing that individual rights are not subject to a public vote, and that the political function of rights is precisely to protect minorities and individuals from oppression by majorities.

 

The great English constitutional jurist A V Dicey, writing about the problem of British old-age pensions in 1914, considered whether England as a whole would gain by enacting into law that the receipt of poor relief, in the shape of a pension, should be accompanied by the pensioner’s forfeiting his right to vote in parliamentary elections. Compulsory invasion and violation of private property rights at the ballot box is deemed by many to be a form of tyranny. As it happened, England and other democratic states in the West moved to universal suffrage without the disenfranchisement of either pensioners or other recipients of state aid.

 

The idea that a majority coalition of the relatively poor can impose taxes on the relatively rich through a majoritarian democracy has often been put forward as an explanation for why subsidies and transfers will grow under a democratic system of government with a majority voting rule.

 

This is a simple and powerful explanation. But it cannot explain why the amount of state transfers and subsidies is so large. When governments transfer as much as 20-25% of GDP then even the median voter will lose because the value of the benefits he obtains will be much less than the taxes he has to pay. According to majority rule, voters would have switched their voting choice in favor of fewer transfers and subsidies.

 

The tyranny of the majority hypothesis also fails to explain why the transfers and subsidies have not been in the form of cash supplements for low-income families, but instead are overwhelmingly transfers and subsidies-in-kind made through thousands of separate distinct programs. Furthermore, countries that are not democracies have also experienced an explosion of government transfers and subsidies.

So what explains the growth of transfers and subsidies that have taken place in both democratic and non-democratic states?

 

Tyranny of Minorities

 

Hans O. Staub wrote:

 

Democracy is, by definition, government of the majority. But today, such definitions have a ring of mockery. It is not the majority that governs. Minorities of all kinds have become the decision-makers; they dominate, tyrannize, or terrorize the majority, which appears principally as a conglomerate of constantly shifting minorities.

 

There are racial and ethnic minorities, separatist minorities, ecology-minded minorities, minorities for the emancipation of women and now for men as well, homosexual minorities, religious sectarians, minorities for important or abstruse political causes, local or regional interests. In the economic sphere there are numerous small and vocal interest groups whose single purpose is to steer the economy in a direction calculated to give them an advantage. Employer lobbies, trade unions and professional organizations are among the most well-known economic lobbies. In the non-profit sector the lobbies are just as numerous and vigorous in seeking private donations and especially public subsidies.

 

The brilliant Italian economist Vilfredo Pareto was the first to recognize that in politics the real power lies in organization and power belongs to the well-organized minorities. Lenin took this point to heart and made it the central tenet of his Bolshevist doctrine. Pareto was the first to recognize that minority groups had much greater incentive to lobby for favorable legislation and were more likely to be successful at it.

 

Pareto’s reasoning was very simple and logical. First, it is easier to organize 100 persons than 100,000. This means that cohesive organizations are usually small rather than large. For example, it is easier to organize taxi-drivers than to organize all motor vehicle drivers, let alone the working class as a whole.

 

Second, it is always more difficult to tax a well-organized minority than a large majority. If the state wants to raise a sum of $100,000, it is better off taxing 100,000 persons $1 each than 100 persons $1,000 each. A person to be taxed $1,000 will invest much more time and money to resist it than a person to be taxed only $1. It is also more likely for the said group of 100 persons to seek out each other to become politically organized than the larger population of 100,000.

 

Rent Seeking and Social Welfare

 

Combining these two points implies that successful political lobbies always belong to organized minorities. Their real objective is to levy a small per person tax on the large majority and transfer a significant sum to each of themselves. The activities of the organized minority in seeking government transfers and subsidies has become known as “rent-seeking” in economics, and was re-discovered by Mancur Olson (1965), Gordon Tullock (1967), and Anne Krueger (1974) in different contexts.

 

The early economic studies of rent-seeking activities focused on the political lobbying efforts of business groups, trade unions and occupational associations. But it soon became obvious that the same logic could be applied to social advocacy groups wanting to secure government transfers and subsidies for the poor and disadvantaged in society.

 

Why are social advocacy groups interested in helping the poor and disadvantaged? Is it because of their benevolence or their self-interest? If it were purely out of benevolence than it would make sense to give low-income families cash supplements. This would be the most efficient form of transfer and subsidy. In other words, it would give the biggest bang for every dollar spent on the poor and the disadvantaged.

 

If, however, the social advocates were self-interested then it would make sense for them to lobby for specific transfer and subsidy programs to provide direct services. If they were to become the service providers then this would result in paid jobs for themselves, albeit in the service of some specific group among the poor and the disadvantaged. Surely these service providers would be paid market salaries for otherwise there would be no reason for them to accept the job or even to lobby for the program to begin with. Whether the benefits received by their clients added up to the cost of the service would be less certain, and would depend on the efficiency of the programs.

 

This also explains why, once a specific program is established, it is almost never terminated regardless of whether it is still needed, for otherwise the service providers would become unemployed. Very often how much they are paid and through what mechanism or arrangement are also matters of great contention between service providers and the government funding agencies. This is not surprising since service providers are in fact the key stakeholders of the program rather than their clients.

 

It also explains why governments rather than private donors are their preferred source of targeted funding. Private donors are more likely to hold these service providers accountable for how their donation is spent, whereas government bureaucrats are less motivated to look after the money of taxpayers.  After all benevolent private donors always have the choice not to donate; government bureaucracies have much less choice. This also explains why these advocacy groups are more often politically active rather than market oriented.

 

Such an explanation provides the most consistent argument for why the welfare state has grown beyond the resources needed to help the poor and disadvantaged live a good life. It explains why cash supplements have been shunned in favor of inefficient programs. And it explains why it has been so difficult to tame the welfare state, given the considerable power of the organized rent seekers.

 

Bureaucratic Inertia

 

The more resources a government has at its disposal, the greater will be the incentive for rent-seeking social advocacy groups to lobby government for a share of it. It is not surprising that the Hong Kong government has been facing an increasing demand for transfer and subsidy programs since there is a widespread perception that the fiscal reserves have grown significantly in the past two decades.

 

Government agencies that fund these programs develop symbiotic relationships with the service providers. Although there are conflicts between the two, government bureaucracies do not like to be accused of making policy or funding mistakes. Programs are unlikely to be killed because killing a program is tantamount to admitting a mistake. Often government bureaus prefer to point to their funded programs and agents as proof that policy objectives have been attained.

 

Government bureaucratic inertia also makes it impossible to cut existing programs. New problems and new concerns are addressed by creating new programs, not by replacing old ones. This creates a mutually reinforcing effect that allows the welfare state to keep on growing in size and inefficiency.

 

The growth and persistence of the welfare state by this logic depends on the twin effects of bureaucratic inertia and the rent-seeking activities of social advocates. Both effects exist in democratic and non-democratic political systems. While the tyranny of the majority depends on the presence of a majoritarian democratic political system, the tyranny of minorities does not.

 

Nevertheless in a democratic political system, the magnitude of government transfers and subsidies may still be larger for another reason. Social advocacy groups are likely to have a larger presence because of the greater tolerance of the state towards their activities. If this is indeed the case, then democracies may find an oversized social welfare state impossible to downsize.

 

Rent-seeking activities in the economic sectors are also present and considerable, but they take place mostly through regulations that limit competition, for example, minimum wages, standard hours of work, barriers to entry, franchises and monopolies, protectionist tariffs and quotas, and the like. Such regulatory features also make the economy less efficient and have been criticized by economists since the time of Adam Smith.

 

In non-democratic political systems, the state usually plays a bigger role in the economy so the most active rent seekers tend to be more heavily represented in the economic sectors than those lobbying for a larger social welfare state. Both forms of rent seeking activities have a detrimental effect on the economy. Olson (1982) attributes the rise and decline of nations to the growth of rent-seeking activities.

 

Nothing in the economic analysis of the rent seeking behavior of social welfare service providers belittles their benevolent motivations to help the poor and disadvantaged. Like everyone else they are on average motivated by more or less the same things in life as the average businessman, unionist and professional. They would like to be respected by peers, by the public, have a steady job, receive rising pay and avoid seeing their own trade decline.

 

Adam Smith famously said “it is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest.” Analogously it is not from the lack of benevolence of the social welfare service providers that transfer and subsidy programs have proliferated, but from their regard to their own interest.

 

References:

 

A V Dicey, Law and Public Opinion in England, London, 1914

 

Anne O Krueger, “The Political Economy of the Rent-Seeking Society,” American Economic Review, 1974

 

Mancur Olson, The Logic of Collective Action, Harvard University Press, 1965

 

Mancur Olson, The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities, Yale University Press, 1982

 

Gordon Tullock, “The Welfare Costs of Tariffs, Monopolies and Theft,” Western Economic Journal, 1967

 

Ninth essay in the series on Rekindling Hong Kong’s Magic

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