Media Briefings

THE INTERGENERATIONAL WELFARE STATE: New thinking on a social compact to encourage greater investment in education

  • Published Date: June 2017

A new social compact can drive higher investments in human capital for the benefit of society as a whole without any generation needing to sacrifice. That is the central message of research by Torben Andersen and Joydeep Bhattacharya, published in the June 2017 issue of the Economic Journal.

They analyse an intergenerational compact that would ask current wage-earners – the middle-aged generation – to pay taxes to cover the costs of public education for the younger generations. Compensation would come later in life in the form of payouts from a public pension system that the by-then-middle-aged but richer and more educated generation pays into gladly.

What’s more, the analysis shows that while public pensions are required do the heavy lifting in terms of lifting public education off the ground, they are not needed forever. From a forward-looking perspective, unfunded public pensions can be phased out, without hurting any generation, and eventually be replaced by fully funded pensions.

The researchers note that across the world, younger generations facing the looming prospect of losing jobs to globalisation and automation are urged to increase their investments in human capital.

Right away though, such arguments hit a snag. Human capital accumulation requires upfront investments but the gains may take a long time to materialise; indeed, they may accrue mainly to future generations. So it is no surprise that with the prospect of such a long wait to get a return on their investment, the young under-invest in socially desirable, forward-looking endeavours.

The new study explores how a welfare state embodying a two-armed (public education, one arm, social security, the other) intergenerational social compact offers a way out. In the compact analysed by the authors, the middle-aged finance both public education for the young and public pensions for the retired – and then, when their time comes, the next cohort of middle-aged compensates their benefactors via pensions.

Subsequent generations receive more education and are richer, needing less compensation in the form of pensions. The upshot is that while public pensions are required to usher in public education, they may be phased out without hurting any generation, an idea gaining traction in many aging nations.

One may ask: can’t the parents of the young help? To some extent, yes. But first, they have to care enough; and second, they need to have the resources to finance the right level of education for their children.

Can private capital markets help? Not so much. Capital markets for education loans are largely missing; if present, they are imperfect and charge high interest rates.

Even disregarding this, left on their own, the young are likely to under-invest in education because they do not internalise the tremendous positive ‘spillovers’ (or ‘human capital externalities’) that their education decisions have, both within and across generations:

• Within, because businesses can hire from a more educated workforce, can expect more from their workers and can pay them more;

• Across, because better-educated parents raise more educated kids themselves.

The question is how to harness this generational tailwind when the market can’t?

The researchers study how a welfare state operating under an intergenerational social compact can use this tailwind. In any welfare state, the government makes significant tax-financed expenditures on education, health and old-age pensions. The young and the old generations are typical net beneficiaries, while the middle-aged are net contributors because they work and pay the taxes.

The intergenerational compact that the study examines asks current wage-earners – the middle-aged generation – to pay taxes to cover public education expenses for the younger generations. They will be remunerated later at the opportunity cost of that education, the interest that the market would have charged the young for the same. This compensation would come in the form of payouts from a public pension system that the by-then-middle-aged – a more educated and richer generation – pays into gladly.

For sure then, such a compact acts as a cheaper stand-in for private capital markets. But it does a lot more, because it can finance a much higher level of education, one that exploits the tailwind that the market cannot.

The researchers show that it is thus possible to use the social compact they propose to raise higher investments in human capital without any generation needing to sacrifice. Importantly, future generations, by virtue of the tailwind coming their way, are made better off; as such, they need to be compensated less and less.

The take-away is that while public pensions are required do the heavy lifting in terms of lifting public education off the ground, they don’t have to stick around forever because of the tailwind the overall welfare package generates. From a forward-looking perspective, unfunded public pensions can be phased out, without hurting any generation, and eventually be replaced by fully funded pensions, a notion in vogue in many OECD countries.

The analysis demonstrates the power of the welfare state in its cradle-to-grave form. First, newborns gain because the expected value of publicly funded care, education and health benefits received early in life as well as care, health and pensions received later in life ultimately exceeds the cost of tax payments. Europe, especially the Nordic welfare states, has long recognised this power.

For example, by some calculations, the net lifetime gain to a Danish citizen from participating in the welfare state is roughly €80,000 or 5% of the average present value of lifetime income. And this is true for a welfare state balancing its budget period-by-period.

Second, the proposed welfare package can internalise externalities and therefore lead to higher human capital, higher earnings and higher long-run welfare than is possible even with perfect capital markets.

This last point may help to explain why in spite of their large public sectors and ostensibly huge tax burdens, ‘cuddly’ Nordic countries continue to rank high in terms of various economic performance indicators. It may also rationalise why Bernie Sanders and Hillary Clinton advocate free public college education in the United States, a welfare state after all.

ENDS


Notes for editors: ‘The Intergenerational Welfare State and the Rise and Fall of Pay-as-you-go Pensions’ by Torben Andersen and Joydeep Bhattacharya is published in the June 2017 issue of the Economic Journal.

Torben Andersen is at Aarhus University. Joydeep Bhattacharya is at Iowa State University.

For further information: contact Torben Andersen on +45 87 16 55 57 (email: tandersen@econ.au.dk); Joydeep Bhattacharya on +1 515 294 5886 (email: joydeep@iastate.edu); or Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com; Twitter: @econromesh).