Blogs & Comment

The welfare state and the debt supercycle

Welfare states appear headed Titanic-like toward their collisions with icebergs, and the Conservatives are doing little to stop it.

“Much of the welfare state concept was always an illusion, one financed by lavish amounts of debt for which present and future taxpayers will pay in the form of higher taxes and reduced services during their lifetimes,” writes University of Calgary lecturer Mark Milke in a recent article. “It is akin to buying an expensive home and several luxury sports cars and handing the payments to the kids once they have become adults.”

I also worry that this intergenerational sleight of hand will lead to more than higher taxes and reduced public services. Given that the welfare state is ultimately unsustainable and increasingly running out of options for responding to economic disturbances, a painful day of reckoning appears to lie ahead. At some point, people will discover, like the individual who has been lulled into believing he can live beyond his means forever, that their standard of living will have to take a rather sudden hit to the downside.

Here’s one example of the disregard for economic incentives: federal transfer payments to the provinces, especially for health, social and education services. The provinces receive close to $40 billion from the federal government under the Canada Health Transfer (CHT) and the Canada Social Transfer (CST) programs. Because they aren’t responsible for collecting the taxes for these payments, “a provincial government and its voters are incited to always demand more from the centre, shifting a large part of the costs to the taxpayers of other provinces,” argues Université du Québec economist Pierre Lemieux. “All provincial governments end up with more busybody activities than their taxpayers are willing to finance.”

The solution would be for the federal government to transfer the tax points to the provinces and let them pay directly for the health, social and education services they provide (they are supposed to be provincial matters anyway, according to the constitution). This would bring about a more sensible alignment in the costs and benefits of the programs, which should lead to a more efficient use of resources.

More generally, people are programmed to maximize their utility, so they look for ways to enjoy public services and minimize their taxes. For example, in “A Short History of the Income Tax,” John Steele Gordon points out that the U.S. income tax act of 1913 was only 14 pages long; by 1942, it had blossomed to 208 pages with over three-quarters of them “devoted to closing or defining loopholes” that tax lawyers and accountants were using to “game the system.” It has since gotten worse.

According to OECD statistics, net liabilities as a percentage of GDP have ramped up dramatically since 1995 in nearly all welfare states. France has gone from 37.5% to 60.2%, Germany from 29.7% to 50.2%, the U.K. from 26.4% to 62.4% and the U.S. from 53.8% to 74.8%. The basic problem is that during each recession, governments increase their debt load to stimulate the economy and maintain (or even increase) services, but rarely cut back on their debt loads or services during the prosperous times—creating a long-term upward trend in indebtedness that Tony Boeckh of The Boeckh Investment Letter calls the “debt supercycle.”

As the debt supercycle relentlessly marches onward, it progressively reduces options for responding to financial crises and economic downturns. Someday one of those upheavals will be the trigger for an abrupt downsizing of welfare states and living standards. Hopefully that will be avoided, especially as 2011 rolls into 2012. But it seems politicians are unable to respond proactively with an ounce of prevention; full blown calamities are required and then they administer the pound of cure.

Alas, the solutions enacted during the panic of a meltdown will be hasty, rough and full of inequities. A microcosm of what to expect is how the Ontario Government recently addressed runaway costs in a dietary supplement allowance offered to persons with certain ailments. Increasing numbers of persons were able to secure medical referrals for the monthly payments even though they really did not fit the qualifications. Consequently, the program was radically scaled back. But as the case of Brandon McCarthy illustrates, many persons truly in need of the allowance were cut off too.

And so we come to the federal Conservatives’ promise to balance the budget by 2015. It would be no surprise if this goal was not realized. The projected elimination of the federal government deficit—currently exceeding $30 billion—relies on the assumption of annual GDP growth of 5.6% while program spending is held to an average annual growth rate of 2%.

It’s regrettable that the Conservatives are relying on such an optimistic forecast of economic growth and don’t have more aggressive plans to rein in government spending, deficits and debt. Being in the early stages of a Conservative majority, they have an unparalleled opportunity to live up to their political philosophy of small government—yet seem to be letting it pass them by.