Unbundling the Welfare State

Reform of the welfare state has been a strong theme in public policy pronouncements over recent years. Much of the pressure for reform has come from a burgeoning social security budget and, partly as a result of measures taken and partly as a result of substantial reductions in unemployment in the later 1990s, expenditure growth has fallen back of late. Underlying pressures for increased spending remain, however, and budgets will likely grow more quickly again when the effects of falling unemployment wear off.

Cost containment brings problems of its own, most notably problems of complexity and under-provision. Chronic under-provision has been a general feature of the UK public sector as whole for some while now and it arises from the limitations of tax funding as a mechanism for financing the supply of goods and services on which expenditure might be expected to grow faster than national income.

Whilst targeting of benefits through some or other forms of means testing may help contain budgetary costs, it effectively operates as a tax on self-provision, thereby reducing incentives for personal initiative. The largest effects are likely to fall on millions of households who, though not in poverty, enjoy relatively modest incomes. For these people, incentives to supplement state benefit levels are relatively weak, and dependency on inadequate levels of state provision is encouraged.

If problems of growing complexity and underprovision are to be tackled, some of the key features of existing welfare arrangements will need to be radically re-designed. In particular, public policy objectives need to be clarified and made more precise, and government activity needs to be reshaped in ways that minimise the ‘crowding-out’ effects that they have on self-provision.

One necessary condition for this to occur is that there be greater separation or ‘unbundling’ between measures to redistribute income and the public provision of particular types of benefit. This will reduce the ‘cross-subsidisation’ implicit in many state benefits/services, and hence the distortions to markets that such cross-subsidisation creates. In effect, it means re-establishing much closer links between specific insurance and savings (e.g. pensions) benefits and contributions made, and more clearly distinguishing these from income transfers.

More stable and more precise contractual arrangements also need to be established so that (i) non-state providers will have incentives to make the investment necessary to develop low-cost, mass-market products and services and (ii) there is greater clarity about risks that, going forward, will be borne publicly and risks that will be borne via insurance pools and capital markets.

There is considerable scope for increasing social security provision through elimination of existing distortions at the boundary between state provision and self provision. Some of the reforms made to date point the way forward: for example, tax credits can be used systematically to unbundle income redistribution from insurance and saving products. Without some radical re-design of existing arrangements, however, progress can be expected to be slow, and under-provision will likely continue to be a problem for many years to come.