“An appropriate approach”

Are governmental social-protection policies the right way to reduce growing inequality?
To answer your question, let me first clarify in what sense inequality is growing. At the international level, it is interesting to note that inequality has recently been reduced in an important respect. Countries’ average per-capita incomes have been converging for several years, whereas previously we saw the gaps widening. The new trend is a good sign. It shows that emerging markets and developing countries are catching up. Within countries, however, income inequality is indeed growing.

And that is a reason to worry?
Yes, in rather general terms we can say that the wealthy are becoming richer while poor population groups are being left behind. That is happening in advanced economies and developing ones. Data from various countries show, however, that social-protection policies do indeed slow down this trend.  

What are the relevant indicators?
Economists use the Gini coefficient to determine a country’s level of inequality. Before taxes and social benefits, the Gini coefficients for the USA, Germany and the Scandinavian countries are quite similar, which means that the market dynamics lead to similar results. If we look at the Gini coefficients after taxes and social transfers, however, the USA is clearly more unequal than Germany, and Germany is more unequal than Sweden. That proves that governmental efforts to reduce poverty and protect the lower strata’s standards of living are effective.  

Why is social protection desirable ?
It has beneficial social, economic and political impacts. The social impact is obviously that poverty and inequality are kept in check. And that has a positive economic impact which tends to be under-estimated. People who feel secure are more willing to take risks such as investing in productive assets or education. Such investments mean that, though they have less money in the short term, they will probably have higher incomes in the long run. People who lack access to social protection tend to hoard  savings instead of investing spare cash in a productive way because they cannot afford to lose any money. If people know, however, that some kind of protection will be available in case of need, they become more willing to take risks. Social protection makes them more willing to start a business, for example, or to send their children to school. They become more endeavouring, and that makes markets more dynamic.  

Are you saying that it is wrong to wait for an economy to become prosperous enough to invest in social protection because without social protection it will not generate the prosperity it needs to fund social protection?
Yes, you have a point. Historically it is evident that countries like Germany were much poorer than they are now when they began to build welfare states, and welfare-state institutions contributed to their economic growth. By the way, the fact that Otto von Bismarck began to build the German welfare state in the late 19th century was linked to the political impacts that I just mentioned. Social-protection policies boost the legitimacy and stability of a political order – and of society in general. People are more loyal to a government if they know that their government is doing something for them. Bismarck wanted political stability. He outlawed the Social Democrats, but introduced a national health insurance and a pension system, thus tackling social problems that had made the labour movement gain strength.

To this day, the social-insurance systems Bismarck created are based on employers and employees contributing a pre-defined share of wages into public funds that pay pensions, cover health-care expenditures and grant unemployment benefits. This payroll-tax approach does not work in the informal sector however, because government agencies have no bearing on it. Does that imply that welfare policies only become feasible once an economy is fully regulated?
No, that would be a mistake. It is possible to fund social benefits from the national budget. National budgets are financed by general taxes, not social-insurance contributions. That is basically the approach taken in Scandinavia. The British social-protection system similarly relies mostly on tax money. In general, it is correct to say that social policies that are funded from the national budget serve to reduce poverty by guaranteeing a minimum standard of life to all citizens. Public social-insurance schemes that basically rely on individual wage-based contributions, however, mostly serve to protect those individuals’ standard of living.  

What is better?
Well, that depends on what you want to achieve. Tax-based systems are better for fighting poverty, because they serve everybody and not only those people who have paid contributions. They also have the advantage of not raising the costs of labour. High labour costs are an incentive that leads companies to invest in machines and energy rather than hiring people. For this reason, it makes sense to fund social policies with money generated from taxes on capital revenues as well as sales taxes that are paid by consumers. As you just said, moreover, Bismarck’s approach is not suitable for fighting poverty in the informal sector, which tends to be quite big in developing countries.  

So what are the advantages of the Bismarck model?
It is appreciated by important population groups such as urban middle classes, skilled workers and so on. These people are not at risk of desperate poverty, but their prosperity will suffer should they get sick or lose their jobs. They want some kind of safety net.

Is this the reason for the Bismarck model being so widely copied in advanced nations?
It is one reason, and the other one is historical: Germany was a pioneer in social protection because Bismarck needed to provide legitimacy to the newly-united German nation state. When, after World War I, Alsace and Lorraine became French again, the French government decided to copy  the Bismarck model nation-wide. It simply could not deny the people of Alsace and Lorraine the social protection they were used to, for those people would have yearned to belong to Germany. On the other hand, special rules in separate regions did not fit the French tradition of centralism. National-level insurance systems, however, made sense. And once Germany and France relied on the same model, other countries such as Spain copied it.  

But why was Scandinavia different? The Nordics use their national budget to fund their welfare states.  
Sweden for example was inspired  by Germany too. Sweden’s Social Democrats wanted the kind of protection for workers that had been established in Germany. However, a huge share of the people were smallholder farmers. You could say the country had a huge informal sector, so in a way, the situation in Sweden was a lot like it is in many developing countries today. Sweden’s Conservative party wanted to act on behalf of the rural farmers and demanded that any new social-protection system must serve them too. As a result, Sweden introduced a system that did not only rely on wage-induced individual contributions. It used budget funds to cover self-employed people.  

So the Swedish model suits developing countries and emerging markets better than the Bismarck model?
Yes, in principle. In real life, however, the question hardly arises in such a clear-cut manner. Every country must take an appropriate approach that suits its situation and needs. It has to build on what is already in place. Former French colonies, for example, typically have more or less inherited some kind of social insurances for government staff, members of the military and formally employed people. They cannot simply dismantle those systems without triggering massive opposition of the people concerned. Today, Tunisia has about one dozen different social insurance schemes for different population groups. The system works quite well, though it has the disadvantage of making it difficult to shift from one kind of occupation to another. If switching was easier, the economy would be more dynamic. The big political challenge is always to solve new problems by building on what was established earlier.  

Are there any promising innovations in emerging markets and developing countries?
Yes, quite a few, actually. The best known are probably the conditional cash transfers that were first introduced in Brazil, Mexico and other Latin American countries. If poor families send their children to school and have doctors check them regularly, they get a kind of welfare payment that covers their basic needs. Some critics argue that these rules are condescending and that the money should be disbursed unconditionally. It is obvious, however, that the conditions make better-off people accept the programmes. The better-off tend to argue that there should be no free give-aways to the poor.

Do unconditional cash transfers work?
Yes, they do. That is evident in various countries in southern Africa. Lesotho, for example, has introduced a government-funded minimum pension for anyone who is 70 years or older. The scheme is very successful. One result is that the elderly are no longer a financial burden on their families. In many cases, the elderly share some of the money with their children and grand children. Compared what we are used to in the EU, the minimum pension is still rather modest, but it certainly contributes to reducing poverty.

What is your take on guaranteed employment as enshrined in India’s Mahatma Ghandi National Rural Employment Guarantee Act (MGNREGA)? According to this law, every rural family is entitled to 100 days of work paid according to the legal minimum wage.
MGNREGA is another attempt to provide welfare without giving away anything for free. The approach makes sense in political terms. The disadvantage is that some people who are particularly needy cannot participate. Single mothers, for instance, simply cannot go to work. In some areas, day-care facilities were established to allow them to do so, but that is not the case everywhere. In general, the empirical evidence shows that the quality of MGNREGA implementation varies from state to state in India. In some states, the results are very good. A strong point of MGNERGA is that the Indian Constitution enshrines a right to work. That means MGNREGA cannot be scraped easily because it is fulfilling a constitutional promise. 

Are there any innovative ideas for providing poor people with health insurance?
In this respect, India is taking another interesting approach. The central government is working on a national health insurance that will:

• cover poor people on the basis of tax money,
• subsidise individual insurance contributions made by middle-income people and
• protect the well-to-do on the basis of their individual contributions.

Health coverage is to be provided to the poor first, and then the scheme will be extended to the other population groups. The idea is to ensure that the poor will not be forgotten once the better-off have been taken care of, which is the case in many countries where social-protection systems are not making progress.

In India, government-run hospitals are supposed to provide services free of charge. But that isn’t working. Those who want to get treatment have to pay bribes, unless they are well connected.  
Yes, that is the way things are in many developing countries. When these countries became independent, the governments promised free health care, but they lacked the money to make that promise come true. In the rural areas, moreover, there were only very few hospitals and general practitioners. Due to lack of funds, the health infrastructure never improved. The result was that urban hospitals became black markets for selling and buying health-care services. The good news, however, is that the understanding has grown, not only in India, that the current free-of-charge approach to health care does not work. Other approaches are needed, and private-sector providers are playing a growing role in the health sector.  

Are donor governments doing enough in support of social-protection systems in developing countries and emerging markets?
Your question is not as simple as it sounds. In Germany, for example, we have a consensus that our development agencies can invest in building schools or hospitals, but must not spend money on running such institutions. This approach makes sense. Why should German tax payers pay Nigerian nurses for example? Many Nigerians are prosperous enough to pay taxes and social-insurance contributions, but their government is not collecting such revenues properly. Therefore, “investments yes, operational costs no” is a reasonable rule of thumb. Whether it always makes sense is debatable however. In a post-conflict situation, when a state has to be rebuilt, it might be wise to fund a national health insurance with official development assistance. Such a policy would boost the legitimacy of the new state substantially and fast. Once the new state is firmly established and operating successfully, the foreign funding of health-care services could eventually be discontinued.

Markus Loewe is senior researcher at the German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE).
markus.loewe@die-gdi.de