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The Economy of Obligation: Incomplete
Contracts and the Cost of the Welfare State
Avner Offer
University of Oxford
Abstract
Wes=
tern
governments typically pay out some 30 percent o=
f GDP
for social purposes. This is financed by taxation on a pay-as-you-go (PAYGO)
basis. How efficient are these transfers, and can market or other mechanism=
s do
it better? The problem arises since no individual stands alone. During the =
life
cycle there are several periods of unavoidable dependency, in which there i=
s no
earning and little to bargain with: motherhood, infancy, childhood, educati=
on,
illness, disability, unemployment, old age. The
problem is how to transfer resources from ‘producers’ to
‘dependants’ over the life cycle. The market solution is for
individuals to accumulate financial assets and to transfer them over the li=
fe
cycle by means of long-term contracts with financial intermediaries. <=
/o:p>
But=
law,
economics, psychology, political science, and history, all suggest that
long-term contracts are not reliable. People are myopic. Financial intermediaries exact high rents, and market entitlemen=
ts are
volatile. Equity markets do n=
ot
have sufficient capacity to support life-cycle transfers. Governments convert private life-c=
ycle
transfers into intergenerational cross-sectional ones, financed by PAYGO. T=
he
resource base is much larger than financial markets, and is made up of the
whole of the tax base. Costs =
are
low, transfer levels are not rigid, are fixed by political consent, and can=
be
adjusted. The national income resource base is stable. The constraints are (1) the demand=
for
security (2) taxable capacity (3) integrity and competence of government (4)
potential capture by finance. Because of these constraints, although govern=
ment
can do it better, it cannot do it alone, and the whole repertoire of transf=
er
is required.
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