Munich, 14 May 2002
The present system of welfare benefits, in particular Social Aid in its function as a wage-independent floor for claims against the state, forms an important barrier to the employment of low-skilled workers in Germany. Social Aid puts a floor under the wage structure and thereby creates unemployment. No entrepreneur will employ a person whose value added is lower than the wage he must be paid, and hardly any eligible person will take a job whose net wage is not sufficiently above Social Aid. Eligible persons whose productivity does not or only little exceed the level of Social Aid, cannot be placed into jobs. That is why the market for low-skilled workers has dried out, and why an important economic factor of production remains idle.
The Ifo proposal for a reform of the welfare system aims to make the German labour market in the low-income segment able to function again without reducing the attained standard of social protection and without placing additional burdens on the government budget. This goal may be reached by a thorough reform of the way Social Aid is granted, a reform based on a change from the present system of wage replacement payments to one of wage supplementing payments. This change removes the wage floor, results in wage reduction and induces profit-seeking employers to offer additional jobs.
The Ifo Institute has come up with a detailed proposal and has calculated its allocational, distributive and budgetary consequences. If this proposal were adopted, 2.3 million people in the low-wage segment could find employment in the medium term. This implies employment growth of about 6%.
The additional employment also implies additional national output and additional aggregate demand. The extra growth of GDP is estimated at 1.9% or €38.4 billion. This would be a one-time growth surge which would, however, lift GDP permanently above the level that would have been achieved in its absence. The notion that growth creates employment is reversed. Employment creates growth.
In detail, the Ifo Institute recommends the following three reform steps:
· Social Aid entitlements including the lump-sum rent subsidy will be drastically reduced for employable persons who are not holding a job in the private (primary) labour market. The new minimum level guaranteed by public welfare payments is so low that it is only attractive if other incomes are available.
· In a second step, employment in the primary labour market will be promoted by the payment of a subsidy to low wages. The "income tax credit" that will have to be created is of a size that low-income earners who work part-time will receive a household income consisting of the earned wage and the state subsidy equal to the Social Aid hitherto received and markedly above it if working full-time.
· In a third step, the state will offer jobs to able persons who cannot find jobs in the regular labour market. The wage for these jobs will be set at a level that the household income of the recipient will as a rule equal the level of Social Aid hitherto received.
All three reform steps depend on each other for their effectiveness and must not be introduced in isolation. Only through their combination can the basic goals of the welfare state and the requirement of a reduced budget deficit be jointly achieved.
In order to eliminate the wage floor which precludes employment of low-skilled workers, the state must not give fewer subsidies to low-wage earners in the private sector than to employable persons who do not work. If it wants to meet this requirement by continuing to pay in full the existing Social Aid and by expanding the number of eligible persons by cutting the transfer-reduction rate (citizen allowance), additional expenditures of €80 billion would arise every year. In view of the already excessive welfare expenditures and the general budget tightness, this is not a viable solution.
Taking account of a realistic fiscal scope for action, the necessary inducements can only be created by reducing Social Aid for employable but unemployed persons. It is this reduction which generates the funds that are needed for promoting employment through wage subsidies, and at the same time this reduction increases the incentive to find regular employment.
The problem of such a reform lies in the fact that the reduction of Social Aid runs the risk of pushing those people, who initially cannot find a regular job, below the subsistence level and of raising the sceptre of a conflict with the welfare-state obligation anchored in the constitution. The third step of the proposal serves to solve this problem. By obliging the local communities to offer jobs at wages equal to the present level of Social Aid, social hardship can be avoided. Without the third step the first step cannot be introduced, and without the first step the second step becomes unaffordable.
The third step weakens the incentive to move to the private sector, but it does not eliminate it. Firstly, it reduces the attractiveness of Social Aid and the underground economy which it finances. Secondly, wages paid for community work are only half of what low-skilled workers can earn in the private sector. Moving from community work to private sector employment results in a considerable income gain despite the wage reduction due to the reform.
The local communities should transfer the task of employing Social Aid recipients to independent non-profit or private firms and should provide them with incentives for preparing Social Aid recipients as efficiently as possible for the primary labour market. Communities may also use the help of private loan-employment agencies to place part of the people in the private sector via this indirect way These people remain formally employed by the communities and on their behalf provide services to the private sector. In Germany and elsewhere, loan-employment agencies have successfully helped to integrate low-skilled workers into the regular labour market.
In addition to the three above-mentioned core elements of the reform of Social Aid, the Ifo proposal also demands the elimination of Unemployment Aid as well as Job Creation Measures and Structural Adjustment Measures of the existing type and their inclusion in the new Social Aid system. Child support should no longer be reduced as income grows but should be set in such a way as to remain largely constant across all income classes.
The fiscal effects of the reform will on balance be positive. Should all of the 2.3 million low-skilled unemployed, at whose employment the proposal is aimed, be successfully integrated into the primary labour market, fiscal savings of €6.2 billion per year will result. Tax credits of €19.4 billion are offset by additional social security contributions of €9.1 billion and savings from reduced benefit payments and eliminated labour market measures in the amount of €16.3 billion. Even if only 1.8 million unemployed (80% of the target group) are placed into regular employment, the public authorities would still save €2.8 billion. Only if only 60% of the potential labour force would find regular employment would some fiscal costs ensue.
Overall, the adoption of the reform proposal would result in considerable mobilisation and improved efficiency of the labour market, causing few losers but many gainers. In any case, the degree of accomplishment of social policy, measured in terms of the income of typical low-skilled workers who currently receive Social Aid, would be raised markedly. At the same time the tax burden of the working population could be lowered. Starting from a situation in which the share in the total labour force of those working is continuously declining in favour of those not working because those working must transfer more and more income to those not working, it is possible to introduce reforms which strengthen the welfare state without expanding the welfare budget. With its proposal, the Ifo Institute has detailed such a reform concept.
Hans-Werner Sinn, Christian Holzner, Wolfgang Meister, Wolfgang Ochel, Martin Werding
Published in: ifo Schnelldienst 9/2002, S. 3 - 52 (PDF, 2.9 MB)
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