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Measuring fiscal sustainability in the welfare state: fiscal space as fiscal sustainability

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Abstract

This study measures the fiscal capacity of welfare states to derive parameters for a sustainable welfare state. To secure fiscal soundness, it is critical to maintain affordable welfare spending by ensuring public capacity. Adapting the concept of fiscal space, defined as the difference between the current level of public debt and the debt limit implied by the country’s historical record of fiscal adjustment by Ostry et al. (2010) and Ghosh et al. (2011), this research measures and compares the fiscal sustainability of 17 welfare states. To derive this fiscal space, the debt limit of each country is set, primarily based on the estimating of fiscal reaction function and selecting interest schedule (Ghosh et al. 2011, p. F13). We use a pooled-time-series-cross-sectional model to estimate fiscal reaction function and the vector regression model to set the interest schedule. It is found that Southern European welfare states are unsustainable if they do no immediately change their fiscal policies. Countries outside of Southern Europe are generally financially sustainable. However, the UK, the US, and France have in their recent actions exacerbated their financial sustainability. For their part, the social democratic states remain financially sound, despite high levels of welfare spending. This indicates that welfare spending does not necessarily weaken fiscal soundness, which depends on the type of welfare state.

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Notes

  1. Although this has been criticized as inefficient (Chen et al. 2010; Reed and Ye 2011), it has been used to generate adequate precision in a more than 15-year pooled-time-series, cross-sectional set of data (Beck 2001, pp. 278–279; Beck and Katz 1995, pp. 639–641). Therefore, it is considered appropriate for the analysis of the 28-year period that this study analyzes.

  2. It is necessary to point out that the estimates have greater bias in the fixed-effects regression models in combination with the autoregressive model (Beck and Katz 2011, pp. 341–342). Beck and Katz (2011) recommend using a lagged dependent variable over the two models (Beck and Katz 2011, pp. 341–342). However, the financial variables, such as debt and primary balance, can only determine the lag of the dependent variable with difficulty because they have the potential of producing a cumulative effect. In addition, if the time series is greater 20, the bias of the estimates is significantly reduced (Beck and Katz 2011, p. 342), making this study relatively safe to use with two models.

  3. The interaction term between the political and fiscal systems is calculated by using average centering.

  4. The results obtained for the fiscal reaction function are presented in the Appendix due to length restrictions to this article.

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  1. Korea Institute for Health and Social Affairs, (Building D) 370, Sicheong-daero, Sejong-si, 30147, Republic of Korea

    Hyejin Ko

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Ko, H. Measuring fiscal sustainability in the welfare state: fiscal space as fiscal sustainability. Int Econ Econ Policy 17, 531–554 (2020). https://doi.org/10.1007/s10368-019-00453-2

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