The Social Welfare State and the Future of the Middle Class

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1 Insight The Social Welfare State and the Future of the Middle Class DOUGLAS HOLTZ-EAKIN MARCH 5, 2012 Do we want to keep these tax cuts for the wealthiest Americans? Or do we want to keep our investments in everything else like education and medical research; a strong military and care for our veterans? Because if we're serious about paying down our debt, we can't do both. The American people know what the right choice is. So do I. As I told the Speaker this summer, I'm prepared to make more reforms that rein in the long-term costs of Medicare and Medicaid, and strengthen Social Security, so long as those programs remain a guarantee of security for seniors. But in return, we need to change our tax code so that people like me, and an awful lot of Members of Congress, pay our fair share of taxes. President Barack Obama, State of the Union Address 2012 President Obama has consistently insisted that there is no real need to change the basic framework of the U.S. social safety net, that discretionary spending on investments and national security should be preserved, that taxes for the wealthy will have to rise, and that the projected federal debt will still be controlled. In short, it is possible to have a future in which there is more federal spending from expanding social welfare state to accommodate more seniors and their health costs and federal investments paid for by higher taxes on the rich, with no real impact on the middle class. One way to answer the question is to look around the world at places that have a more extensive social welfare state and see if it is possible to reconcile the president s claims. As shown in Chart 1 (based on data from the Organization for Economic Cooperation and Development or OECD), European social welfare spending does vastly exceed that of the

2 United States. It averages nearly 23 percent of GDP on the continent, compared to only 16 percent in the United States. That s more than 30 percent more (as a percent of GDP). And that is the average, which is held down by parsimonious states like Ireland and Poland. The progressives ideal, France, weighs in at over 28 percent. Chart 1 So, it is quite likely that in pursuing the president s vision, the U.S. will have to spend a lot more. However, if the President is right then across the pond we should see the rich bearing a larger share of the burden of this expanded government. Consider Chart 2 that utilizes OECD data and shows that in the United States the rich (the top 10 percent) pay more of the income and payroll tax burden than is the case in Europe not the other way around. In France, for example, the rich pay under 30 percent of the taxes; in the United States it is already over 45 percent. For the European countries shown, the average tax share for the rich is just under 35 percent.

3 Chart 2 Evidently, when the Europeans opted for a massive welfare state, it was not possible to finance it on the backs of a wealthy few. Arithmetic alone dictates somebody is bearing the costs, and the data show that it is the middle class. Chart 3

4 In the United States, the middle class shoulders just under 30 percent of the burden. In France and Germany, it is nearly 50 percent; Italy 47 percent; Sweden 43 percent; and Spain 40 percent. Only in Ireland and the United Kingdom is the middle class sheltered close to the extent that it is in the United States. This difference has very real implications for tax rates. In the United States, the average wage earner pays a combined tax rate of 30 percent. With the sole exception of Ireland, European rates are higher. In many cases they are much higher. France and Germany are close to 50 percent. But even in countries like Spain and Portugal they are in the vicinity of 40 percent. If the European experience is any guide, what does the future hold for the American middle class? Recall that the average European social welfare bill totals 22.9 percent of GDP. That means that a rough estimate of the president s vision is an increase in social spending of 6.7 percent of GDP $1 trillion more each year. For the middle class, the good news is that the top ten percent will pick up 45 percent of the tab, leaving the middle class with an additional yearly burden of $550 billion. Suppose that the middle class constitutes 150 million Americans earning on average the $43,040 labor earnings computed by the OECD. If so, the president s social dream means an extra $3,666 in taxes each year, or 8.5 percent of income. The president s vision of the social welfare state will be purchased at the expense of the

5 middle class. The bottom line? If the middle class buys into President Obama s promises their tax rate now of 29.7 percent will rise to nearly 40 percent.