Social protection budgets in the crisis in the EU. Working Paper 1/2013 Olivier Bontout & Terezie Lokajickova

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1 Social protection budgets in the crisis in the EU Working Paper 1/2013 Olivier Bontout & Terezie Lokajickova

2 This paper reviews social protection expenditure developments in the crisis, focusing on expenditure trends in volumes following the peak of the crisis (2009), on changes in the distribution of incomes and, notably, on the distributional impact of austerity packages. Employment and social analysis portal: Contact: Neither the European Commission nor any person acting on behalf of the Commission may be held responsible for the use that may be made of the information contained in this publication. Europe Direct is a service to help you find answers to your questions about the European Union Freephone number (*): (*) Certain mobile telephone operators do not allow access to numbers or these calls may be billed. More information on the European Union is available on the Internet ( Cataloguing data as well as an abstract can be found at the end of this publication. Luxembourg: Publications Office of the European Union, 2013 ISBN ISSN doi: /47052 European Union, 2013 Reproduction is authorised provided the source is acknowledged. May 2013 I 2

3 Table of Contents Summary... 4 Introduction Social expenditure in the crisis Social protection expenditure in Europe in international comparisons... 7 In the mid 2000s, EU accounted for 24% of the World GDP and 40% of public social expenditure... 7 Box 1 Sources and measurement of social protection expenditure In Europe, social protection expenditure increased in 2009, nearly stabilised in 2010 and decreased afterwards Did social protection expenditure follow its trends in the current crisis? Box 2 estimating the cyclical component of GDP and social protection expenditure Decomposition of recent trends of unemployment expenditure Distributional impact of the crisis and of austerity packages The impact of bad economic times on the distribution of incomes Box 3 Nowcasting poverty Impact of austerity measures on the income distribution Conclusion REFERENCES ANNEXES detailed tables May 2013 I 3

4 Summary This paper reviews social protection expenditure developments in the crisis, focusing on expenditure trends in volumes following the peak of the crisis (2009), on changes in the distribution of incomes and, notably, on the distributional impact of austerity packages. The significant increase in social protection expenditure in the early phase of the crisis appears to have been broadly in the line with the exceptional severity of this crisis (though there may have been some overadjustment). Social expenditure thereafter stabilised in 2010, which also appears to be broadly in line with past trends and afterwards declined (in real terms) in 2011 and The downward adjustment observed since 2011 is significantly larger in comparison with past periods of economic underperformance. It points to weakening of the economic automatic stabilisation function of social protection systems in Europe and EMU, with signs that they were actually procyclical in The crisis translated into very different changes in the distribution of incomes in different Member States, broadly reflecting the combination of initial declines in market incomes, automatic adjustments in benefits and taxes levels sustaining households' incomes, and the impact of adjustments in taxbenefit systems since the beginning of the crisis. In particular, the burden of austerity packages has been shared differently across Member States, with varying impacts on the distribution of incomes, reflecting the specific design and mix of measures taken in different Member States. May 2013 I 4

5 Introduction This paper reviews social protection expenditures developments in the crisis, focusing on trends of social protection expenditure in volumes following the peak of the crisis (2009), on changes in the distribution of incomes and, notably, on the distributional impact of austerity packages. While social systems played a key role of automatic stabilisation in early phase of the crisis, they actually showed signs of weakening over time (European Commission 2013). This raises concern about current trends in social protection systems, since it raises an issue of their ability to protect households' incomes in case of adverse economic shocks and to contribute to the overall stabilisation of the economic cycle. In other words, this paper reviews some evidence on how the stabilisation (in the first part) and protection (in the second part) functions of social protection systems have been affected during this crisis. Following Musgrave's (1959) classical framework, which defines the three main functions of public intervention in the economy as stabilisation (aimed at smoothing the economic cycle, in terms of GDP but also of employment and price levels), distribution (aimed at securing adjustments in the distribution of income and wealth, not least an equitable distribution of incomes) and resource allocation (aimed at securing adjustments in the allocation of resources and in particular the efficient use of resources), social policies can indeed be considered according to the three functions: social investment (primarily linked to the allocation function), social protection (primarily linked to the distribution function, considered in a very broad sense covering in particular distribution of incomes over the life course) and stabilisation of the economy. The paper focuses on how the (real) growth of social expenditures in this crisis compares to past trends during similar periods of economic underperformance. It should, however, be noted that by doing so, this paper does not fully reflect on the overall sustainability of current developments of social protection expenditures, which would ideally require confronting trends in social expenditures growth with estimates of a possible drop in potential GDP and economic growth. Indeed, the recovery was relatively weak and the following years saw another episode of recession in 2012, while 2013 is foreseen to remain a year of weak growth in EU and recession in EA and overall recovery is expected only in In this context, output gap estimates indicate that most of foregone growth since the beginning of the crisis may not be recovered1 and it is debateable whether potential growth will be affected in the medium or even longterm. In this context of uncertainty about short and medium term GDP prospects, this paper tries to identify possible under or overadjustment of social protection expenditure in the current crisis (and some of its underlining factors) on the basis of past trends, leaving aside the question to what extent the current trends may point in the direction of a possible break in potential growth. The paper is organised as follows. In the first section, changes in social protection expenditure volumes in this crisis are compared with trends, during past periods of economic underperformance, focusing on their path and composition and characterising latest developments in a broader international context. In the second section, it provides a synthesis of available information on the impact of the current crisis on the distribution of incomes, focusing in particular on available nowcasting exercises (which provide information up to 2012) and on available assessments of the 1 For instance, in an economy reaching in 2012 the levels of GDP of 2008 and with former average economic growth of 2% a year, foregone growth amounts to around 8% (accumulation of 4 years of overall stagnation). If the order of magnitude of the output gap is around 3% of GDP, it suggests that 3% of GDP (out of 8%) or only nearly 1/3 of foregone growth could be recovered by GDP catching up to potential. May 2013 I 5

6 distributional impact of the austerity packages that have curbed public expenditure growth in some Member States. May 2013 I 6

7 1 Social expenditure in the crisis This section presents trends in social expenditure since the beginning of the crisis (for an overview of what is meant by social expenditure in this paper see the Box on sources and measurement of social protection expenditure which is below). It first provides international comparisons of the levels and trends in social expenditure in Europe. It then provides details on changes in social protection expenditure in Europe during the period and compares these changes to trends and changes in past periods of belowpar performance. It finally focuses on contributions to changes in unemployment expenditure in 2009 and Social protection expenditure in Europe in international comparisons In the mid2000s, EU accounted for 24% of the World GDP and 40% of public social expenditure In the mid2000s, in the EU, public social expenditure (including health care) accounted for around 25% of GDP, while it reached 19% in the OECD and around 15% in the whole world (table 1). EU accounted for around 40% of the World's public social protection expenditure. 2 This is partly because the EU represents an important share of the World's GDP (24%) and because per capita public social spending is higher than in the rest of the World, including when compared to the OECD, a region with a similar level of GDP per capita. On average, per capita public social spending is 15% lower in the OECD than in the EU27, and actually very similar in the USA. It can also be noted that the EU and the OECD have similar levels of per capita spending on public health expenditure (expressed in levels in PPS), actually reflecting much higher levels in the USA (which also reflects higher GDP per capita). 2 This differs from the estimates presented in the World Bank (2012) showing that 58% of world public social protection spending is performed by Europe. The difference has three reasons: 1) in this paper we look at the EU27, while the WB refers to Europe as a zone of 36 countries 2) in this paper we reflect on data for 175 countries for the world, while the WB covers 96 countries 3) data sources might be different. May 2013 I 7

8 Table 1 Public social protection expenditure in Europe, the OECD and the world in the mid 2000s Social Health Total social protection GDP expenditures expenditures expenditures (public) (public) Share in GDP EU27 100% 17% 7% 24% EUROZONE 100% 18% 7% 25% Levels per capita (100 EU27) USA 100% 9% 7% 16% OECD 100% 12% 7% 19% CHINA 100% 4% 2% 6%* WORLD 100% 9% 5% 14% EU EUROZONE Geographical repartition USA OECD CHINA WORLD EU27 24% 44% 33% 40% EUROZONE 17% 33% 25% 30% USA 22% 21% 32% 25% OECD 60% 80% 83% 81% CHINA 10% 4% 4% 4% WORLD 100% 100% 100% 100% Source ILO and DG EMPL calculations. Note: all levels are expressed in PPS (Purchasing Power Parity) which provide some correction for the different in relative prices in the different zones (see calculations in a common currency in annex). Public social expenditures are provided in gross terms, not reflecting differences in tax systems. For the world, 175 countries are reflected. (*) Latest estimates from the OECD (2013) for 2011 show levels of 6.5% of GDP, excluding pensions from the public sector. accounting for total public and private social protection expenditure reduces the OECD EU gap in per capita social expenditure to around 3% When accounting not only for public expenditures, but also for mandatory private expenditures and voluntary ones (which refer mainly to health and oldage functions), total per capita social protection expenditure in the OECD are only 3% lower than in the EU27. This mainly reflects higher per capita health expenditure in the OECD than in EU27 when accounting for private health expenditures, (higher by around 30%). May 2013 I 8

9 Table 2 Total public and private social expenditure in Europe and the OECD in 2005 GDP Social Health Total social protection expenditures expenditures expenditures Share in GDP EU % 18% 7% 25% EUROZONE 100 % 20% 8% 28% USA 100 % 13% 13% 26% OECD 100 % 15% 9% 24% Levels per capita (100 EU27) EU EUROZONE USA OECD Geographical repartition EU27 41% 49% 32% 42% (50% for public only) EUROZONE 27% 36% 24% 31% (37% for public only) USA 35% 30% 51% 38% (31% for public only) 100 OECD 100% 100% 100% % Source OECD, DG EMPL calculations. Note: information for CY, MT, BG, RO, LV and LT complemented from Eurostat. All data in PPS (Purchasing Power Parity) which provide some correction for the different in relative prices in the different zones. Social expenditures are provided in gross terms, not reflecting differences in tax systems. All social protection expenditures accounted for, public and mandatory private as well as voluntary. Public social protection expenditures increased more quickly in the OECD than in the EU in the crisis and did not decline as much in the OECD as in Europe until 2011 Recent trends in public social expenditures in volume can be derived from National accounts. Compared to the OECD average, the increase in public social protection expenditures in Europe and Eurozone has been relatively modest in the crisis compared to precrisis levels (2007). In 2009 overall increases compared to 2007 ranged between 5% and 10% in the EU, while average increase exceeded 10% in the OECD and reached 15% in the USA (see OECD 2012a).3 In 2010, social protection expenditures increased at a much slower pace in EU27 and OECD, while they stabilised in the Eurozone and increased much more dynamically in the USA. In 2011, public social protection expenditures stabilised in the OECD and USA, while they began declining in EU27 and the Eurozone. Overall, in the period , public social expenditures have increased by around 20% in the USA, 12% in the OECD, 7% in the Eurozone and 8% in the EU27. It should be noted that these differences result neither from significant differences of changes in prices nor from GDP developments, since over the period changes in prices are fairly similar (around +10% in the various zones) and GDP levels in 2011 are comparable to 2007 in the various zones. 3 The rise in social protection expenditure in the USA was mainly driven by spending on health care, old age and unemployment. However, the highest relative increase between 2007 and 2009 was seen in expenditure on unemployment and on active labour market programmes. May 2013 I 9

10 Chart 1 Public social expenditures and GDP in the EU, EA, OECD, Japan and the USA (200711; indexed levels, 2007=100) United States Japan OECD Real public social spending Real GDP Consumer price index Real public social spending Real GDP Consumer price index Real public social spending Real GDP Consumer price index EUROZONE EU Real public social spending Real GDP Consumer price index Real public social spending Real GDP Consumer price index Source: OECD (SOCX) and National accounts (Eurostat) for Eurozone and EU27. These significant differences in the developments of public social expenditures in the crisis between the EU and the OECD (and notably the USA) reflect different structural composition effects (such as a higher share of unemployment benefits in public social expenditures in the OECD and the USA), but also suggest that in 2010 and more significantly in 2011, the growth of social protection expenditure has followed a different path in Europe, with some decline in volumes, while the OECD saw a stabilisation in a broadly similar economic context. Box 1 Sources and measurement of social protection expenditure Social protection expenditure trends can be assessed in different ways, and are most frequently looked at as a share of GDP or as a share of other public expenditures, or in volumes (deflated by some price index, generally HICP) or expenditures per capita, which allows taking into account of the size of countries. This paper focuses on trends in volumes, since other measures actually reflect a number of other trends, such as changes in GDP levels or changes in the levels of other public expenditures. Four main data sources on social protection expenditures are used in this analysis, the European System of Integrated Social Protection Statistics (ESSPROS until 2010), the National Accounts (until 2012), SOCX (OECD) and ILO. ESSPROS data on social protection expenditure are compiled by Eurostat in accordance with the methodology of the European System of Integrated Social Protection Statistics "ESSPROS Manual 2011". Social protection is defined as encompassing "all interventions from public and private bodies intended to relieve households and individuals of the burden of a defined set of risks or needs, provided May 2013 I 10

11 that there is neither a simultaneous reciprocal nor an individual arrangement involved". As such, the field of observation of the ESSPROS goes beyond that of social security (i.e. social protection provided by governments) to include benefits provided by private social protection schemes, in so far as they have similar effects to social security for the beneficiary. Social protection expenditure includes social benefits, classified by function, and administrative and other costs incurred by social protection schemes. These data are currently available for up until 2010 and in gross terms. An exercise to provide net data as well has been the subject of pilot programmes and is now in the regulation process. The eight policy areas covered in ESSPROS are the following: sickness/health care, disability, old age, survivors, family/children, unemployment, housing, social exclusion. ESSPROS also provides the information whether given benefits are provided in cash or as services directly to citizens ("in kind"), and also whether they are meanstested or not. Data on social protection expenditure from National accounts are in accordance with the European System of Accounts 1995 (ESA95) and cover "Social transfers in kind" and "Social benefits other than social transfers in kind". Generally speaking the levels for total expenditure on social protection is somewhat higher than in the ESSPROS. The main differences are that: First, National Accounts also include the function of Education in social protection expenditure. Due to this, developments in expenditure on social transfers in National Accounts are influenced by developments in the Education function (unlike social protection expenditure in ESSPROS). The order of magnitude of this effect on the level of growth of total social transfers aggregate from the national accounts can however be gauged based on the COFOG classification of the national accounts: it has been on average around only 0.1 pp since 2000 for both EU27 and EA17 and in each year has been lower than 0.5 pp. Therefore, it does not impact significantly on the changes in social transfers growth described below for 2011 and Second, while the ESSPROS covers both current and capital transfers, National accounts only cover current transfers. Third, the treatment of certain reductions on taxes and other obligatory levies payable by households is accounted in a different way by the ESSPROS and National Accounts. Fourth, while ESSPROS also includes benefits provided by private social protection schemes (see above), data used from the National accounts only show benefits provided by the general government. For more details on the main differences compared with the European System of Integrated Social Protection Statistics (ESSPROS) in the way social benefits in cash and in kind are distinguished please refer to the Manual on sources and methods for the compilation of COFOG Statistics, page 6566, Eurostat. 4 Data that were missing in the National accounts (for Malta, Luxembourg, Bulgaria and Ireland) were complemented by estimates available from the AMECO database of the European Commission. At the time of writing this paper, annual data were available until 2011 for most Member States and quarterly data were available for a large selection of Member States until the third quarter of 2012 (except for AT, BE, DE, IE, PL and RO). For Member States where the first three quarters for 2012 were available, an estimation of the 2012 annual growth rate was produced, reflecting the information available until the 3 rd quarter, that is estimating the level of growth reached in 2012 if no change would be observed in the last quarter compared to 3 rd quarter levels, the latest available. For this quarterly data are deseasonalised (based on average quarterly 4 May 2013 I 11

12 coefficients observed since 2000) and the level of the 4 th Quarter is left at the level of the 3 rd quarter ; the estimation of the growth rate for 2012 is obtained based on the deseasonalised quarterly data for 2011 and 2012 (in other words this is an estimate of the growth rate that has been attained in the 3 rd quarter, neutralising the potential impact of the 4 th quarter, for which data are not yet available). The SOCX database of the OECD was developed in the 1990s. The nine policy areas covered by SOCX are the following: oldage, survivors, incapacityrelated benefits, health, family, active labour market policies, unemployment, housing and other social policy areas. Given the inclusion of labour market policies in SOCX, its scope is larger than that of ESSPROS. Compared to National accounts, the same holds with respect to active labour market policies. Also, SOCX is not limited to public social protection expenditure only, but includes mandatory private social expenditures and voluntary private ones. Data provided by the ILO are a combination of several different data sources (ESSPROS, SOCX, data of the International Monetary Fund, the World Health Organisation's Statistical Information System and also the ILO's Social Security Inquiry). May 2013 I 12

13 1.2 In Europe, social protection expenditure increased in 2009, nearly stabilised in 2010 and decreased afterwards Social protection expenditure provides automatic stabilisation of economies in bad times Social protection expenditure provides for automatic stabilisation of the economy in bad economic times, since expenditure generally increases and thus partly compensates for the initial decline in households' disposable income following the decline in market income. This stabilisation function of social protection systems is typically present for unemployment benefits but is also for means tested benefits from various functions (typically social exclusion, family or housing), as well as but to a lesser extent for health or pension expenditures, since those generally continue to grow or remain constant while market incomes decline. Estimates of automatic stabilisers generally do not distinguish between various public expenditures and taxes. However, Chart 2 shows that social protection systems account for a key dimension of overall automatic stabilisation and in standard recessions (translating into increases of unemployment) they represent the major share of automatic stabilisation. This is clearly apparent in estimates of stabilisation in case of an unemployment shock, like in Dolls et al. (2009) and this has been actually observed since the onset of the crisis in Europe (see chart below). For instance, estimates from European Commission (2013) based on the period indicate than when the output gap decreased by one percentage point, unemployment expenditures increased on average by 6%, while social exclusion, family and housing expenditures increase by 2% and pensions and health by around 1%1.5%. Chart 2 Contributions of components to the growth of nominal gross disposable income of households, EA 17 ( ) May 2013 I 13

14 Source: Eurostat/ECB. Note: annual percentage change and percentage point contributions. Labour income includes compensation from employees and gross operating surplus and mixed income (compensation from selfemployed). In the rest of this section, the period is used as reference for comparison of growth rates of social protection expenditure in recent years. The choice of this period stems from that this was a 5 years period of relatively modest GDP growth on average in the EU (since the early 90s where information is available), with annual economic growth of +1.5% for EA17 and +1.9% for EU27. In this respect, social expenditure growth in 2010 and 2011 can be compared to a period with nearly similar average growth conditions: in 2010 economic growth was of 2.1% in EU and 2% in EA, and in 2011 respectively 1.5% and 1.4% (in 2012 it was respectively 0.3% and 0.6% according to the Winter 2013 European Economic Forecast). An acceleration of social protection expenditure in 2009 and a stabilisation in 2010 In 2009, social protection expenditure increased by around 7% in EU27 and EA17, an acceleration mainly driven by increases in unemployment expenditure, but also in health and disability as well as in old age and survivors expenditure and to a lower extent by an increase in family and social exclusion and housing expenditure (see Chart 3). The increase in unemployment expenditure mainly reflected increases in the number of unemployed (see below section 1.4). In 2010, the increase was very modest, reflecting an overall stabilisation in unemployment expenditure, but also very modest increases in health and disability, and an increase in old age and survivors benefits. The growth in health and disability expenditures in 2010 appears very modest in the EU, which mirrors very modest changes observed in the OECD (see OECD 2012b). Changes in unemployment expenditure were mainly driven by the number of unemployed, but also to a lower extent by declines in average benefits (as measured by the average expenditure per unemployed, see below section 1.4). May 2013 I 14

15 Chart 3 Contributions to real growth of social expenditures in EU27 and EA17 ( ) Source: ESSPROS and DG EMPL calculations. Note for EU27, actually refers to EU25 since EU27 not available. In the period the average annual growth rate is shown. May 2013 I 15

16 Chart 4 Growth in (real) total social expenditures in Europe , 2009 and 2010 Source: ESSPROS and DG EMPL calculations. Expenditure on unemployment benefits increased in all countries in 2009, and in most countries in 2010, when it started declining in a few countries, including those where unemployment kept increasing (ES, EL, HU, SK and UK). In 2010, health and disability expenditure showed on average very modest increases, with declines in real levels in some countries (EE, EL, ES, HU, LT, LV, PT and UK). Old age and survivors expenditure grew at a slow pace, also with declines in real terms in some Member States (EE, EL, LT, RO and UK). In a few countries, family benefits expenditure (CZ, EL, HU, IT, LT, LV, RO) and social exclusion and housing expenditure declined (EL, HU). Most recent trends show real declines in 2011 and 2012 Data for years 2011 and 2012 only allow to track developments in expenditure on benefits in cash and in kind. In 2011, social expenditures declined on average in May 2013 I 16

17 Europe and in 2012 in most countries. 5 In 2011, declines affected both inkind and cash benefits. In 2012, in a degraded economic context, most Member States showed declines of inkind expenditure, but relatively stable cash expenditure. While declines in cash benefits are reflected in the gross households' disposable income, those of inkind benefits are not. However, falling inkind benefits are likely to have a negative impact on the population (e.g. when provision of health care services or child care are affected). Chart 5 Annual growth in real public social expenditures , EU27 and EA17 Source: NA and DG EMPL calculations. Note: No averages for 2012 since quarterly data used to establish national estimates are not available in some Member States (AT, BE, DE, IE, PL and RO). In 2011, the declines affected most Member States and both inkind and cash benefits. Declines were particularly significant (around 5% or more) in EL, LV, PT and RO and were below 1% in most other Member States (AT, CZ, DE, DK, EE, ES, HU, IE, IT, LT, PL, SK, UK). In 2012, the rates of decline were in general less pronounced, but still very significant in a few Member States (EL, HU, LT, PT) and were still below 1% in some other ones (CY, CZ, ES, IT, LV, SI). Cash benefits recorded real increases in some Member States (BG, CY, DK, FI, FR, IE, LU, SE and UK). 5 For 2012, the annual growth rate reflects an estimate based on 3 first quarters (see Box 1). May 2013 I 17

18 Chart 6 Annual growth in real public social expenditures and Source: NA and DG EMPL calculations. Note: (*) for not available. May 2013 I 18

19 1.3 Did social protection expenditure follow its trends in the current crisis? These developments can be further analysed by confronting deviations from trends in social protection expenditure and output gaps, as observed since The Box on estimating the cyclical component of GDP and social protection expenditures (see below) provides more detail about how cyclical components of social protection expenditure and GDP are obtained. In 2009 and to a lesser extent in 2010, social expenditure showed a strong positive deviation from its trend, in a context of adverse economic situation as reflected by the negative values in output gaps. Chart 7 Deviations from trend of real growth in social expenditure and GDP in 2009 and 2010 Source : Eurostat, National accounts, DG EMPL calculations. In 2011 and 2012, while output gaps remained negative (and generally worsened in 2012), the deviation of social protection expenditure from the trend declined and became negative on average in Europe. May 2013 I 19

20 Chart 8 Deviations from trend of real growth in social expenditure and GDP in 2011 and 2012 Source: Eurostat, National accounts, DG EMPL calculations. Box 2 estimating the cyclical component of GDP and social protection expenditure The cyclical component of social protection expenditure has been estimated as the gap between actual levels and the trend in social protection expenditure, and expressed as a percentage of the trend of social protection expenditure. The trend of social protection expenditure is estimated using the HodrickPrescott filter, which is a standard method used for identifying trends and cycles in time series. It is based on the following formula, with y the initial series and τ the estimated trend (the standard value of λ for annual data has been used, i.e. 100): min T 2 ( y t t ) + λ [( τ t + 1 τ t ) ( τ t τ t 1 T 1 2 τ 1)]. 2 The cyclical component of GDP corresponds to the European Commission estimates, as provided in AMECO (AVGDGP, or the gap between actual GDP and potential GDP, percentage of potential GDP). In this methodology, the potential GDP is estimated based on a CobbDouglas production function and not through a statistical method. Years labeled as "periods of belowpar performance" are defined as those years when the cyclical component of GDP (or output gap) was negative, i.e. when actual GDP was below its potential. The deviation from trends in social protection expenditure following the initial recession ( ) and following years of recovery (2010) and slow (2011) or negative growth and (2012) can be compared with episodes of belowpar performance May 2013 I 20

21 in the 1990s and 2000s. It can be noted that, as compared with previous periods of belowpar performance, the one started in and triggered by the financial crisis was not followed by a sustained recovery, but often by a second recession notably in countries characterised by fiscal and current account crises. Compared to the initial years of past periods of belowpar performance, the economic performance was much worse in this crisis (year N, 2009 in most countries), as reflected by more negative output gaps on average (around 4%, depicted by pink columns) and relatively high positive deviation of social expenditure from trends (around +5%, depicted by the red line). In past periods of belowpar performance where information is available (see annex), the negative output gap was milder (1% 1.5%, depicted by blue columns) and the positive deviation from trend social expenditure was lower (around 1%, depicted by the blue line). This suggests that social expenditure reacted in the first year of this crisis slightly more strongly to the economic cycle than in the past. The year after the start of the recent crisis (N+1, 2010 in most countries) showed a relatively quicker decrease in the output gap than in past periods of belowpar performance and a parallel decline in the positive deviation from the trend social protection expenditure. These developments seem broadly in line with past trends with an improvement in the output gap and a reduction in the deviation of social expenditure from its trend. Two years after the start of the recent crisis (N+2, 2011 in most countries) showed a steady improvement of the output gap which, however, stayed negative. In this context, the deviation from the trend social protection expenditure declined more significantly than in the preceding year (N+1) and even became negative on average. These developments seem to be diverging from the past since, in former periods of belowpar periods, the adjustment of the social expenditure relative to its trend slowed down in N+2, while in this crisis the downward adjustment pace has been constant or accelerating. Three years after start of the recent crisis (N+3, 2012 in most countries) showed a worsening of the output gap. However, in this context, the negative deviation of social protection expenditure from its trend kept decreasing at broadly the same pace as in preceding years. These developments also seem to be diverging from past trends, since a deterioration in the output gap was usually accompanied by an upwards deviation of social protection expenditure from its trend, while in this crisis it continued adjusting downwards at a comparable pace as in former years. This profile of social protection expenditure in year N+3 provides an indication that social protection expenditures have been procyclical in 2012 (it should be noted that figures for 2012 used in this paper are provisional, see box 1). As a result, in year N+3, while the output gap stands at around 2%, the deviation of social expenditure from its trend stands at around 5%. This significant downwards correction can be seen as a correction in the cycle of social protection expenditure in this crisis, but can also partly reflect a permanent adjustment in social expenditure growth during this crisis. It also partly reflects the exceptional scale of the fiscal adjustment needed in the context of the euro crisis, as reflected notably by a more persistent contraction of GDP and a context of reduced fiscal space. May 2013 I 21

22 Chart 9 Deviation from trend of public social expenditures and GDP in current crisis and past periods of belowpar performance in EU27 and EA17 Source : Eurostat, National Accounts, DG EMPL calculations. Note: 2012 data are estimated based on quarterly data from the first 3 quarters. In the current crisis, N is year 2009 in most countries. Reading notes: in the initial year of belowpar performance in the current crisis, social expenditures were around 5% above their trend in Europe, while the GDP was about 4% below its potential (output gap of 4%). Averages are unweighted country averages (since countries do not always experience a negative output gap the same year). 1.4 Decomposition of recent trends of unemployment expenditure The development in unemployment expenditure in the crisis can be decomposed into effects of, on the one hand, changes in the numbers of potential beneficiaries (here proxied by the change in the number of unemployed people) and, on the other hand, changes in average benefits (here proxied by the change in the average expenditure per unemployed person. May 2013 I 22

23 Chart 10 Contributions to the annual change in real unemployment expenditure (200410) Source : Eurostat, ESSPROS, DG EMPL calculations. Reading note: this graph shows the annual change in real expenditure on unemployment benefits (in %) and the main factors that influence it: the average expenditure per unemployed and the number of shortterm (ST) and longterm (LT) unemployed. The contributions of these factors are expressed in percentage points. In 2009, in Europe, the increase in unemployment expenditure was driven nearly exclusively by changes in the number of unemployed, probably also reflecting shifts in the structure of the unemployed and associated impact on the average expenditure per unemployed (with increases in the number of short term unemployed with higher benefits and increases in the number of long term unemployed with lower benefits). In 2010, the decline in volumes reflects two opposite effects with still overall increases in the number of unemployed (increases in the number of long term unemployed and decline of the number of short term unemployed) and a decrease in the average expenditure per unemployed. This decline in the average benefit per unemployed can reflect both a composition effect (since long term unemployed have on average lower benefits) and some changes in the calculation rules of benefits leading to lower benefit levels. Differences in developments across Member States can be seen in the chart below. Unlike in the EU on average, in some countries in 2009 the change in the average unemployment expenditure per unemployed had a significant role (such as BG, CY, EE, LT, RO, SK) and in 2010 there were a few countries where its influence was positive or nearly negligible (such as AT, DE, IT, LU, RO, SE). May 2013 I 23

24 Chart 11 Contributions to the annual change in real unemployment expenditures (2009 and 2010) Source : Eurostat, ESSPROS, DG EMPL calculations. Reading note: this graph shows the annual change in real expenditure on unemployment benefits (in %) and the main factors that influence it: the average benefit per unemployed and the number of shortterm (ST) and longterm (LT) unemployed. The contributions of these factors are expressed in percentage points. May 2013 I 24

25 2 Distributional impact of the crisis and of austerity packages The recession of , the following recovery of and further recession episode of 2012 translated into significant changes in the income distribution, reflecting sharp changes in market incomes, which were offset to different degrees by automatic changes in taxes and benefits levels, but also discretionary changes in taxes and benefits, such as through austerity packages. This section reviews evidence on the main changes in the distribution of incomes since the offset of the crisis, including through nowcasting methods and reviews available evidence of the impact of austerity packages for a selection of Member States. 2.1 The impact of bad economic times on the distribution of incomes Gross Household Disposable Income developments In the initial phase of the crisis ( ), in most Member States, market income contributed negatively to gross household disposable income (GHDI) development (except in SI, BE, CY, SK, LU, PL, RO and BG), with taxes and social transfers playing their role of automatic stabilisation by sustaining households' incomes (see Chart 12). Chart 12 Contributions to GHDI development and May 2013 I 25

26 Source: National accounts. Note: GHDI development is expressed as percentage change. In the second phase (200911), the decline in market incomes was in general less important (EE, HU, IT, NL, IE, DK, AT, UK, CZ ) and sometimes recovered to positive values (LV, LT, DE, FR, FI, SE), with significant exceptions of acceleration in declines (EL, PT, ES ) or move towards negative values (SI, BE, CY, PL, RO), BG and SK being the sole two countries with positive developments in the two periods. However, the contribution of social transfers tended to erode in the second period (see Chart 13), with in particular some Member States compounding a decline in real market incomes by a negative contribution of social benefits to households incomes (EE, EL, AT, UK, CZ, PL) and more generally, less significant positive contributions of taxes and benefits to household incomes when market incomes declined. Chart 13 weakening of the stabilisation impact of social transfers and May 2013 I 26

27 Source: National accounts. Overall impact of the crisis on the income distribution The impact of the crisis on the overall income distribution can be gauged by comparing real income growth at different levels of the income distribution. Both in the initial phase of the crisis (200709) and the subsequent recovery in 2010, the pattern of changes of disposable income over the whole income distribution varies substantially among Member States (see Chart 14). In the first part of the crisis, income inequalities increased in more than half of Member States (with most significant increases in ES, IE, SK and LT) and slightly decreased in some Member States (more significantly in BG and RO). In most countries, the decrease in inequalities was due to a decline of incomes in the 9 th decile of the income distribution. Incomes in the lowest decile decline in particular significantly (more than 5% a year on average on both years) in ES, IE, LT, DK and LV. In 2010, a year of partial recovery for most countries, income trends were progressive in a majority of Member States, notably in DE, SK, LV, MT and LT, often reflecting substantial declines in the level of the 9 th decile. A few countries did not experience much developments in inequalities, though average declines in real disposable incomes were particularly sharp at all levels of the income distribution (such as EL and ES).In a third of Member States regressive trends in income distribution were driven by decreases in real incomes in the lower end of the income distribution (BG, HU, IT and EE), in some cases associated with significant increases at the higher end (BG, HU, DK, AT, MT). The developments reflect three contributions: the initial changes in primary incomes from households (labour income but also capital income), but also the stabilising impact of the tax benefit models and the potential impact of fiscal consolidation measures. For instance, Ozdemir and Ward (2012) estimate that the deterioration of the labour market in the crisis (as reflected by changes in the work intensity of households) has translated into an increase of the poverty rate of the 2564 age group of around one point in Europe between 2007 and 2009, with sharp increases in some Member States (EE, LV, LT around 3 points ES, IE and BG around 2 points) and that the deterioration of the labour market situation has been particularly harmful to May 2013 I 27

28 poverty in Greece in 2010 and to a lesser extent Portugal (with some improvement in EE, LT and LV). These results assume that there is no change in the stabilisation function of the taxbenefit system, which allows compensating for a large share of the decline in labour incomes. For instance, Dolls et al. (2009) estimates range around 50% of income stabilisation in Europe in case of unemployment shocks (against 33% in the USA), with levels ranging from around 20% in EE, 30% in ES and PL, 40% in IT, EL, SI, IE, UK towards 60% or more in FR, PT, DE, BE, AT, SE and DK. Chart 14 Yearly growth of real incomes at different points of the disposable income distribution (200709) and 2010 Source: EUSILC. Note: countries on the left side show lower increases of disposable incomes in the lower part of the income distribution (regressive trends), while countries on the right side show higher increases of disposable incomes in the lower part of the income distribution. May 2013 I 28

29 Nowcasting poverty Nowcasts of the poverty rate (and related income measures) are estimates based on microsimulation models that take into account policy and economic/labour market changes, and are available in year N for income year N. More detailed information on this matter is provided in the Box 3 on nowcasting poverty. These methods provide information on the latest changes in the distribution of incomes, while actual information from EUSILC surveys is currently available until 2010, nowcasting allows analysing trends up to These estimates essentially assume that cross section relations between variables are constant over time and built on the main changes observed in the labour market (from the LFS) which are incorporated in EUSILC and by adjusting for changes in the design of the taxbenefit systems (as reflected in EUROMOD). The main limitation arises from possible changes in other incomes than labour market ones as well as to possible changes in the labour market or possible changes in the link between employment situation taken into account and related incomes. The example below presents results for a selection of Member States for the period They highlight an increase in median incomes in EE, LT and LV, linked to the improvement of the labour market conditions, as well as an overall stability in ES, IT, PT and RO and a sharp decline in EL. In EE, LV and LT, the increase in medium incomes tends to translate into an increase in the poverty rate, since poor people would not benefit to the same extent of increases in incomes. In EL, the sharp decline in incomes would translate into an increase of poverty, with more modest incomes being relatively more affected. At the same time, an increase in the risk of poverty among children and the elderly also reflects measures taken to adjust (either freeze or reduce) some benefits (such as child benefits and minimum pensions) with in particular significant increases of poverty among children in EL, ES and PT and among older people (EE, LV and LT). Table 3 Nowcasting the income distribution (change since latest available SILC wave) Period (income years) Median (%) Gini (ppts) AROP (all) (ppts) AROP (18) (ppts) AROP (65+) (ppts) Estonia % Greece % Spain % Italy % Latvia % Lithuania % Portugal % Romania % Source: Euromod estimates on the basis of SILC 2008 data (2007 incomes), Navicke and alii (2013). AROP: atriskofpoverty rate (60 % of the median). Box 3 Nowcasting poverty The method uses the microsimulation model Euromod to adjust market incomes with available information about their developments (wages, prices, etc.) and simulates the effects of changes to the design of the tax and benefit system until 2012 (level of benefit, duration, conditionality, etc.). Further data adjustments are made to account for specific labour market developments between and 2012 (e.g. increase in 6 The EUROMOD model is currently being updated to refer to the latest SILC data available May 2013 I 29

30 unemployment), but no account is made of demographic and other compositional changes (see Navicke and alii 2013). This methodology makes it possible to provide an estimate of changes in the distribution of incomes and accordingly of the potential increase in the risk of poverty and other income variables (including the poverty threshold) for the total population and for specific subgroups. Testing the method on past developments where SILC data are available (income years ) shows that the method allows identifying nearly all inflexions in the changes of the median incomes and provides estimates of changes of poverty rates within the confidence intervals of the SILC survey. This methodology also allows providing estimates of the contribution of different factors to the overall change, e.g. worsening labour market conditions or changes in the tax and benefit system. 2.2 Impact of austerity measures on the income distribution The economic crisis and the austerity measures to counter the subsequent government budget deficits are inevitably affecting income poverty and inequality. Until detailed data become available, it is very difficult to establish the scale of this effect across countries and even then, it will be difficult to distinguish the direct effect of the crisis from that of the policy responses to it. However, updated results from the EUROMOD microsimulation model allow illustrating the impact of some austerity measures on households incomes in nine countries (Avram et al. 2012). Evidence from past consolidation episodes A recent IMF assessment indicates that based on observed fiscal consolidation episodes in the past (over the period in some OECD countries) a 1 percentage point of GDP consolidation is associated with an increase of about 0.6 % in inequality of disposable income (as measured by the Gini coefficient) in the following year, also suggesting that the cumulative impact peaks after five to six years and fades after the tenth year (IMF 2012). Ahren et al. (2011) provide evidence that the distributional impact of financial crisis and fiscal consolidation varies depending on institutional setting and in particular is smoothed by a more progressive the tax system, a more developed welfare system and notably higher EPL and levels of unemployment benefits. Bastagli et al. (2012) highlight that the mix of tax and spending measures during past consolidation episodes in advanced economies (based on available literature) has been an important determinant of the impact of consolidation on income inequality, and in particular protecting the most progressive benefits. In this respect they identify three levers: greater reliance on more progressive measures (which can obviate the need for large cuts in social transfers), removing opportunities for tax avoidance and broadening the scope for expenditures reform (including in particular military spending and subsidies including tax expenditures and public sector wages). Rawdanowicz et al. (2013) also underline that there is scope to balance current consolidation efforts in favour of more equity with only limited adverse impact on potential growth, such as through reducing tax expenditures, raising taxes on immovable property, increases in the retirement age or raising efficiency in education and healthcare. Size of austerity packages modelled and overall effects of the crisis on household income The economic and financial crisis and subsequent fiscal consolidation measures have translated into an overall stagnation of real gross household disposable income since 2008 on average in the EU, with very significant declines in a number of Member May 2013 I 30