TCS Daily

The FlexDollar Welfare State

By Arnold Kling - February 4, 2004 12:00 AM

"Freddie Mac provides its employees FlexDollars to help pay for the benefits our employees select. These funds offset the cost of employee's medical, dental, vision, life insurance and vacation purchased."
-- Freddie Mac web site

As pundits geared up for the 2004 Presidential campaign, a number of President Bush's defenders have argued that he is redefining conservatism. Rather than shrinking government, the President is, like Freddie Mac, giving people more choices within their menu of benefits. One might say that, according to these pundits, the new conservative ideal is the FlexDollar Welfare State.

For example, George Will writes,

Today "strong government conservatism" -- "strong" is not synonymous with "big" -- is the only conservatism palatable to a public that expects government to assuage three of life's largest fears: illness, old age and educational deficits that prevent social mobility.

And in Commentary magazine, Daniel Casse writes,

...such conservative causes as school vouchers, modernized weapons systems, and privatized Social Security all require expanding the role of government...What it comes down to is that, for Bush, there are conservative goals that take precedence over limiting the reach of government.

Casse cites an essay late last year from Michael Barone, which Casse says "suggested that Bush has successfully replaced the conservative touchstones of small government and spending cuts with the bolder, more inspirational ideas of choice and accountability."

The Bush-friendly conservative pundits cite Administration initiatives on school testing, health care spending accounts, and private accounts for Social Security as evidence of the new focus on choice. The argument is that once these initiatives are in place, they can be expanded to make choice available to more Americans, giving us the sort of flexibility provided by Freddie Mac and other companies that offer "cafeteria-style" benefits.

My own view is that it is very risky for Republicans and conservatives to embrace the FlexDollar welfare state. The reforms involved may be too timid and peripheral to have any lasting meaning. I fear that, like the drip castles that my daughters and I like to build when we go to the seashore, whatever miniscule reforms are enacted during this era of Republican ascendancy will be washed away the next time that the tide sweeps the Democrats into power.

Oxymoronic Benefits

The term "company benefits" is an oxymoron. When the company gives you "benefits," it takes away more than that in salary. Why, then, do so many people like to work for companies with "good benefits?" For example, if you could buy health insurance for $4000, then why would you want to have $5000 less in salary in order to have health insurance paid for?

Many economists, including Milton Friedman, speculate that tax arbitrage is the main reason that companies offer health insurance and other benefits. Salary is subject to tax, but benefits are not, so that on an after-tax basis a worker might be better off with non-cash benefits.

I am not sure that I find this explanation convincing. Contrary to my training as an economist, I believe that at least some of the preference that workers have for in-kind benefits reflects flat-out irrationality. Even without tax arbitrage (and, after all, something like half the population pays no income tax and therefore does not even participate in tax arbitrage), many workers would choose to receive $4000 in health insurance rather than take $5000 in salary, even though the latter would allow them to buy health insurance and have $1000 left over. (See my earlier essay, America is Crazy.)

In a world with rational workers, and certainly in such a world without tax distortions, companies with "good benefits" would be shunned in favor of companies that paid better salaries. Company benefits would disappear. As it is, the oxymoron of company benefits seems to fool most people.

What is interesting is that workers are not naturally suspicious of companies that pay "good benefits." Apparently, most people believe that "good benefits" reflect generosity and sharing by the company, rather than a shrewd, calculated effort to save on compensation costs. My guess is that the people who see through the scam of "good benefits" tend to gravitate toward self-employment, which allows them to take their payments in cash and buy benefits themselves.

The Oxymoron of Welfare State Benefits

Like company benefits, the concept of middle-class benefits in the form of government programs in education, health care, and Social Security is an oxymoron. On average, the value of what we receive is less than the value of the taxes that we pay to support these programs. That is because tax collection is not a costless process. Taxes create considerable friction in the economy by distorting choices. Payroll taxes penalize work. Personal and corporate income taxes penalize thrift. The lost output and reduced capital stock that result represents what economists call "deadweight loss," and it amounts to trillions of dollars. In the case of Social Security, for example, see this analysis by Martin Feldstein.

As with corporate benefits, I am not sure why the public does not see through the scam of government benefits for the middle class. However, one possible reason that people under-estimate the cost of the welfare state is that much of that cost has been shifted into the future. The taxes that will be required tomorrow to meet the promises that we make with Medicare and Social Security today are staggering to contemplate.

If Social Security and Medicare were defined-contribution plans, in which the money you spend in old age comes from principal and interest on the money you pay into the plans while you work, then they might be perceived differently. People would see a stronger connection between taxes and benefits.

If taxpayers were carefully comparing the benefits of government programs with the costs of funding those programs, then government provision of education, health care, and pensions would disappear. We would be better off taking care of these needs as individual families, while using a progressive consumption tax to provide for the poor. See Bleeding-Heart Libertarianism.

As that essay pointed out, public education, Medicare, and Social Security are the drivers of big government. Public works projects (i.e., pork), agricultural subsidies, and other programs that pundits like to rail against, are a drop in the bucket by comparison. No conceivable cuts in domestic discretionary spending could offset the tax revenue increases needed to fund Medicare in the middle of this century. As satisfying as it might be to conservatives to see President Bush veto some spending bills, such moves would be symbolic rather than substantive.

Experiments with Autonomy

Large segments of the population are afraid of privatized Social Security, school vouchers, and paying for medical care as individuals rather than collectively. That is the political reality that is leading the Bush Administration toward the FlexDollar Welfare State.

Because most of the public does not recognize that middle-class benefits are an oxymoron, the Bush Administration is offering alternatives only in small, experimental stages. Instead of fully privatizing Social Security, the President proposes a partial privatization plan -- and even that probably will be badly compromised in Congressional negotiations. Instead of school vouchers, the President has offered limited choice to parents of children in "failing schools." Rather than scale back promised Medicare benefits for future recipients, the Administration has set up experiments with medical savings accounts and incentives to purchase catastrophic rather than first-dollar medical coverage.

If the experiments develop enough success and traction, then a constituency may develop to extend -- or at least to maintain -- such efforts. In theory, over time the success of alternatives could open the way to shrink the public benefits programs.

The perils of such a timid approach are illustrated by the "No Child Left Behind" act. Our local elementary school qualified, based on low test scores, as a school that parents could opt out from. However, the only choice is another public school that itself is of marginal quality as measured by test scores (about which I am skeptical to begin with). The bottom line is that parents feel no sense of empowerment whatsoever, and instead of creating a constituency that supports choice and reforms, the No Child Left Behind concept is getting a bad name, which it probably deserves.

My own view is that at some point we should confront and overcome the public's desire for middle-class government benefits, because they require heavy taxes and impose large economic costs. Perhaps the FlexDollar Welfare State is a necessary step in that direction, because people who do not trust economic theory will nonetheless believe experiments that they can see with their own eyes. But if all of the experiments turn out to be as weak and ineffectual as the No Child Left Behind Act, then the political capital that the Administration is spending on limited reforms will go to waste. Given the likelihood of such an outcome, the enthusiasm of George Will and others for conservatism redefined as the FlexDollar Welfare State is difficult for me to share.


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