The political left is usually a strong supporter of the welfare state, as it believes that it provides social insurance to the population at large, and aims to benefit those most in need, even if outcomes sometimes fall short. In this way it is thought to reduce poverty and inequality and increase social justice. Those on the right tend to be less enthusiastic. They often suggest that public spending on welfare and the taxes needed to fund it undermine individual responsibility and incentives to work, as well as increasing the costs of doing business. These approaches mostly draw on a static microeconomic analysis, while not attempting to use a systemic or macroeconomic and more complex one.
How might social welfare affect overall economic performance? If we ignore the economic cycle and assume that the government budget is balanced, the taxes and public spending which produce the welfare state can affect two of the main categories of income: wages and profits. If the taxes levied to fund it only affect wages, then for all categories of welfare spending, which might include unemployment benefits, in-work tax credits, pensions and other categories, income would tend to be redistributed from richer to poorer households. If richer households spend a lower proportion of their income, and thus save more, such redistribution will increase the level of consumption in the economy and reduce the saving rate. Whether or not this improves economic performance then depends on the constraints on the level of private sector investment. If investment spending is constrained by a lack of saving, then a further fall in the latter would reduce it further and lower economic growth. If on the other hand, prior to the act of redistribution, investment is constrained by a lack of consumption, then the existence of the welfare state could increase the number of investment opportunities created by higher consumption and growth would be stimulated.
Many economists argue that the rise in income and wealth inequality in most western countries in recent decades acts as a drag on the growth of demand and output but reducing the growth of consumption. If this is indeed the case, social welfare has the potential to improve economic performance, as described above.
Turning now to the effects of the welfare state on the economy-wide rate of profit: if the taxes levied to fund welfare spending reduce business profits, and redistributing the income to poorer households (which are likely to spend it on consumption), the macroeconomic outcome once again depends on the constraints affecting the whole economy. If profits are too high, meaning that they are either being used to fund unproductive and inefficient investment with low returns, or a large proportion of profits is being spent on consumption by richer households via dividend payments, or is being saved and is thus reducing consumption, then redistribution through the welfare state from profits to consumption would reduce the level and share of investment in the economy, but increase its efficiency and the rate of return as the increased consumption stimulates productive investment opportunities for firms. This would tend to improve efficiency and material welfare. The effect on economic growth would be ambiguous in the short-term, as the previously higher investment might have led to higher growth rates for a while, but will ultimately prove unsustainable, as the rate of return on investment falls. In the medium to longer term, growth rates should prove to be both higher and more sustainable.
If investment is constrained by too low a rate of profit (which funds the investment), social welfare could act as a constraint on growth. In this case, what is needed is a lower rate of wages and consumption, which might mean more inequality of incomes, as the latter are shifted from wages to profits, increasing what is called functional income inequality (the distribution between wages and profits).
Drawing these examples of the effects of welfare (and redistribution through the tax system more generally) together, we can see that there is no simple answer as to whether, at the level of the economy as a whole, performance will improve or deteriorate after a change in policy. A particular case study chosen from those worked through above might be used by those on the left or the right, depending on their biases, to influence policy. Which holds in practice should not be a political question and should be used only after careful analysis. Macroeconomic influences are therefore as important as the effects of taxes and public spending on individual or household incentives at the microeconomic level, and should be considered alongside them in any analysis of the welfare state.