Ifo Viewpoint No. 6: A New Welfare Concept

Hans-Werner Sinn
Munich, 15 Nov. 1999

In Germany the lowest wage is 70% of the overall average wage; in the United States it is 30%. This is basically why under-employment in the area of simple jobs is so great in Germany and so small in the US. Simple jobs cost more than they create in value, and this is why they are not so plentiful.

High pay for simple jobs is a result of the German social welfare system. Since entitlement to full welfare payments is only possible when no labour income is present, and since welfare payments are reduced in direct relation to labour income, the lowest wage cannot fall below welfare benefits.

Instead of designing welfare as a subsidy for inactivity, it would be better to convert welfare into a subsidy for activity, since this would lead to a disappearance of the lower wage level in the negotiated pay system. Welfare that would only be paid when the recipient takes on a job and which in addition would increase along with earned income up to a specified income level would create the incentive to take on low-paid jobs. Negotiated wages for simple jobs would decline, and new jobs would be created.

This would be more in accord with the goals of the social welfare state than the present system, since earned income would be joined with the money that the state provides as social welfare. Despite the lowering of wages, despite the unchanged social welfare budget, and because of the full free-rider effect, the incomes of low-wage earners will be higher than is the case today. Moreover, the creation of new jobs will provide a stimulus to growth that will create new prosperity for everyone.

The earned-income tax credit in the US is an example of a social welfare system that has the characteristics just presented even though, from a German point of view, the level of American social welfare is too low. In addition to the 1986 tax reform, the earned-income tax credit can be seen as a major reason for the American job miracle. It is not the level but the incentive structure of the American system that should be adopted in Germany in order to create a similar job miracle.

Hans-Werner Sinn
President of the Ifo Institute