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Welfare Policy Integration Inconsistencies Giuseppe Bertola (Università di Torino) First draft: April 2004 Revised: January 31, 2005

ABSTRACT What purposes should social and labor market policy serve in increasingly interrelated economic systems, and do current arrangements serve them well in the European framework? This paper reviews historical experiences and theoretical issues, focusing in particular on assignment of decision power at different levels of governance and on theoretically clear and empirically apparent sources of incoherent and ineffective policy structures. It discusses proposals of “delayed integration” welfare provision, argues that several aspects of Nation-based organization of basic redistributive benefits is obsolete, and concludes that reform efforts should be better focused on reappraisal and modernization of social responsibilities at all levels of governance in the European Union’s economic system.

_________________________________ I am grateful for helpful comments by an anonymous referee and by the discussant, the editors, and other conference participants.

The policy of Europe, by obstructing the free circulation of labor and stock both from employment to employment, and from place to place, occasions in some cases a very inconvenient inequality in the whole of the advantages and disadvantages of their different employments. (Adam Smith, The Wealth of Nations, Chapter X: “Of wages and profits in the different employments of labor and stock”).

1. Introduction The current policy of Europe, at least according to the letter of its Treaties, is well aware of the problems discussed by Adam Smith some two hundred and fifty years ago. The Treaty establishing a Constitution for Europe (signed on 29 October 2004 by the member countries’ Heads of State or Government, subject to ratification at the time of writing) lists mobility and social progress among the Union’s objectives in Article I-3: 2. The Union shall offer its citizens … an internal market where competition is free and undistorted. 3. The Union shall work for … a highly competitive social market economy, aiming at full employment and social progress, .. . It shall combat social exclusion and discrimination, and shall promote social justice and protection, … These and other objectives, however, are to be pursued within the institutional framework of “subsidiarity”, as defined in Article I-11: 3. … in areas which do not fall within its exclusive competence, the Union shall act only if and insofar as the objectives of the proposed action cannot be sufficiently achieved by the Member States, either at central level or at regional and local level, but can rather, by reason of the scale or effects of the proposed action, be better achieved at Union level. Social policy is not currently among the competences of the Union. Unfortunately, social protection and undistorted competition need not be achieved in the resulting policy framework any more effectively now than in Adam Smith’s times when, as discussed in other quotes below from the same chapter of the Wealth of Nations, economic integration was occurring within rather than across Nation States. This paper reviews the purposes of social and labor market policy in modern, interrelated economic systems, where the tension between social equity and productive efficiency may or may not be adequately addressed by market and government interactions. It focuses in particular on issues arising from present arrangements

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regarding the assignment of power at different levels of governance, in this and other fields, within the European system of economic policies. Section 2 reviews briefly the purposes and tools of social and labor market policy and its predicaments in environment, such as the Europe of Adam Smith and that of present times, where the scope of political decision-making does not coincide with the scope of economic interactions. Section 3 summarizes the conceptual framework of Sapir et al.’s (2004) approach to policy evaluation: conflicts of interest, not appropriately mediated by political processes, can easily result in incoherent and ineffective policy structures. Possible solutions are illustrated with examples from European experiences in the fields of competition and macroeconomic policies. The history and prospects of European labor and social policies are reviewed in Section 4. Broad agreement on the importance of the issues contrasts with very little agreement as regards how desirable aspects of policymaking in this area may be reconciled with the new challenges and opportunities of an ever larger, and perhaps ever closer, union of Europe. Section 5 focuses on a comparison of the Richter (2002)/SinnOchel (2003) and Bertola et al (2001) approaches to the relevant issues. It again returns to Adam Smith’s analysis of his own time’s attempts to regulate or delay integration of diverse populations, and outlines how reform efforts could instead be focused on reappraisal and modernization of social responsibilities at all levels of governance in the European Union’s economic system. Section 6 concludes arguing that a comprehensive policy framework can reconcile economic integration and politically important social objectives. The policy of Europe, at a crossroads between development and stagnation, should resist temptations to revert to a dubious Golden Age and develop a forward-looking, constructive, and coherent approach to reconciling its citizen’s needs and its economy’s evolving constraints. 2. Welfare policy in an integrating world Governments should address problems that markets cannot solve efficiently (Sinn, 2003). As regards distribution of labor income across differently fortunate individuals, problems whose market solution is socially and politically unsatisfactory abound. Following Bertola et al. (2001), it is helpful in this respect to recognise that social policy has a variety of goals. Policy intervention aims on the one hand at transferring resources to “excluded” individuals, who would otherwise experience extreme poverty; on the other, at insuring individuals who currently enjoy adequate income levels against future misfortune. The first objective is primarily pursued by unconditional or targeted benefits, granted as a right of citizenship and financed by general tax revenues. Some individuals are both ex ante and ex post unable to earn in the market such an income as would be necessary for them to be included in society, and society chooses to help them (and prevent them from offering unpalatable poverty to the public eye, or engaging in crime).

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The second objective is primarily pursued by employment-based social-security systems, whose experience-rated benefits are financed by mandatory contributions. Markets, even in a modern and sophisticated economy, are not well equipped to handle labor income risks. Hence, ex ante similar individuals are exposed to substantial ex post income risk in a laissez faire situation, and may well agree to collectively implement redistribution schemes. 2.3 Choices and changes Different and evolving socio-economic systems have historically emphasized the two objectives differently, and have used widely different policy instruments to address them. The notion of “citizenship” as a body of jus soli obligation and rights that can be granted or acquired (rather than inherited as a birthright on a jus sanguinis basis) was introduced in ancient times, and has always been controversial. Under Pericles, the citystate of Athens restricted citizenship to persons whose mother and father were both citizens, but soon after his death citizenship was granted to many thousands of immigrant residents; in Roman times citizenship was important and importantly restricted until AD 212, when it was finally granted to all free residents of the empire. Throughout history, much of the reciprocal support offered to each other by human beings has been based on nearness and blood relation, rather than on formal legislated rights and obligations. Before the industrial revolution, extended families and villages shared common resources without formal market or government organization – and still do, as village-level and family-level interactions still play an crucial role in less developed portions of the modern world. Face-to-face family, friendship, and non-profit relationships still shape an important portion of individuals’ access to economic welfare within industrialized societies where a complex and heterogeneous set of formal government interferences with labor income has developed alongside an equally complex, and evolving, set of market interactions. Progressive enlargement of the scope of economic interactions has been an extremely important source of economic progress. While the village might have been enclosed by well-defined and largely impermeable boundaries, members of industrialized societies interact from a distance on markets that have increasingly expanded throughout man’s history. Since any collective policy intervention needs to be mandatory and appropriately enforced, the span of government has also expanded beyond the boundaries of prehistoric villages, to enclose broader geographic and political entities. To the extent that economic integration has distributive effects, enforcement and effectiveness of social and labor market policies are obviously undermined by new margins of choice by economic agents. In the modern globalized world, product market integration makes it possible for producers to avoid domestic taxation by relocating abroad, and migration can be motivated both by tax avoidance and by welfare benefits when they are available in the destination country. But these problems are not new, as is

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clear from Adam Smith’s discussion of the relevant issues. Smith was observing the transition from a parish-based to a National organization of economic interactions, and found that among the sources of comparative advantage’s limited exploitation the provision of welfare played an important role. Parishes were charged with welfare provision by the Poor Laws: … it was enacted by the 43rd of Elizabeth, c.3. that every parish should be bound to provide for its own poor …. And that overseers of the poor … with the churchwardens should raise, by a parish rate, competent sums for this purpose. .. Who were considered as the poor of each parish became, therefore, a question of some importance and a “residence-based” entitlement criterion was therefore established: it was at last determined by the 13th and 14th of Charles II when it was enacted that forty days undisturbed residence should gain any person a settlement in any parish; but that within that time it should be lawful for two justices of the peace, upon complaint made by the churchwardens or overseers of the poor, to remove any new inhabitant to the parish where he was last legally settled. As noted by Hanson et al. (2002), this situation readily generated incentives to dump poor individuals over the boundaries of parishes: Some frauds, it is said, were committed in consequence of this statute; parish officers sometimes bribing their own poor to go clandestinely to another parish and by keeping themselves concealed for forty days to gain a settlement there, to the discharge of that to which they properly belonged. Adam Smith proceeds to outline and discuss very interesting details regarding various permit-based refinements of the Elizabethan residence-based system of welfare provision: those “origin”-based rules are discussed below, and the historical experience proves relevant to current discussions of the shortcomings and merits of that and alternative entitlement rules. Over the following century, the problems he was identifying were aggravated by urbanization. Industrial workers were no longer as able to rely on common properties and family networks, and their welfare needs were only partially addressed by institutions such as the workhouse for the poor, familiar from Dickens’s novels. The bureaucracy-based Welfare State as we know it was then introduced and developed in the context of the European militaristic Nation-State, a fact which has interesting implications as formation and continued integration of the European Union may make that concept obsolete. In England and other parts of Britain, during and after World War Two Lord Beveridge engineered a universal system of welfare provision, addressing primarily the first (poverty-prevention oriented) general task of redistribution policies. Similar concern with the welfare of increasingly urbanized workers was at the root of other policy systems, most notably, the employment-related old-age and sickness benefits introduced in Bismarck’s 19th century Germany.

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Individuals’ welfare needs, no longer catered to efficiently by villages and families in industrial economies, were thus addressed by National schemes. Of course, Lord Beveridge did not mean to relieve the poverty of immigrants. Chancellor Bismarck was keenly aware of welfare provision’s competitiveness implications: at a conference with trading partners Germany tried (and failed) to achieve agreement on welfare provision minima. But National welfare systems were clearly meant to protect individual persons against specific risks, such as that of accidents and bad weather in the construction industry: they could not cope with permanent competition by foreigners. The same twentieth century that saw introduction and development of elaborate government redistribution systems and formal citizenship rights at the NationState level also, not coincidentally, saw the introduction of passports and of increasingly formal regulation of immigration and citizenship – whether on the basis of blood, as in Germany (until recently), Italy, and Japan, or on the basis of birthplace and/or parents’ residence, as in France and in the United States. These and other historical heritages shape the variety of welfare state systems within the EU (Esping-Andersen, 1990; Bertola et al, 2001). Nordic countries (Sweden, Finland, Denmark) and the Netherlands come from a tradition of full employment and universal welfare provision, feature relatively generous unemployment insurance benefits, and a very important role for active labor market policies (including job creation in the public sector), while social assistance plays a residual role. Continental countries (Austria, Belgium, France, and Germany) derive from the Bismarkian tradition: wage determination is mostly centralized, and generous unemployment insurance benefits and stringent employment protection legislation leave again a residual role for social assistance as a general basic safety net, while pensions and health services are provided on an occupational basis. The Anglo-Saxon countries (UK and Ireland) are closer to the Beveridgian tradition: social assistance schemes as a safety net for a relatively unregulated and unequal labor market, with relatively low unemployment insurance benefits, little employment protection, and decentralized wage-setting. Southern European countries (Greece, Italy, Portugal, and Spain) have more recent and less precisely defined Welfare States, where extended family arrangements still tend to play a nontrivial role. As the scope of economic interaction has further enlarged across the borders of Nations, the heterogeneous status quo welfare systems need not be able to deliver their intended objectives. Obviously, solidarity concerns depend on a society’s social and racial homogeneity, and it is far form surprising to find (Alesina and Glaeser, 2004) that redistribution and poverty-reducing policies are far more widespread in Europe’s relatively stable populations than in America’s immigration-rich and racially diverse ones, and most important in Scandinavian countries characterized (at least historically) by extremely uniform ethnic and social backgrounds. Less obviously, and very importantly, the nature and character of traditional welfare systems has to be revised in light of new economic integration developments. Just as village-based solidarity

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systems had to give way to State schemes in the aftermath of each country’s Industrial Revolution, a system of economic interactions that generates welfare across the boundaries of Nation-states calls for new market and non-markets risk-sharing instruments. The Nation has long been the natural decision and implementation unit for social policy. But this need not be a permanent arrangement, and the concept of a Nation is itself a matter of different and evolving definition - as exemplified by the different link in the French and the recently reformed German rules between nationality on the one hand, and birthplace, culture, and ancestry on the other. 3. Economic policy in the European Union Economies and societies are always shaped by the interaction of market forces and collectively decided policies, neither of which guarantee unambiguously desirable outcomes. Following Sapir et al (2004), it is important to acknowledge that all policies have both potentially positive and potentially negative effects; that these effects are differently desirable across different groups of agents; that political interactions among such groups and administrative procedures need not, in general, ensure better outcomes than laissez faire would bring; and that the relationship between the scope of policies and of the governance process that implements policy instruments is crucial. The organization of economic and political interaction across National lines that emerged in the 1800s performed poorly in the early part of the 1900s, which saw two World Wars and a Great Depression deepened by trade and migration barriers. The origins of what is now the European Union can be traced back to the unfortunate tendency of European Nation States to fight each other’s coalitions for economic and political supremacy. After World War II, the original six members chiefly wished to organize their relationship to each other in a way that would prevent future wars. Accession by Spain, Portugal, and Greece had important implications for those countries’ commitment to democracy, and EU accession also has obvious political and implications for the formerly Communist Central and Eastern European countries. Thus a variety of different, if similarly strong, political reasons for European accession led the member countries to “ever closer integration.” Economic policy instruments always played a major role in that framework, pursuing the objectives of growth (economic efficiency), stability (prevention of economic crises), and (social) cohesion. The policy instruments available to pursue these objectives are the same in the EU system as in all other economic systems: market liberalization and regulatory policies, tax and spending programs, and the stance of monetary and fiscal macroeconomic policies. In practice the degree to which policy objectives have been achieved is not uniform over time and across policy fields. In theory, as discussed in more detail by Sapir et al. (2004), it is useful to organize a discussion of unsatisfactory policy outcomes in terms of imperfect consistency between the scope of policies and that of decision-making processes across policy effects and policy decisions, either at a point in time, or over time.

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Dismantling barriers to trade and factor mobility, and organizing a common economic policy framework, not only served the purpose of preventing confrontation and fostering co-operation among European Nations. Like the common competition and industrial policies that foster competition and efficiency, market integration was and is valuable on purely economic grounds – very much as it was 250 years ago, when Adam Smith noted that The statute of apprenticeship obstructs the free circulation of labor from one employment to another, even in the same place. The exclusive privileges of corporations obstruct it from one place to another, even in the same employment. […] Whatever obstructs the free circulation of labor from one employment to another, obstructs that of [capital] likewise; the quantity of [capital] which can be employed in any kind of business depending very much on that of the labor which can be employed in it, and advocated removal of all such barriers. Removing barriers to voluntary exchanges improves the efficiency of the integrated economy’s pattern of production, and generally yields economic gains (see e.g. Bean et al., 1998, and their references) Opportunities for trade and factor mobility may reflect different factor endowments, and the pattern of trade and factor mobility within the EU has been increasingly driven by this endowment-based comparative advantage (rather than by economies of scale at the intra-industry level) as membership has expanded beyond the original core of highly industrialized countries. To some extent, goods-market integration can substitute for factor mobility when either would be triggered by different factor endowments and comparative advantage. When absolute productivity differentials exist, reflecting not only natural endowments but also the different level of development of social institutions, migration is instead the natural outcome of integration. Policy instruments designed and implemented to reach a particular objective can have undesirable implications for other objectives, however. Economic integration may foster efficiency, and growth, but an efficient allocation of economic activity need not in general be equitable and politically acceptable ex post. Market pressure can be perceived to be unfair when markets are imperfect, and not all individuals need gain relative to the pre-integration situation. If the owners of relatively abundant factors in each countries gain from economic integration relatively to the owners of relatively scarce factors. And if relative per capita income levels reflect different endowments of factors (i.e., high-earning factors are more abundant in the relatively rich country), then integration tends to reduce income differentials in the poor country. For example, highly skilled labor may be scarce (and earn high wages) in the relatively poor country, but scarcity and incomes should decrease when the relatively abundant supply of skill factors in rich countries becomes available. Conversely, integration should tend to reduce the incomes of relatively poor individuals in rich countries, whose factors become more abundant and less valuable in the integrated economy. Hence, while aggregate inequality may well decline over the whole area, economic integration can

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have an adverse impact on inequality (or cohesion) within previously separate economies. The European continent has in the last century witnessed too many wars, revolutions, hyperinflation, and excessive fluctuations resulting in social and political crisis episodes. Hence, it is far from surprising that National and supranational policymakers should be concerned not only with economic growth but also with cohesion, in that divergent economic circumstances could foster social conflict; and with stability, in that excessive fluctuations of economic, monetary, and fiscal circumstances could precipitate political crises. Stability and efficiency may be fostered by fiscal discipline at the same time as they prevent addressing the social welfare needs of certain groups of citizens, and there may be circumstances where the inability to run government deficits hampers growth by making it more difficult to reform market regulations and social welfare schemes. Since policies can reinforce or offset each other’s desirable effects, policy can lack coherence when it fails to achieve its objectives efficiently. Market liberalization may foster faster growth, but may also fail to do so if other policies (such as property right enforcement) prevent liberalization from resulting in desirable outcomes. Fostering competition is akin to delivery of a public good. It should be, and is, chiefly entrusted to policymakers at the European level when economic interactions span all of the Union’s territory. In other policy areas, however, lack of coherence can result from different policy objectives across policymakers acting at different levels of government, or within different constituencies. The nature of policy failures resulting from improper “systems competition” (Sinn, 2003) is similar to the mechanism underlying undesirable outcomes of laissez faire interactions among individual economic agents. Just like imperfect factor and good markets can fail to appropriately balance the objectives of economic agents with conflicting objectives, so political interactions between collective decision-makers whose objectives differ can result in undesirable policy configurations. Conflicts of interests between policymaking entities may lead to attempts to undo the effects of policies implemented at higher or lower levels. The resulting situation can easily be worse than laissez faire in much the same way non-competitive markets can damage economic efficiency when individual economic agents are in a position to exploit their market power in pursuit of their own economic welfare. Lack of coherence can also be brought about by more subtle failures of policy co-ordination. Even policymakers who share an ultimately common view of what would constitute desirable outcomes may fail to take appropriate action. When implementing policies that have effects beyond their immediate constituency, each may rely on others to implement costly actions in pursuit of a common good, and inaction may result even when all share similar views on appropriate actions. Again, the nature of the relevant policy failure is similar to what may be observed when interactions at the individual level fail to address public-good aspects appropriately: just like individuals cannot be expected to spontaneously pay taxes in the absence of collective enforcement, so

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policymakers cannot be expected to implement the tax, subsidy, and regulation policies that would be optimal from the viewpoint of a large integrated area when their constituency is smaller than the scope of those policies. In both cases, the failure to see policy tradeoffs in their entirety can imply that policy implementation fails to address them appropriately (Sinn, 2003). When this happens, poor co-ordination results in outcomes that are unsatisfactory from the constituents’ and policymakers’ own point of view. Just as market interactions can fail to support efficient outcomes when some markets fail to exist or function properly, so imperfect co-ordination of (for example) state aid to industry can fail to foster efficiency. Political choice and implementation processes may fail to take into account consistently their own ultimate consequences over time. It is again possible to identify a counterpart in laissez faire markets for the resulting policy failure: rather than because of static externalities, markets may find it difficult to achieve an efficient allocation because of dynamic market failures of the type that has been identified as very important by recent theoretical and empirical perspectives on growth and development. Co-ordination of individual innovation efforts and orderly exchanges in the factor and product markets can be fostered by an appropriately sustainable policymaking environment, able to deliver appropriate incentives to entrepreneurship, low and predictable interest rates, and public institutions conducive to enforcement of property rights and the rule of law. Limiting local constituencies’ ability to run deficits and issue debt fosters financial stability: not only by preventing policymakers from disregarding their own actions’ consequences for future citizens and policymakers but also, in a context of actual or potential mobility of individuals and factors of production, by preventing debt burdens from eroding each constituency’s tax base, as local residents may walk away from “public” debt when taxation would be needed to repay it. Accordingly, in the United States (where Alexander Hamilton engineered a Federal bailout of State-level debts in the aftermath of the Revolution) many States have balanced-budget rules. In Europe’s Economic and Monetary Union, a Stability and Growth Path in principle imposes commonly agreed limits to National fiscal policies. Macroeconomic policies can stabilize an economy in the face of imperfectly coordinated savings and investment decisions and imperfectly flexible price and wage arrangements, but can also generate and propagate aggregate shocks if used in pursuit of objectives different from macroeconomic stability, and can precipitate crises if implementation is unsustainable. Fiscal policy is a particularly delicate instrument: it can have favorable stabilization effects through changes (rather than high levels) of fiscal deficits. Policymaking processes may be unable to change the stance of budgets quickly enough to stabilize business cycles, and may instead tend to fall prey to policymakers’ short-horizon electoral incentives ways (see e.g. Gali and Perotti, 2003, for references and evidence). Coherence over time is a very desirable and very elusive feature of economic policies everywhere, and it may be particularly difficult for the European Union’s young and evolving institutional framework to adopt an

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appropriately long horizon in its policy implementation and institutional reform processes. An obvious example of incoherence over time in the EU policy framework was that between monetary, exchange rate, and capital control policies (Padoa Schioppa, 1994). Fixing exchange rates in the absence of appropriate supporting policies or institutions, i.e. under independent monetary policies and free capital mobility, led to frequent realignments in the ERM, and ultimately to unsustainable instability. Adoption of the euro, and agreement to delegate to a European institution the common monetary policy, removed an important source of policy inconsistency across the integrated economic area. 4 Social policy and the European Union The economic and social objectives mentioned at the beginning of this paper are pursued by the European Union in a context of a rapidly changing political and economic environment (Sapir et al, 2004). In the recent past, change has been driven by technological change, globalization, German reunification, as well as by the process of European integration itself. The advantages of wider economic opportunities are obvious to economists, but disadvantages of integration are equally apparent when policies and institutions are not adapted so as to best exploit the new opportunities. As economies integrate and markets (especially financial markets) develop both within and across national borders, reforms of collective instruments need to address common problems within a common policy framework, and require coordination of policies that, when implemented locally, have important spillovers on other elements of the integrated economic system. These problems are not unfamiliar: the same challenges and opportunities arose in previous integration experiences, such as that of villages into kingdoms and empires, or of regional States into National entities. European institutions have developed that address several important policy aspects at the level of the whole integrated economic area. Single Market and competition policy target a common good by preventing uncoordinated policy interventions. Adoption of a common currency has also eliminated temptation for member countries of EMU to pursue opportunities to damage each other through uncoordinated expansionary policies and competitive devaluations. To the extent that the performance of European economies is not uniformly satisfactory, however, it is necessary to seek the sources of political and economic unhappiness in inappropriate allocation of decisions and/or in a political process that does not correctly address the relevant tradeoffs. Coherence across jurisdictions and decision-makers is not surprisingly difficult to achieve in the EU system of economic policies. The EU is a multi-tier government system, where each of the three policy instrument sets mentioned in Section 1 of this chapter have both Community and national dimensions. The Single market encompassing goods, services and capital - is a Community program, but labor market regulation as well as many flanking initiatives rest with the national authorities and are

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subject to different degrees of co-ordination. The income redistribution function is spread across the EU level and the national level, the former dealing mainly with interregional and inter-countries cohesion, the latter with inter-personal cohesion. And tools of macroeconomic stabilization are also spread across the two levels: monetary policy is centralized for countries belonging to the euro area, but fiscal discipline is decentralized to the national level, subject to Community rules. 4.1 Principles and policies Evidence of social-policy issues’ political importance is given by their prominent status in the draft EU Constitution, cited in the Introduction; earlier Treaties also gave at least lip service to social cohesion goals, which were officially incorporates in the 1990s.1 And evidence of their controversial nature is, of course, given by that document’s difficulties at the approval and, now, ratification stage. The fundamental rights include the right not to be unjustly dismissed; the right to working conditions which respect the worker’s “health, safety and dignity”; the right to receive state benefits for unemployment, sickness and old age (without reference to cost); and the right to strike. The broad objectives of EU treaties and the targets set by the Lisbon European Council appear quite wishful. EU-level institutions have successfully dismantled protective barriers to free and efficient mobility of goods, services, and factors of production, thus indeed creating an area without economic frontiers. In the area of social policy, such a process of “negative integration” tends to enforce deregulation whenever existing policies conflict with desirable economic efficiency. Even though the scope of economic interactions spans across the National boundaries of the economically integrated European Union, the social and labor market policy action advocated by the Treaty is almost completely subsidiary, left to intergovernmental negotiation, and subject to explicit unanimity requirements. Thus, official EU documents hopefully envision desirable social-policy convergence and co-ordination as the automatic result of European countries’ sharing a common social model faced by common challenges at each national level, rather than of a process of “positive integration” through explicit collective agreement. In practice, an extremely small portion of EU-level policy activity is explicitly devoted to cohesion objectives. Such lack of European-level action may appear surprising in light of the fact that the issues are broadly similar to those more or less successfully targeted by the European Union – from the prohibition of State aid and enforcement of Single Market rules, to adoption of a single currency, to agreement on 1

See Bean et al (1998) for a detailed discussion of early and largely ineffectual social concerns in European-level legislation. The 1960 Treaty of Rome mentioned among its goals improved working conditions, “so as to make possible their harmonization,” especially with regard to equal pay for equal work for men and women and paid holiday schemes. Some relevant directives were issued in the 1970s and the Social Chapter, after initial disagreement by the UK, was incorporated in the Treaty at Amsterdam, in 1997.

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fiscal policy constraints. Reform and possible harmonization of tax and subsidy instruments are even more clearly necessary on theoretical grounds, as such instruments pursue goals whose importance depends on the overall economic environment and their effects depend on elasticities that are sure to change when economic interactions span different and wider environments (Bertola and Boeri, 2002). By opening up opportunities to react to taxation through mobility as well as through reduction of labor-supply, integration with poor countries threatens rich countries’ welfare systems. For example, implementation of Single Market public procurement rules implied that much East-German construction activity was performed by British, Portuguese, and Italian firms posting workers to German construction sites, at the same time as many German construction workers were able to draw unemployment benefits of Bismarckian generosity (see Bean et al, 1998). Clearly, the German system of employment-based social insurance was not designed so as to cope with the new types of labor market risk generated by economic integration. Equally clearly, integration grants both rich and poor countries new trade and specialization opportunities: rebuilding East German infrastructure would have been much more expensive had local labor only been employed. Thus, there is an obvious rationale for financial instruments that direct towards poor countries some of the resources that would otherwise be paid in rich countries (in the form of, for example, unemployment benefits paid to local workers displaced by immigrants). Some such instruments are already in place. Not surprisingly, cohesion-oriented instruments were introduced in synchrony with the design and implementation of Single Market policies (for a more detailed discussion and further references see Sapir et al 2004, Chapter 4.3). In the 1980s, enlargement of the EU to relatively poor and peripheral countries prompted the implementation of a complex set of supranational cohesion-oriented policies, aimed at fostering income equality across Europe’s geographical units. The existing instruments do not simply transfer resources to lowincome regions: disbursement of funds is conditional on industrial structure, peripherality, and other regional characteristics as well as on income levels, and EUlevel policies aimed at fostering cohesion transfer funds with important strings attached. The Treaty itself refers to a reduction in “disparities between the levels of development,” not in disposable income levels. Indeed, agreement on unconditional transfers to poor regions would hardly be politically feasible: transparent transfers of funds across the borders of Member States’ redistribution schemes would create obvious winners and losers and would be difficult to agree upon at the Community level. But the instruments are not obviously coherent with other objectives. For example, regional and state-aid policies are often designed so as to work against the structural adjustments, based on comparative advantage, called for by economic integration processes (Midelfart-Knarvik and Overman, 2002) - thus reducing efficiency more than would be necessary to achieve a given level of cohesion. And political

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tensions do surface despite the current scheme’s attempts to link disbursements to objective criteria rather than to income levels. Almost all Member States, no matter how rich, claim at least some underdeveloped regions, and region-oriented spending is mired in negotiations involving other financial flows, such as those implemented through the Common Agricultural Policy. A paramount concern of National representatives in the relevant negotiations is that of “getting their money back.” Such concerns are politically understandable, as transfers are difficult to accept for the electorates of net-contributor Member States. By largely neglecting income per capita considerations, however, political interactions not only fail to embody the notion of a common European concern with poverty, but also leave unaddressed the need to avoid undesirable policy spillovers. Policy can be far from coherent and lack efficiency when decision-making is decentralized, policymaking authorities are accountable to constituencies that are small relative to the scope of economic interaction across a large integrated area, and each policymaker focuses on a small portion of aggregate tradeoffs or relies on others to provide common goods. In the resulting system of economic and political interactions, it is difficult to offsetting market failures by appropriate tax-and-subsidy or regulation policies in the social and labor market area, as well as in financial and other markets. The difficulties of European policy interventions on labor income determination and redistribution derive from two interrelated problems (Bertola et al, 2001). First, there are many reasons why welfare systems designed decades ago need to be redesigned in light of new demographic and technological trends, and of changes in the structure of market and non-market economic interactions. But while the relevant changes are broadly similar in all industrialized economies, their impact and implications are quantitatively and qualitatively different across EU member countries’ diverse configurations of their systems of social protection, summarized by the distinction introduced above between Scandinavian, Anglo-Saxon, Continental, and Southern European Welfare States. Budget problems are the most pressing cause of distress for the public-employmentbased Scandinavian Welfare State. The United Kingdom (like many non-European Anglo-Saxon countries) faces increasing social exclusion in the form of permanent “working poor” status. The Continental countries are troubled by low employment rates. Last, but not least, the Southern European countries also find it increasingly difficult to target poverty as their family- and pension-oriented social policies are challenged by demographic and labor-market trends. Second, and as a result, the EU policymaking framework in the relevant area is much less well developed than (for example) in the area of monetary and fiscal policy. This can of course be a source of policy inconsistency. Just like uncoordinated macroeconomic policies, fixed exchange rate, and free trade with capital mobility before Economic and Monetary Union, free mobility of goods and/or factors, local decision-making powers in the labor-market and social protection area, and social inclusion coexist uneasily (Bertola, 2004). And, as in that case, the relevant issues are

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most clearly seen in terms of an ‘inconsistent trio’ of policy characteristics and goals: pursuing two of the three to the limit necessarily implies forsaking the third (see PadoaSchioppa, 1994, for such reasoning in the monetary and fiscal policy area). 4.2 Incoherence Consider first the implications of completely unrestrained economic competition among constituencies with completely independent social policy-making authority. This situation cannot foster social inclusion: economic competition leads local constituencies to forego social objectives, and social policies are theoretically predicted to enter a “race to the bottom” downward spiral. The pursuit of equity always needs to be traded off lower economic efficiency. From the point of view of local policy makers the trade-off is clearly worse when more generous subsidies and higher tax rates lead to relocation of production rather than lower labor supply, and economic integration makes it easier for individuals to opt out of supposedly mandatory redistributive schemes. Foregoing the “protection” afforded by barriers to trade and labor mobility reduces the effectiveness of social policies and increases their cost, and theory predicts that as each decision maker privileges economic competitiveness over the pursuit of social inclusion uncoordinated policy choices by local constituencies should trigger race-to-the-bottom tensions. Thus, the EU can have complete economic integration and subsidiary social policies, but only by accepting much less generous social protection. The far from satisfactory performance of many member countries’ social and labor market policies may lead some to favor such an outcome, but the resulting caricature of the US system (local social policies without any Federal competence in the area) is not politically feasible. Economic integration and subsidiary policy are not likely to be the chosen members of the inconsistent trio at the cost of social exclusion. In most European countries, social policies are politically stable and resistant to reform. Such stability is often read as evidence that “race to the bottom” fears are unjustified. But it can also be read as evidence that the extent of economic integration (especially as regards labor mobility) is not yet as full as would be necessary in order to reap its full specialization and flexibility benefits. To some extent, the pre-EMU situation of strongly limited international economic competition and personal mobility and strong National redistributive and regulatory policy (which in terms of the trio forsakes competition, but preserves local decision-making powers and local social inclusion) is closer to the political consensus of European countries, and much of the resistance encountered by dismantlement of international economic barriers appears dangerously related to such social and political feelings. The third possible extreme configuration of the inconsistent trio, namely unrestrained competition and effective social policy intervention at the cost of local decision-making power in the area, also presents obvious problems. It would require EU-level competence in social and labor market policy but, given the high degree of

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heterogeneity in the status quo levels of economic development, would very much be in danger of replicating at the continental level the current configuration of large and heterogeneous member countries like Italy, Germany, or Spain, where homogeneous national institutions tend to reduce the intensity of interregional and inter-occupational competition at the cost of generating pockets of persistently high unemployment in the relatively less developed areas (Sinn and Ochel, 2003; Bertola, 2004; and their references). And, as in those countries, it would require substantial fiscal transfers from the richer regions, whose political sustainability is very much dubious in the absence of pan-European solidarity feelings – but can hardly be ruled out completely, to the extent that national political decision processes do often appear to privilege protection over economic efficiency at the cost of substantial economic and fiscal costs. 5. Enlargement, delays, and reforms An incoherent approach to policy issues in an integrating economic systems faces two dangers. First, that of slow and limited economic integration, with less than optimal exploitation of the resulting economic gains. Second, that of imperfect policy implementation along other very relevant dimensions – such as welfare provision, as the National systems of redistribution are challenged by new sources of labor market risk. The issues outlined in the previous section are at least as old as Adam Smith’s writings. Historically, social policy has been implemented by Nation-States with strong central governments, and has encountered difficulties when diverse levels of development and imperfectly integrated labor markets happened to coexist within such States. Conflicts between integration and redistribution remain important within the larger current members of the European Union, in particular Italy, Germany, and Spain. As regards international integration, such problems certainly become more visible and important as the European Union expands to encompass increasingly diverse countries. Absolute productivity differentials are very wide across Western and Central/Eastern European economies, reflecting not only natural endowments but also the different level of development of social institutions, particularly as regards security arrangements, political stability, and the enforcement of property rights. Hence, migration is a natural outcome. The new members acceding the EU in the current enlargement, however, are economically small relative to the esisting integrated area. Hence, not only trade flows but also migration trends from the Central and Eastern portions of the EU are likely to be relatively small (Boeri and Brücker, 2001) and probably of less consequence, at the aggregate level, than existing migration pressure from North Africa and other non-EU neighboring regions. Concentration of immigration in certain industry, regions, and population segments can have important consequences in interaction with social policies, however. While trade among the core EU members may be largely based on economies of scale and intra-industry in character, trade and especially migration flows with the CEECs

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should at least in part reflect differential endowments of different factors. Hence, the distributional effects of CEEC accession (if any) within older EU members can be expected to be negative, i.e., income inequality can be expected to increase in Western Europe. Further issues are raised by legislation that, like the recent Directive on Free Movement (2004/38/EC) grants rights of residence and potential access to welfare assistance to all EU citizens. In many previous trade and labor market integration experiences, the effects of actual or potential migration in relatively rich labor market were largely avoided by explicit or implicit subsidization of unemployment in relatively poor labor markets. But it is hard to envision that EU transfers could or indeed would be used for this purpose to cope with its Eastern enlargement. First, the size of the EU supranational budget is tiny relative to the size of the transfers effected, for example, in the German unification episode. Second, and most importantly, the income differentials between the EU-15 and the CEE countries are much wider than those featured by other European integration episodes. Anything resembling the policies enacted in East Germany could not be effected even if Poland were to be integrated fully within a federal fiscal budget, let alone in the current institutional structure of the EU (where fiscal policy is essentially subsidiary). Migration to older EU members of workers from the relatively poor CEECs may therefore put important stress on social policy arrangements. As shown by the theoretical model of Wellish and Wildasin (1996), external immigration affects the strategic interaction between decentralized redistributive policies, such as those prevalent in the EU institutional arrangements. Depending on whether immigrants are net fiscal contributors or recipients, local welfare policies may attempt to attract or repel them, hence the very existence of potential immigration magnifies the adverse welfare effects through coordination failures. While the relatively limited income differentials and substantial cultural differences among Western European EU members do not excite much migration, the incentives of CEEC immigrants to “benefit shop” once they have been uprooted by the much larger income differential between their country and any of the richest Western labor market may potentially disrupt the current state of affairs, and multiply the difficulties of local social-welfare systems within the EU. As further discussed below, a ius loci basis for fiscal treatment of economic interactions is economically naïve. Trade unavoidably spans the boundaries of different jurisdictions, and persons do not need to move to make a difference in the age of the internet. But even though foreigners need not be present to affect the sustainability of welfare state arrangements, fears of immigration pressure are widespread. In the run-up to Eastern enlargement, the increasingly apparent inconsistency of the current EU social and labor market policy framework has spurred interest in previously neglected issues. And the reaction of heterogeneous countries to the possibility of worker inflows from the new members conforms nicely to the same countries’ heterogeneous characteristics in terms not only of geographic position, but also of status quo welfare-state

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configuration. The Nordic and Anglo-Saxon EU countries (with the exception of Ireland, at the time of writing) have chosen to restrict only immigrant workers’ to their citizen-based welfare benefits. Austria and Germany have chosen to restrict labor market access for the longest allowed period, and this is of course unsurprising in light not only of these countries’ geographic location but also of their labor-market based approach to welfare issues. 5. 1 Integration, delayed? When social policy instruments are decentralized in an integrated economic system, unfettered access to local social policy subsidies (on a residence or employment basis) fosters mobility but reduces local incentives to provide welfare benefits. Conversely, exclusion from welfare benefits of individuals hailing from other constituencies, on an origin principle basis, improves the sustainability of local welfare schemes, but at the cost of reducing mobility incentives and providing doubtful support to migrants.2 Since there are advantages and disadvantages to both extreme configurations, Richter (2002) sensibly suggests that an intermediate solution may be desirable, perhaps in the form of a time period (longer than zero, and shorter than infinity) to elapse before a migrant’s welfare-system membership shifts from the original to the destination constituency. This suggestion is debatable in terms of the dimension (time) along which an intermediate solution should be sought; in terms of the trigger (migration) for the switch; and in terms of ease of implementation. Choosing time as the dimension along which extremes should be bridged can of course be justified if advantages and drawbacks of extreme solutions materialize with different delays. Sinn and Ochel (2003) base such an argument on the notion that migration may be driven by misguided welfare-shopping incentives in the short run, while in the longer run capital flows would support income levels in initially poor countries and stem the migration flow. Theoretically, however, capital or labor mobility can play the same role as trade in goods in a wide variety of circumstances, and both should be responsive to market and policy circumstances on a forward-looking basis when adjustment is costly. Empirically, a piece of evidence brought in support of delayed integration is the dynamics experienced in the German unification episode (Sinn and Ochel 2003, footnote 7). In that case, nearly all migration occurred in the first two years after unification, while capital flows were smaller and persistent. That single 2

The origin principle is still adopted within Switzerland (Art.48 of the Swiss Constitution stipulates that “Needy persons shall be assisted by the Canton in which they are living. The cost of this assistance shall be borne by their canton of domicile” and “the Confederation can order that recourse be had to a previous canton of domicile or the canton of origin.”). That country did not develop into a Nation as regards political organization (and wars of conquest), and remains rather Medieval as regards welfare provisions, which plays a residual and not very effective role in its society. The Swiss economy’s personal mobility requirements have been fulfilled by (temporary) migration from other countries, and its system of welfare provision, like other Swiss peculiarities, is better viewed as an exception in the context of worldwide integration trends, not as a model for broader economic areas.: only one Switzerland can exist in the heart of a warring and then integrating Europe, and it would be moot to argue that all European countries to try and imitate its financial, trade, and personal mobility policies.

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observation, however, is very special along both the cross-country and time-series dimensions. Migration (not only for economic reasons) was certainly a more natural option for reunited East Germans than for citizens of truly different countries, who face much higher language and cultural barriers. And migration did not cease because of the mere passage of time but because of public policies meant to stop it. Public transfers from western Germany were at times as high as 80% of East Germany’s GDP, and the convergence of wage rates (if not of employment opportunities) was accelerated by extension of national wage agreements rather than by productivity growth. Large subsidies to poor integrating regions were in this case the other side of the coin of the adoption of a single regulatory framework. As shown by the experience of the Italian Mezzogiorno over a long period, and so far confirmed by the experience of eastern Germany after unification, this type of integration results in slow growth, long-term unemployment and inactivity in the poor regions (Boeri et al, 2002, and their references). And while intermediate solutions are indeed likely to be better than extremes, the correct mix should depend on the relative prominence of pros and cons in a variety of respects. Focusing on migration-related aspects also has some elements of extremism. Migration is more visible and politically sensitive than other symptoms and means of economic integration. However, it is neither the most important not the most natural convergence vehicle, and it is not well predicted (in light of different cost of living and system productivities) by the initial difference between Eastern and Western labor costs. Immigration is intense from non-EU areas, and accession of CEECs to the EU may but need not increase migration pressures. Product market integration, via factor-price equalization, can have the same effects unless labor mobility (rather than product mobility) is necessary, as in the personal services sector. The Posted Workers case mentioned above remains a very clear instance of tension between national welfare systems and economic integration. Building has to be performed on-site, hence (temporary) migration of construction workers made the tension more visible than in the case of, for example, relocation of automotive plants. But posting of construction workers – where a major factor of change was the Single Market provision of EU-wide bidding for public projects – illustrates that immigrants need not draw benefits themselves to trigger important consequences: when they compete with low-skill workers and the latters’ wages fall below the non-work benefits, substitution of the indigenous poor by foreigners is effectively subsidized by the taxpayers of more generous constituencies. An excessive focus on immigrants’ visible welfare benefits also risks disregarding important elements of the broader integration-and-social-policy picture. Some migration may of course be driven by welfare-seeking motives.3 But 3

In the United States in 1969 the Supreme Court’s Shapiro decision ruled that State-level welfare benefits could not be conditioned on previous residence. This exposed States offering generous benefits to the danger of attracting welfare recipients. Not surprisingly, some welfare-motivated migration by single mothers and non-US citizens can be detected: Meyer (2000) offers a careful empirical analysis and a review of the extensive literature on benefit-induced migration in the US. Of course, each State of the US

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welfare benefits can hardly be the only or even the main motive for migrants, and any impact on welfare provision is certainly not the only consequence for the economies of host countries – economies that can clearly profit from immigrants’ willingness and ability to perform tasks different from those of natives, and at lower cost (as in the German public works case) to local consumers and taxpayers. Economic development relies on specialization and gains from trade, hence diversity is a productive asset for an economy. Like trade, migration is beneficial when it occurs across the boundaries of diverse regions, and can be expected to benefit typical (but not all) individuals in most cases. Ethnic diversity is a potential obstacle to adoption of beneficial policies when it is a source of conflict but – other things equal - does appear to foster economic productivity (see Alesina and La Ferrara, 2003, for references and evidence). Consider next ease of implementation and labor mobility in a system whereby migrants remain entitled to benefits (and liable to taxes) in their original, independently managed constituency. As pointed out by Poutvaara (2002) decisions and negotiations regarding the length of delay are no less difficult than those regarding rates of contribution and other aspects of harmonization or, perhaps, immigration quotas meant to balance the advantages of economic integration and the disadvantages of welfaresystem externalities. And if an agreement could be reached on such rules, administration of a system of constrained access to welfare policy instruments would not be easy. It is interesting to revisit again the 18th-century situation analyzed by Adam Smith and revisited above, where […The obstruction given to the free circulation of labour] by the poor laws […] consist[ed] in the difficulty which a poor man finds in obtaining a settlement, or even in being allowed to exercise his industry in any parish but that to which he belongs. Entitlement issues were then addressed by a complex system of written notification rules and certification requirements: In order to restore in some measure that free circulation of labor that which those different statutes had almost completely taken away, the invention of certificates was fallen upon. If any person should bring a certificate form the parish where he was last legally settled, … every other parish should be obliged to receive him …he should not be removeable merely upon account of his being likely to become chargeable, but only upon his becoming actually chargeable, and that then the parish which granted the certificate should be obliged to pay the expense both of his maintenance and his removal. This system was remarkably similar to a possible configuration of “delayed integration,” and to the several German-Turkey treaties whereby (temporary) workers remained attached to the origin country’s social security systems. In 18th century England, a formal origin-principle system failed to foster labor mobility: in equilibrium, finds it difficult to implement generous welfare suport systems, and this “welfare magnet” effect may explain why U.S. social policies are mostly co-funded and implemented at the Federal level.

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certificates ought always to be required by the parish where any poor man comes to reside, and… ought very seldom to be granted by that which he proposes to leave and as a result, The very unequal price of labor which we frequently find in England in places at no great distance from one another, is probably owing to the obstruction which the law of settlements gives to a poor man who would carry his industry from one parish to another without a certificate. Lack of agreement regarding welfare provision as a common good in support of economic integration condemned 18th century England, and may condemn the European Union, to forego important mutual gains from factor reallocation. 5.2 Redesigning and modernizing welfare delivery Is the European Union doomed to repeat English history, or can historical experience help it devise a coherent policy framework and reconcile integration and welfare provision? As trade already puts important pressure on existing policy arrangements, and as both migration and capital flows are driven by forward-looking decisions, a coherent and sustainable policy framework is needed to foster migration that has beneficial effects for both the source and destination country, and discourage migration driven by exploitation of policies that have different purposes. Such a framework is that proposed by Bertola et al. (2001). Rather than accepting unquestioningly the assumption that all welfare provision must be local (or “subsidiary”) in an integrated economy, appropriate reform of welfare systems should recognize that harmonization and coordination can support a desirable process of economic and social integration that is advantageous to all parties involved. To imagine how this could be achieved, it is useful to start from the distinction, introduced in Section 2, between social policies motivated by market failures in the face of labor market risks, and social policies motivated by solidarity and prevention of social unrest. This distinction is not always clear in actual policy frameworks, but is crucial in theory to devise appropriate resolution of issues in the relevant area: the potential tensions between economic integration and the provision of adequate social protection are different for the two sets of policy goals, which therefore call for differently configured co-ordination and harmonization processes at the EU level. Policies meant to implement quasi-market redistribution of ex-post income across workers are of course very much needed within each countries, especially in the presence of underdeveloped and inefficient market provision of insurance and savings vehicles: Bertola and Koeniger (2004) and their references show that differences across countries in the efficiency of legal enforcement, and the development of financial markets, do appear theoretically and empirically relevant to the desirability and implementation of redistribution and labor market regulation. As better financial

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markets develop in Europe, government intervention in this field may well be less needed. And to the extent that collective organization of insurance against life risks remains necessary, no race to the bottom need develop in an integrated economic area as regards policies meant to protect labor income against such risks. Social insurance is not subject to downward pressure from fiscal competition when there is a clear link between contributions and benefits (Atkinson, 1998). Hence, collective schemes can coexist if they offer actuarially fair benefits. Insurance against labor market risk may generally be more efficiently provided by collective schemes rather than private contracts: governments can enforce continued participation by ex post lucky individuals, and can in principle monitor and implement such schemes more efficiently than private providers. Just like competition among private insurers, however, competition among collective systems needs to be appropriately regulated and monitored, so as to ensure that individual participants are adequately informed. EU-level institutions can potentially play an important role in certifying and clarifying to citizens the appropriateness and sustainability of the relevant schemes. Just like supranational authorities can play a useful role in testing and enforcing budget rules that ensure coherence over time of public finances, so they can play a similar role as regards pension, health, and unemployment insurance schemes. Hence, •

Quasi-market arrangements meant to provide insurance, such as unemployment benefits and pension schemes, should not redistribute resources ex ante and should not be funded at the EU level, because economic incentives for factor mobility and allocation are best preserved when benefits and contributions balance each other within appropriately defined local markets. Participation in such schemes needs to be mandatory and comprehensive. Minimum contribution rates and standard configurations should be agreed centrally so as to eliminate opportunities to “opt out” by individuals and by local constituencies. (Bertola et al, 2001)

In actual practice, social insurance schemes always entail ex ante as well as ex post redistribution. Targeting risk outcomes is difficult if information is incomplete and asymmetric: just like any insurance, social insurance faces moral hazard problems and can hardly avoid actuarial unfairness. Moreover, the political determination of entitlements tends to build redistributive components into schemes that should be meant to insure participants; and to the extent that the distributional impact of pensions and unemployment benefits reflects political power rather than need, it too often fails to improve the lot of truly poor individuals. Conceptually, however, insurance objectives should to the fullest extent possible be pursued separately from solidarity-based social cohesion goals. And to prevent inconsistencies in an integrated economic area, the instruments meant to target the latter goals do require coordination and harmonization, rather than just monitoring and certification. Redistribution is motivated by goodwill and solidarity,

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as well as by a more selfish desire to prevent crime and unrest and to maintain social peace. Neighbors are more immediately disturbing when poor, but as noted above economic integration need not involve labor mobility to disrupt National welfare systems. As evidenced by the German integration experience, rich citizens often help poor ones in their own interest, in order to preserve the welfare and labor market structure they prefer while (hopefully) exploiting economic and social gains from integration with previously isolated regions. To ensure the long-run sustainability of social protection and free personal mobility within the EU, the social rights of European citizens should be defined in the form of minimum welfare standards at the EU level (Atkinson, 1998; Bean et al., 1998; Bertola et al., 2001). Agreement should therefore be possible on an appropriately devised scheme whereby •

Solidarity-based transfers, guaranteeing a minimum welfare level, should be coordinated at the central level to prevent competition among subsidiary levels of government from resulting in either unacceptably low levels of welfare provision, or in more or less implicit limits to economic integration. Minimum-welfare transfers and services should be co-financed by a specific budget line item at the EU level. Central co-financing of social assistance programs would also provide means for enforcement of EU-wide guidelines. (Bertola et al, 2001)

The wide income differentials among EU members (especially after enlargements) do imply that minimum-welfare transfers and services would need to be co-financed at the EU level. If targeted narrowly on poverty, however, the relevant EU instruments could be much less important than the US Federal government, which does regulate and finance or co-finance the bulk of that country’s social policies (Bertola et al., 2001). Disbursement in each country of benefits based on low-income status is large when the country’s population is poor on average and, for given country-specific average income, when incomes are widely dispersed within the country. Some relevant data are reported in Morrisson and Murtin (2003), and can be combined with income and population data so as to assess the orders of magnitude of a possible EU-wide welfare scheme (see the Appendix below). Benefits should be indexed to the cost of living, both in order to prevent both poverty and welfare-shopping incentives. Suppose in all countries a fund amounting to 10US$ per day (corrected for purchasing power parity) was disbursed to citizens earning less than 20US$ per day in 1998, the overall size of the relevant budget would be in the order of 1.3% of EU GDP, and cross-border redistributive effects would range between a maximum net contribution of 1.3% of GDP (from Luxembourg) and a maximum 2.8% of GDP net receipt (by Portugal). Both the overall size and redistributive component of a theoretical scheme targeting economic income appear broadly comparable to those of the current schemes based on residence in certain regions or activity in agriculture, which currently absorb a little more than a percentage point of GDP and generate net imbalances in EU budget contributions ranging from -0.45% (Germany) to 3.66% (Greece). Since roughly half of total EU funds is currently spent in the Common Agricultural Policy context, that obsolete

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scheme’s funding would appear to be adequate to eradicate the most extreme European poverty, without National intervention, if it were rerouted to that end. These are only very rough computations, of course, and do not take into account the implications (much more dramatic for the new, if not for the existing, members) of the recent enlargement to Central and Eastern economies with much lower average income levels. More detailed income distribution data could be used to compute more sophisticated estimates, and a cost-of-living adjusted 10US$ benefit distributed among individuals earning less than 20US$ a day (in 1998) may or may not be an appropriate benchmark for EU-level poverty-prevention schemes. Minimal standards in theory could correspond to what the least generous countries would be willing to offer if they were forced to take account of spillovers across the boundaries of local constituencies, and could be determined in terms of the market value (at local prices) of a basket of goods and services, thereby preventing any ‘race to the bottom’ tendency from undermining political support for EU integration. In practice, many poor individuals are currently cared for by member States: it would be hard to compare the labor-supply effects of a hypothetical European scheme to those of existing National schemes, which are currently very different in terms not only of overall financial generosity (which largely reflects the countries’ different per capita income levels), but also and especially as regards their qualitative structure. In practice, the design and implementation of such a program would need to address many difficult issues, chiefly that of appropriately balancing the undesirable welfare-shopping and labor-supply incentives of any poverty-prevention policy in a heterogeneous environment. In the long term, however, Europe must resolve these issues, because the removal of barriers to personal mobility over increasingly large areas, and the preservation of cohesion in the resulting new environment, will be and have always been key ingredients of its economic and social progress. Many of the same issues, in fact, already arise within Nations, especially large and heterogeneous ones such as Germany and Italy. Within Europe, most Nations are both too small and too large to cope with current challenges: small countries can inflict externalities upon other countries, and large countries tend to impose uniform benefits on their different regions. Within and across countries, social policy standards do need to vary according to local circumstances and traditions, as they do across US States. And they also need to be agreed (“harmonized”) for mobility to be possible and not distorted by welfareseeking incentives. Minimum assistance levels should be specified on a relative basis, as a proportion of local (not necessarily National) average earnings, so as to make them politically acceptable and economically affordable in light of different development levels. They should also be adjusted to reflect local price levels: both criteria would imply lower benefits in the less-developed regions of the EU, and any co-financing at the EU level should be fine-tuned so as to address cross-border spillovers while at the same time minimizing moral-hazard effects, in the form of a tendency for individual

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constituencies – in the style of English parishes of old - to neglect their own needy citizens’ welfare and dump them on other systems of welfare provisions. A welfare floor preventing absolute poverty at the EU-wide level can and will need to be designed and enforced as economic interactions gradually achieve ‘ever closer Union’ objectives, and an appropriately harmonized policy of this type should also reduce or eliminate incentives for welfare-motivated mobility by disadvantaged groups. A pan-European safety net would also contribute to ease social tensions if established as a European citizenship right, and would also provide a strong rationale for EU-wide immigration policies addressing the obvious co-ordination problems (Wellish and Wildasin, 1996) arising when local constituencies grant EU-wide citizenship entitlements. 6. Summary and prospects Market economies are unavoidably imperfect, and relying on competition among also imperfect policymaking systems cannot yield better outcomes than a well-informed policymaking framework addressing the relevant tradeoffs coherently. To preserve both redistribution and economic integration, elements of social policy must be centralized or coordinated. In an integrated European economy, decision-making power in the social field must not be exclusively national, for this would either make social policy ineffective or, more realistically, let calls for protection from foreign social dumping strengthen old and new barriers to trade and factor mobility. Disappointment with the performance of European labor markets has been high and growing for more than 20 years. The United States’ better employment performance and lower degree of interference with labor markets may of course reflect either less concern for inequality, but even that economy’s well-developed ways to address income-distribution issues through financial and product market efficiency fails to deliver equality to its citizens, and in comparison to the EU the United States has also developed a much more integrated system of redistribution and welfare provision at the Federal level. Is Europe ready to reform its labor and other markets, maybe so as to make more similar to their American counterparts? Elements of the reforms advocated in Section 5 are dimly apparent at the National level, where pension and labor reforms are increasingly oriented towards actuarial fairness and economic incentives; and at the EU level, where the Constitution (like previous Treaties) does envision coordination of minimum welfare standards – albeit still with very blunt tools, as the draft that may yet fail to be ratified explicitly excludes the relevant issues from majority voting and in many ways aims at minimizing interference with National schemes. Reforms of pension and unemployment insurance schemes in the direction of actuarial fairness are all the more desirable in an integrated economic area, and need not call for explicit co-ordination or co-financing at the EU level. At the same time as such schemes are reformed to address demographic-trend problems, they should be tailored to the new integrated economic systems, and redesigned so as to encourage mobility

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driven by comparative advantage. They should also be monitored at the supranational level, and the component of social policies that implements redistribution should be explicit, coordinated, and cofinanced at the same level at which economic interactions take place. The EU’s ever closer integration of factor and product markets implies that uncoordinated national policies simply cannot achieve the redistribution they deem desirable in light of financial market imperfections and political cohesion objectives. Directly or indirectly, via migration and capital mobility or via market interactions, tax bases react elastically to taxation and benefits are effectively paid to members of jurisdictions other than those legislating them. Social policy issues are more difficult but arguably more urgent than those relevant to common defense and foreign policy initiatives. An entity that can decide milk production in each member country should presumably be able to influence and coordinate issues that may not be any easier to reach agreement about, but are certainly more important. Sapir et al. (2004) identify a number of such issues, and point out that only historical heritage explains the supranational (Community) status of the Common Agricultural Policy. Currently, allocation to the EU level of expenditures is not clearly targeted to common goods. This justifies suspicions that all money allocated to the EU is wasted, suspicions that in turn motivate budget negotiation strategies that are narrowly and unproductively focused on “money back” concerns. Arguments voiced against the re-nationalization of agricultural policies suggested by Sapir et al (2004) stressed possible likely distortions induced by competing policies in that area. But much the same arguments are valid for National subsidiarity of tax and welfare policies, and the higher transparency of agricultural subsidies granted at the national level would presumably decrease or eliminate their political attractiveness in times of scarce fiscal revenues. Of course, the pitfalls of centralized policies must be avoided. Misguided application of homogeneous rules and tax systems to heterogeneous economic entities can stifle economic development, as in Italy’s Mezzogiorno and Germany’s Eastern Landers. But the problems encountered by social and labor policies in these large and diverse countries is just another element of the case against preservation of National policies through, e.g., delayed-integration entitlement schemes. Welfare provision should be modernized within countries and harmonized across countries: harmonization does not imply uniformity, and the alternative of foregoing integration is not practically possible (let alone desirable) in the modern world. Citizens’ social concerns have to be addressed at the same level where economic interactions take place, for choices made at lower levels too easily heed resentment against economic integration as a source of unfair competition and reduction of already inadequate protection. A coherent policy framework should address the shared goals of all EU countries. Nations, like parishes, are in some respects obsolete policy-making units. If mobility of people and goods over an increasingly large integrated area needs to be

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preserved as a crucial engine of economic development, both increasing attention to regional specificities and construction of a layer of European social policy are ultimately unavoidable. The latter already exists in the limited and imperfect shape of agricultural, regional, and structural funds in the EU budget, and of a relatively small but intrusive body of EU regulation of working time, worker rights, and other socialpolicy issues. Both are motivated by concern about the possible adverse effects of economic integration on distribution and on the governments’ willingness and ability to address them. That concern is politically strong in Europe and it is not surprising to hear it expressed in the same treaties that extol the virtues of economic integration. What is missing, and needed, is a translation of that desire in clear system of rules and adequate financial resources addressing the relevant tradeoffs coherently. EU-level financial and regulatory interference with national social policy is far from negligible, but its opacity and complexity fail to generate goodwill: quite the opposite, each national government only sees incentives to retrieve funds that are not perceived to address common concerns at the European level. Agreement on how to best address the relevant policy issues at the appropriate integrated level is of course not politically easy to achieve: Sapir et al (2004) argue that European economic policy governance could and should be improved by a clearer distinction between objectives to be agreed politically, and implementation to be delegated to accountable supranational agencies (such as the European Central Bank) operating at the Community rather than the inter-governmental level. As mentioned in Section 5.2, similar principles can be readily applied to social and labor market policy instruments. In a reality that sees large Nations unable to cope with their own regions’ economic heterogeneity, and all European policymakers concerned with possible crossborder spillover effects of local welfare policies, it is both theoretically and empirically difficult to see why National competence on labor market and social policies should be preserved by limiting that personal mobility which, with other channels of economic integration, always was and remains the main engine of economic progress. The political and technical difficulties of implementing the appropriate reform of policymaking structures should not lead European citizens and policymakers to accept the status quo situation passively. A clear understanding of the relevant static and dynamic tradeoffs can lead policymaking processes to target their objectives more effectively, and offer a credible alternative to perhaps comfortingly stable, but eventually unsustainable economic stagnation.

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Appendix: Order of magnitude of a European Union poverty prevention scheme [A] 3.6 3.2 0.5 0.4 5 8.9 27.2 11.7 13.4 0.8 2.8 27.2 17.5 1.8 10.2

[B]

[C]

8.0 10.2 5.3 5.2 58.4 82.0 10.5 3.7 57.6 0.4 15.7 10.1 39.9 8.9 58.6 374.4

211898 250321 172428 129499 1451953 2144483 121958 86989 1196663 18900 393471 112386 588022 248287 1423237 8550494

[D] 0.29 0.33 0.03 0.02 2.92 7.30 2.86 0.43 7.72 0.00 0.44 2.74 6.97 0.16 5.98 38.18

[E] 1.08 1.05 1.41 1.14 1.16 1.17 0.32 0.90 0.76 0.93 1.09 0.47 0.64 1.09 0.96

[F] 1133.27 1247.95 136.58 85.98 12406.89 31264.42 3335.62 1428.40 21333.06 11.65 1752.00 4719.74 16407.59 635.72 20834.67 116733.55

[G]

[H]

[I]

0.53% 0.50% 0.08% 0.07% 0.85% 1.46% 2.74% 1.64% 1.78% 0.06% 0.45% 4.20% 2.79% 0.26% 1.46% 1.36%

-0.83% -0.86% -1.28% -1.29% -0.51% 0.10% 1.38% 0.28% 0.42% -1.30% -0.91% 2.84% 1.43% -1.10% 0.10%

-0.22% -0.09% 0.15% 0.22% -0.05% -0.42% 3.66% 1.77% 0.11% -0.28% -0.39% 1.95% 0.91% -0.45% -0.19%

[A] % of population earning less than 20$/day, 1998; source: Morrisson and Murtin. 2003. [B] Population (millions) in 1998; source: World Bank. [C] Gross Domestic Product (millions current US$) in 1998; Source: World Bank. [D] A*B=Millions of citizens earning less than $20/day. [E] Purchasing power parity conversion ratio, USA=1.00; source: OECD. [F] C*D*E*365: cost (millions US$/year) of paying 10 PPP dollars per day to each of the citizens in A. [G] F/C: total paid in country as in B, % of GDP [H] G-1.36%: Cross-border net flow if G financed in proportion to GDP. [I] Net contributions to EU operational (excl.administration) balance, 2000; source: Commission Services.

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Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden United Kingdom

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