Social spending, a euro area cross-country comparison

Prepared by Marta Rodríguez-Vives and Linda Kezbere

Published as part of the ECB Economic Bulletin, Issue 5/2019.

At a time of high government indebtedness, low structural economic growth and ageing populations, a key element in today’s policy debate is the role of government in providing its services and distributing resources to society. Government decisions on tax and social benefit systems have an important bearing on macroeconomic performance in the euro area. This article focuses on how social spending on individual households or on the provision of collective goods and services is organised in euro area countries. Choices made concerning the level and structure of social spending are country-specific and reflect societal policy preferences. The aim of this article is to review government social spending across euro area countries and how it has evolved since the pre-crisis period. It also zooms in on the different social insurance systems in euro area countries in terms of pensions and health and looks at spending on education. We devote particular attention to the analysis of pensions, as pensions represent the biggest social spending item in all countries. The article suggests that countries should look for policies and reforms to ensure the sustainability of social spending, especially in view of ageing populations and possible negative economic shocks.

1 Introduction

Inequality is now at the centre of the international policy agenda because growing inequalities have the potential to undermine future economic development and reduce intergenerational social mobility and social cohesion. In particular, government decisions on tax and social benefit systems have a large bearing on macroeconomic performance. In this context, policymakers are seeking to identify the most coherent composition of public finances to foster “inclusive growth”. The policy guidelines on fiscal and structural reforms under the country-specific recommendations (CSRs)^[1] issued under the European Semester are also supportive of the inclusive growth agenda.

Public finance theory divides government functions into allocation, stabilisation and distribution.^[2] First, governments intend to achieve an efficient use of resources in the economy. Second, fiscal policies are important in stabilising income and consumption over the economic cycle.^[3] Third, fiscal policies are also instrumental in mitigating income inequality resulting from market forces (market inequality). Redistribution can be measured as the percentage reduction in market income inequality due to direct government action (via direct taxes and cash transfers).

Social spending can be defined as government expenditure on social protection, education and health.^[4] These resources are intended to relieve households of the financial burden of a number of risks and basic needs. In practice, a large part of social spending is in the form of social transfers in cash made directly to individual households, such as pensions, unemployment and sickness benefits and social assistance benefits. Other spending is provided in kind, either on a collective basis, i.e. directly produced and distributed by the government, or on an individual basis, distributing market goods and services to individual households (or reimbursing the costs thereof). As explained in Box 1, these different ways of providing public goods and services have a significant impact – directly or indirectly – on household disposable income and, consequently, on consumption.

Social spending can be analysed by using classification of the functions of government (COFOG) data.^[5] The delineation of social spending includes distributive expenditure on social protection and pre-distributive expenditure that supports long-term growth (e.g. education and, to a lesser extent, health). Investment in infrastructure is also conducive to growth, according to economic literature, but it does not fall within our categorisation of social spending.

Social spending represents the largest component of government expenditure in all euro area countries, and pension payments make up the largest share. Social spending has increased steadily since 2001,^[6] both in nominal terms and as a percentage of total government expenditure, albeit with some volatility expressed as a percentage of GDP during the crisis period. In the euro area in 2017, social spending accounted for, on average, around 70% of total government expenditure (see Table 1) and amounted to 31% of GDP, or €3.5 trillion. Social protection is by far the largest component of social spending in euro area countries, accounting for, on average, 42% of total government expenditure and around 20% of GDP. There are clear differences between countries in the level of social protection, which accounts for one third of total government expenditure in Malta and Latvia and approximately half in Finland and Germany. The main component in every country is expenditure on pensions (old age and survivors’), which averages 12.4% of GDP, followed by sickness and disability, families and children, unemployment and social housing. Despite the pension reforms undertaken in many euro area countries, pensions represent the main burden for governments. On the other hand, euro area countries have contained expenditure on health and education in recent years. Expenditure on health and education, respectively, represents on average 7.1% and 4.5% of GDP (or 15% and 9.6% of total government expenditure).

There is no one-size-fits-all optimal level of social spending as a share of the economy. The optimal composition of social spending takes into account microeconomic factors (e.g. the efficiency of social spending systems) and macroeconomic factors (e.g. the size of the fiscal multipliers). This is an argument for growth-friendly fiscal instruments, based on the underlying idea that the composition of public finances has an impact on long-term output. It involves political choices and societal preferences – such as the optimal size of government,^[7] the fiscal governance framework, and the tax system to finance social spending. It also has implications for debt sustainability, interaction with other economic policies, demography and existing political capital for implementing fiscal-structural reforms in a satisfactory manner. In fact, political pressure to reverse reforms that burden older citizens could grow as a consequence of the increasing age of the median voter. In addition, as the ratio of contributors to beneficiaries shrinks, questions of intergenerational fairness arise.

Social insurance systems and the way public goods and services are provided differ substantially across euro area countries. Countries’ systems did not converge over the last decade, as societal preferences are different. Some countries have a “public-integrated model” which links budgetary financing with providers of goods and services that are part of the general government sector. In other countries, the government predominantly purchase the goods and services from market producers under a “public-contract model”. Therefore social spending is represented differently in national accounts across countries, affecting the interpretation of cross-country comparisons. Estimates of social security pension obligations are also diverse across countries, depending on whether pension schemes are more publicly or privately organised. In general, a majority of euro area countries have significant publicly organised schemes, while the Netherlands and, to a lesser extent, Ireland also have considerable private pillars.

As a consequence of this diversity, a comprehensive assessment of social spending requires the analysis of microeconomic data and tax systems in individual countries. Aggregate data need to be interpreted with caution and complemented with further studies. For instance, it is important to monitor closely the costs incurred in the provision of public services and to further analyse the efficiency of public spending in the context of spending reviews (i.e. how to maximise the economic effect of spending using the available resources). Regarding the tax systems in place, apart from the progressivity of direct and indirect taxes and the efficiency of the tax administration, there is widespread use of tax exemptions on pensions, health or housing in euro area countries. It is difficult to calculate the impact of these exemptions on the government accounts and their mitigating effect on income distribution. However, that is outside the scope of this article.^[8]

This article is structured as follows: Section 2 analyses the evolution of social spending since the pre-crisis years and its linkages to household disposable income and consumption; Section 3 discusses the distributive function of public finance in euro area countries, with a descriptive analysis of the differences in social insurance systems and a focus on pensions as the largest social spending item in every euro area country; and Section 4 concludes.

2 The evolution of the composition of social spending in the euro area

The euro area has witnessed an increase in both its overall and its social expenditure-to-GDP ratio, albeit with some volatility during the crisis period. Chart 1 illustrates trends in cyclically adjusted primary expenditure relative to GDP and the social spending categories at euro area level during the period 2001-2017. During the pre-crisis phase (Phase I), primary expenditure (i.e. total government expenditure minus interest payments) was relatively stable. During the financial crisis, the sharp deterioration in GDP in 2008-2010 was accompanied by a temporary spending stimulus (Phase II). This was reflected in the increase in the cyclically adjusted primary expenditure ratio. After the financial crisis peaked in 2010, the primary expenditure ratio started declining (Phase III), reflecting euro area countries’ adjustment policies in view of rising debt sustainability concerns. Since the normalisation of fiscal policies in 2014 (Phase IV), the primary expenditure ratio has remained stable at around 45% of GDP, one percentage point of GDP above the pre-crisis level.

Pension spending in the euro area generally rose faster than potential GDP as a result of ageing populations. As shown in Chart 2, before the onset of consolidation, increases in pension expenditure as a percentage of potential GDP (Phases I and II) were particularly strong in Portugal, Greece, France and Finland. On the other hand, several countries experienced increases below the increases in their potential GDP, particularly during the period 2000-2007 (Phase I). This was the case for Latvia, Lithuania, Austria, Slovakia, Germany and Spain in particular. During the consolidation period (Phase III), increases in pension expenditure relative to potential GDP continued in a majority of countries, while reductions occurred notably in Greece and Ireland. However, these reductions were smaller than the increases in the years before. Germany and Estonia also witnessed drops in pension expenditure as a percentage of potential GDP. After 2013, pension expenditure continued increasing faster than potential GDP in about half of euro area countries, most notably in Finland.^[9] This reflects the rising share of older people in the population, but also the effects of the previously legislated pension reforms and lower potential GDP growth in the post-crisis period. Looking ahead, at the euro area aggregate level substantial changes in the old-age dependency ratio are projected, moving from over three working-age people for every person aged 65 or over to only around two working-age people by 2070.^[10] Pressure from an ageing society will therefore continue to limit governments’ fiscal room for manoeuvre in the coming years.

The impact of policy changes after the onset of the crisis is most visible for health expenditure, as growth in health spending is slowing down in most countries and in the euro area as a whole. As illustrated in Chart 3, significant increases in expenditure on health as a percentage of potential GDP were recorded in a majority of euro area countries in the period before the consolidation, leading to a rise in the health expenditure ratio at the euro area level. Only Germany and Slovenia saw health expenditure growth slightly below that of potential GDP. The start of the crisis marked a trend shift, as most countries experienced a slowdown in health spending which also continued in many countries in the consolidation and post-consolidation periods. Since the crisis, health expenditure has grown less than potential GDP for at least some of the time in a majority of countries.

Education spending, which is generally considered to be conducive to long-term economic growth, has slowed down in a majority of euro area countries since the consolidation period. Increases in expenditure on education as a percentage of GDP were recorded before the consolidation period, mainly in Cyprus, Latvia, Ireland, Slovakia and the Netherlands (see Chart 4). During the crisis, and even more widely during the consolidation period, there was a general drop in education expenditure growth, with a number of countries recording growth rates below that of potential GDP, mainly related to cuts in compensation of employees (wages of teachers and educators). In the period 2014-2017, the dynamics of expenditure on education relative to potential GDP continued to be contained in most countries, particularly in Ireland, Malta, Portugal and Finland.

Other components of social spending also show diverging trends. In particular, the behaviour of unemployment benefits is very heterogeneous across time and countries, mainly due to its economic stabilisation function. While expenditure on unemployment benefits generally increased in the pre-crisis period and in the first part of the crisis (2008-2010), it has tended to decrease since 2011. Unemployment rose significantly in most countries in the wake of the global financial crisis, but the rise in unemployment was much sharper and longer-lasting in some countries (e.g. Greece, Spain and Italy) than in others (e.g. Germany and the Netherlands). Expenditure on sickness and disability, families and children, social housing and combating social exclusion were on a decreasing trend before the crisis years (up to 2005), but have since increased steadily. This was in particular on account of expenditure related to social exclusion, such as social assistance for those at high risk of poverty or in difficult circumstances. The rest of this article focuses on analysing the three main components of social spending, namely pensions, health and education.

3 Zooming-in on the social systems in the euro area

The social systems chosen by euro area countries, and the reforms of those systems, have an effect on government spending patterns and levels. How much countries spend on health or education reflects a wide spectrum of market, political and social factors, as well as diverse financing and organisational structures of their national systems. Cross-country comparisons of government social spending need to be interpreted with care in view of the different social systems and models that exist. This section provides an overview of the different pension, healthcare, and education systems in the euro area and how government expenditure might be affected by the choice of a particular model.

Pensions

The set-up of pension systems varies significantly across euro area countries. This can be attributed both to historical differences and to the different stages they are at in the pension system reform process. In particular, how pension systems are organised into public and private schemes has an impact on sustainability risks. In all euro area countries, government-managed pension schemes play an important role in the provision of pension benefits. In 2017, government expenditure on old age and survivors’ pensions^[13] ranged from 15.1% of total government expenditure in Ireland to 33.5% in Greece (see Chart 5).

Pension systems are traditionally divided into three pillars.^[14] The first pillar consists of a mandatory public social security scheme based on the pay-as-you-go (PAYG) principle. It is usually a defined-benefit scheme, but notional defined-contribution or points systems also exist in euro area countries. Such PAYG schemes often include old age, survivors’ and disability pensions. The second pillar includes social insurance schemes that are employment-related and generally set up by employers for their employees. These schemes are mainly funded, and can be either defined-benefit or defined-contribution plans. Funded and unfunded schemes for government employees are also included in the second pillar. Voluntary private schemes make up the third pillar, but are not part of social insurance.^[15] These are important in countries where the government encourages such saving schemes by providing additional financial support, such as subsidies or tax incentives (e.g. Germany, Luxembourg, Italy, Malta, Austria, Portugal and Slovakia).

In addition, there may be schemes aimed at poverty alleviation that provide a basic pension or social assistance independently of employment-related contributions. These schemes are usually not part of the social insurance system, but the expenditure on these benefits may be included in pension expenditure.

Table 2 summarises the pension schemes in euro area countries under the first and second pillars. All euro area countries have first-pillar pension schemes covering large parts of the workforce. These are by far the largest source of government expenditure on old age, survivors’ and disability pensions. In most euro area countries these schemes are defined-benefit schemes. In three countries (Ireland, Greece and the Netherlands) retirement benefits are paid at a flat rate, irrespective of the contributions or other criteria determining the level of benefits. This flat rate pension can be supplemented by other public or private schemes. A few countries also have notional defined-contribution or points systems.^[16]

In addition, the outflows from the unfunded schemes for government employees that are in place in almost all euro area countries (except Italy, Slovenia and Finland) and the funded pension schemes managed by government that exist in Portugal and Slovenia are also part of government expenditure on pensions. There are no funded employment-related pension schemes in France or Malta.

A new dataset on accrued-to-date pension entitlements in social insurance was published by Eurostat at the end of 2018. The new dataset offers information on the different pension schemes in place in EU countries (first and second pillars) at the end of 2015, and improves comparability between countries. Data are available for all euro area countries except Greece and Luxembourg. Although the data refer to the pension entitlements of households, they also illustrate the relative importance of pension schemes relating to government expenditure. Box 2 explains the new dataset and its possible uses.

Pension reforms in a majority of euro area countries in the last decade have focused on raising the retirement age. In several countries the retirement age is linked or will be linked to changes in life expectancy (e.g. in Belgium, Estonia, Greece, Italy, Cyprus, the Netherlands, Malta, Portugal, Slovakia and Finland). Table 3 shows the statutory retirement age in euro area countries in 2019 along with the early retirement age and average effective age of retirement, which takes into account people retiring early or late. In several euro area countries the retirement age is different for men and women, but there is a trend towards equalising them in future in most countries.

Incentives for retiring earlier or later than the statutory retirement age influence the effective age of retirement. Some countries allow early retirement with full benefits once a sufficient number of years of contributions have been accumulated. In over half of euro area countries, however, early retirement results in reduced pension benefits, while there may be additional benefits for deferring retirement beyond the normal retirement age. The average effective age of retirement is below the statutory retirement age in most countries, indicating that early retirement schemes are widely used.

In addition to increases in the retirement age linked to life expectancy, there may be additional, sometimes automatic, sustainability measures built into the pension systems. Many countries apply formulae that closely link pension entitlements to the contributory career. The aggregate replacement ratios^[27] in Table 3 show that the pension income from all three pension pillars replaces between 33% of working age income (in Ireland) and 86% (in Luxembourg). In Ireland and the Netherlands, a large part of the statutory state pension (first pillar) is a flat rate pension that is not related to the pre-pension income, which also explains the low shares of old age pension expenditure in total government expenditure (see Chart 5 above).^[28] In the rest of the countries, the levels of pension benefits depend on the length of career and contributions made either in the whole working life or the most recent or best number of years.

In addition, the evolution of the benefit ratios during retirement is determined by the indexation rules. Most euro area countries apply indexation to pension benefits. This is linked to price, wage or GDP increases or a combination thereof. On the other hand, there are sustainability mechanisms to reduce pension benefits based on life expectancy at the time of retirement or on the ratio of contributions to pensions in Germany, Finland, Spain, Italy, Latvia and Portugal (see The 2018 Ageing Report^[29]).

Most euro area countries also provide minimum pensions that are often income-tested or means-tested. This implies that the benefit is provided only if the person’s income or wealth is below a certain threshold. Minimum pensions are meant to alleviate the risk of poverty in old age and are part of social assistance. Among euro area countries, the highest proportion of means-tested old age pension expenditure is in Spain (12%, see Chart 6), followed by Ireland and the Netherlands (both above 8%). On the other hand, in several countries there is no means-testing (Estonia, Latvia and Finland) or very little paid out after means-testing (Luxembourg, Lithuania and Germany). However, most means-tested expenditure is related to benefits linked to social exclusion, such as social assistance payments, which are also paid beyond retirement age.

Health

Public health expenditure is the second highest category of government expenditure in the euro area, amounting to 15% of total expenditure in 2017. It ranges from 7% in Cyprus to 20% in Ireland (Chart 7). In euro terms, the highest expenditure per capita in 2016 (over €4,000) was in Luxembourg, Germany, Austria, the Netherlands and Ireland, while it was below €1,000 per capita in Latvia and Lithuania.

Healthcare expenditure is shared between government and households in different proportions, depending on the healthcare financing schemes in the different countries. Direct government financing is more common in countries where there is universal healthcare funded by the government. This means that health services are provided and paid for directly by the government, with hospitals managed by the government (whether owned or rented) and medical staff paid by the government. In other countries financing may be provided mainly through mandatory health insurance, where the government is not the direct provider of the healthcare services and instead buys them from private providers. Both direct government financing and mandatory health insurance are usually part of government expenditure. Government expenditure may also be complemented by private health insurance arrangements and payments directly from households (out-of-pocket expenses).

In 2016 direct government financing and mandatory health insurance accounted for over 50% of total health expenditure in all euro area countries except Cyprus (42%).^[30] In about half of all euro area countries, the main financing of health expenditure was through mandatory health insurance, as shown in Chart 8 (Germany, France, the Netherlands, Luxembourg, Slovakia, Belgium, Estonia, Austria, Slovenia and Lithuania). However, in Finland, Italy, Ireland, Spain, Portugal, Malta and Latvia, direct government financing made up the majority of the health expenditure. In Greece, health financing is broadly divided among government financing, mandatory insurance and out-of-pocket expenses of households, while in Cyprus it is almost equally divided between direct government financing and out-of-pocket expenses of households. In four countries – Malta, Greece, Latvia and Cyprus – out-of-pocket expenses of households cover over one-third of health spending. In Slovenia and Ireland, voluntary health insurance finances over 10% of total health expenditure.

Differences in healthcare financing models also have an impact on government health expenditure. Chart 9 shows the expenditure categories for government health expenditure for three groups of euro area countries – one group mainly directly government financed and two groups with mandatory health insurance financing. For the countries where health expenditure is predominantly directly financed by government (Ireland, Spain, Italy, Cyprus, Latvia, Malta, Portugal and Finland), the share of compensation of employees in total health expenditure is quite high, ranging from 30% to 55%. At the same time, the share of intermediate consumption spending, i.e. expenditure related to purchases of goods and services used in the production of final health services, is also significant (20%-37%). Social transfers related to health expenditure that are predominantly provided in kind (reimbursements of purchases of medical goods and services) are relatively low in these countries.

The countries where the government health expenditure is financed mainly through mandatory health insurance can be distinguished according to whether public hospitals are recorded as part of the government sector for statistical purposes. The first group (Belgium, Germany, Luxembourg and the Netherlands) have a very low percentage of expenditure on compensation of employees (3%-6%) and intermediate consumption (2%-3%). These numbers are explained by the fact that hospitals, including public hospitals, are regarded as market producers, providing their services on a commercial basis. Therefore, their expenditure is not part of government expenditure on health. The largest part of the expenditure (over 70%) is in the form of social transfers in kind, composed of reimbursements and payments from health insurance companies for medical goods and services provided to households. In the second group of countries that finance government health expenditure mainly through mandatory health insurance (Estonia, Greece, France, Lithuania, Austria, Slovenia and Slovakia), the structure of health expenditure is different, as the public hospitals are part of the government sector. Thus the shares of compensation of employees (16%-40%) and intermediate consumption (11%-28%) in total health expenditure are higher than for the first group and social transfers in kind are generally lower. An exception is Slovakia, where social transfers in kind are above 70%.

Going forward, healthcare reforms may affect wages of medical and non-medical personnel, prices of medical goods and capital investment, and there may be legislated changes in targets for future healthcare expenditure.

Education

Government expenditure makes up the bulk of education spending in all euro area countries. It is complemented by private spending by organisations, other non-educational entities and households. The contribution from private expenditure is much higher in tertiary education, such as university programmes, than in lower levels of education. In Cyprus, Spain, Italy, the Netherlands and Portugal, the share of private expenditure in tertiary education exceeds 30%.^[31]

In the euro area, the average share of government expenditure on education was around 10% in 2017, ranging from 7.9% in Italy to over 15% in Latvia and Cyprus (see Chart 10). The bulk of expenditure is on pre-primary, primary and secondary education, with less spent on tertiary education. This is associated with nearly full enrolment rates in primary and secondary education, due to compulsory education. But even at pre-primary level (age four and above) enrolment rates in all euro area countries are close to or above 80%.^[32] In Finland and the Netherlands expenditure on tertiary education is above 3% of total government expenditure.

All euro area governments spend significant shares of total education expenditure on compensation of employees – around 60%-80%. This is in particular the wages and salaries of teachers and other teaching staff. Other large expenditure categories are intermediate consumption and investment. Social transfers play a much smaller role in education than in health and social protection, accounting for about 4.8% of total expenditure on education in the euro area.

The decline in rates of growth in education spending discussed in Section 2 may not necessarily translate fully into reduced expenditure per student, as young people constitute a declining share of the population. While Section 2 showed a clear trend towards containing expenditure in education, gains in the efficiency of growth-enhancing expenditure may nonetheless lead to better outcomes overall. Moreover, some of the countries which made the biggest cuts in expenditure on education after the financial crisis also had the biggest increases during the boom period that preceded it.

4 Conclusions

The composition and levels of social spending vary significantly across countries. The trends identified at the euro area level are heterogeneous at national level, reflecting differences in starting positions and societal preferences. Overall, countries have not converged in terms of the architecture of their social systems over the last decade. Cross-country comparisons confirm that to secure fiscal sustainability in line with the Stability and Growth Pact, while balancing economic stabilisation and equity objectives, countries need to pursue differentiated fiscal policies commensurate with the architecture of their social system. The policy guidance contained in the CSRs issued annually under the European Semester is also relevant in this context. The CSRs highlight the tailored reforms needed to tackle the key challenges in each Member State in the next 12-18 months.

Changes in euro area public expenditure since 2001 illustrate the risks that fiscal vulnerabilities pose to the sustainability of growth-friendly expenditure policies. Pension expenditure is at a historical peak in several Member States and will grow further in many countries in the absence of reforms. The ageing impact will peak when the baby-boomer generation has retired, which will be around 2040 in some euro area countries, but later in others. Countries with public PAYG pension systems will be particularly strongly affected, posing questions regarding intergenerational fairness, as the ratio of contributors to beneficiaries is shrinking and recent estimates of accrued-to-date liabilities in social security amount to more than 200% of GDP in most countries. Moreover, ageing is expected to lead to an increase in health expenditure and a decline in labour supply, growth and innovation, while precautionary savings are potentially rising.

Many countries need to build fiscal buffers, resist the tendency to reverse previous sustainability-enhancing reforms of their social security systems and undertake further reforms as needed to strengthen their national arrangements. This is particularly relevant in view of the fiscal-structural reform proposals of the CSRs for countries with already high government debt ratios and only limited fiscal space. Particular attention should be devoted to ensuring there are sufficient resources for education, as such spending has been shown to have positive effects on long-term economic growth. To safeguard sustainable health systems, further policy action will be needed to make health systems more efficient. Recommendations also call for further improvement in the targeting and efficient use of resources in all social spending categories. Additional structural reforms to increase labour force participation are also generally recommended in the CSRs.