THE ECONOMIC RECORD. VOL. 73. NO. 220. MARCH 1997.

45-50

Targeting Welfare: A Comment"

PETER WHITEFORD
Strategic Planning Division,
Department of Social Securiry,
Canberra

Mitchell, Harding and Gruen (1994) survey the redistributive

impact of Australia's targeted social security system using Lux-
embourg Income Study data. They argue that the Australian system
has the highest target eficiency among ten countries, but the lowest
benefit generosity (after taking account of tar clawbacks). implying
that generosity is greater in universal or contributory systems. This
comment identifies methodological problems with the accounting
framework used by Mitchell, Harding and Gruen. although also
arguing that the Australian targeted income support system is likely
to be more eficient at reducing poverty than social insurance
systems. An alternative mcthodological approach is outlined.

I Introduction in Australia and New Zealand. which alone

In the Economic Record (Vol. 70. No. 10. Sep-
tember 1994, pp. 31540),Mitchell, Harding and
Gruen (hencefonvard MHG) survey the advan-
tages and disadvantages of targeting welfare pay-
ments. The authors' central argument relates to
whether income-tested benefits are more or less
generous to the poor than universal or contribu-
tory benefits.
By definition. for a given expenditure level. a
means-tested system will provide more generous
benefits to the poor than universal or earnings-
related benefits. The level of social security
expenditure is not fixed, however, and may not be
independent of the structure of benefits (Saunders
1994). A means-tested program with a highly
redistributive formula may achieve limited redis-
tribution if the quantum of spending is low, but a
high cost, earnings-related system may achieve
greater redistribution by providing more generous
basic benefits (Barr 1992; Saunders 1994). Com-
parative studies suggest the poor have done best
in large welfare states, benefiting from a 'benign
trickledown' from the middle class (Baldwin
1990). Such arguments are particularly significant
The views expressed are my own. and not those of
the Department of Social Security.
among OECD countries have non-contributory
social security systems. If targeting is actually
associated with higher poverty and inequality than
universal benefits. a major rationale for this
approach appears to collapse.
Most comparative studies, including MHG,
employ a specific framework for analyzing
income redistribution. This comment identifies
some methodological problems with this frarne-
work, although also arguing that the Australian
targeted income support system is likely to be
more efficient at reducing poverty than social
insurance systems. While MHG's conclusion is
correct, their methodology is unreliable. An alter-
native methodological approach is outlined.
11 Measuring the EBciency and Effectiveness
of Transfers
MHG use a framework derived from Becker-
man (1979) and Beckennan and Clark (1982) to
analyze the efficiency and effectiveness of income
support. These measures assume that the differ-
ence between the distribution of income 'before'
and 'after' government intervention measures the
extent to which policy reduces poverty. The
indexes developed all derive from the 'pre-
transfer poverty gap', the shortfall between actual

45
1997. The Economic Society of Australia. ISSN 00134249.
46 ECONOMIC RECORD MARCH

incomes and the poverty line, for individuals FIGUREI

whose incomes are below the poverty line before The Income Accounting Framework
receiving transfers and paying taxes. ‘Need’ is the
pre-transfer poverty gap as a percentage of factor w a g s ud S I h n

income. The ‘poverty reduction efficiency’ of the

transfer system is defined as the reduction in the
poverty gap as a proportion of transfer spending.
‘Effectiveness’ is measured as the ratio of the
post-transfer poverty gap to the pre-transfer
poverty gap. with ‘outcomes’ being the post-trans-
fer poverty gap as a proportion of factor income
(MHG 1994, p. 324-5). The authors extend this
framework to take account of the ‘clawback’ of
transfers through direct taxes.
MHG use 1980s Luxembourg Income Study
(LIS) data to compare the tax-transfer systems of
ten countries and show that the Australian social
security system has the highest targeting effi-
ciency, and one of the lowest tax clawbacks. but
the generosity of the system after taking account
of tax clawbacks is lower than any other country
(Table 2, p. 332). MHG conclude that generosity
is greater in universal or contributory systems, but
the higher efficiency of the Australian system
leads to more favourable outcomes than expected
from spending levels. To this extent, targeting
appears to be a partial success.

111 The Standard Approach

In common with the studies they criticise. MHG
adopt ‘the standard approach’ (Ringen 1987) to
analyze income data. This framework, shown in
Figure I , is essentially an accounting device for
relating different components to each other and
for deriving aggregates such as cash disposable
income. Within the LIS and other microdata, this
framework is applied to each household’s income
to produce the income measures shown. The
redistribution achieved by taxes or transfers is cal-
culated by comparing income shares, Gini coef-
ficients, or poverty indexes at different stages in
the process in Figure 1. MHG use poverty lines
set at different proportions of median disposable
income (Measure 4). Pre-transfer poverty gaps are
calculated by comparing the difference between
market income (Measure 2) and the poverty line.
The need, generosity, efficiency and effectiveness
measures are estimated from the pre-transfer
poverty gaps; only the outcome measure is inde-
pendent of the pre-transfer poverty gap.
This framework is not only used by MHG,but
by virtually all studies using LIS,and most single-
countq studies. There are a number of obvious
limitations, however, that invalidate statistical
measures based on this framework.
IV T h e Countegactual
As is well known, any assessment of the distri-
butional impact of social policies involves a com-
parison of the observed distribution with a
counterfactual-the hypothetical distribution
existing in the absence of the policies evaluated
(Pederson 1994). The Beckerman measures use a
counterfactual in which taxes and transfers have
no behaviounl effects on the underlying income
distribution. The accounting period is usually one
year. and in some countries the original income
data are weekly. The framework is linear, imply-
ing that the distribution of factor and market
incomes ‘precedes’ the operation of the tax and
transfer systems, with no interactions between
them, apart from the direct effect of government
programs in reducing final inequality. Those
applying this approach across countries implicitly
assume that wide variations in welfare state size
 1997 TARGETING WELFARE: A COMMENT
have the same (zero) behavioural impact in each
country.
The standard approach exaggerates the basic
inequality of market incomes and then exagger-
ates the amount of redistribution achieved by
social policies (Layard 1977; Reynolds and Smo-
lensky 1977). This is obvious in MHG’s results.
he-transfer poverty gaps are greatest in the UK.
Sweden, France and Germany and lowest in
Australia, Canada and the United States, the coun-
tries with the lowest level of welfare spending
(Table 3). Similarly, Smeeding and Coder (1993)
find enormous differences in market income in-
equality. and correspondingly in the effectiveness
of different systems in reducing inequality. In
Australia. Canada and the United States. house-
holds at the 80th percentile of market income have
incomes about five times greater than households
at the 20th percentile. In the Netherlands and
Sweden this ratio is twice as great again, and in
the United Kingdom inequality in market incomes
is nearly three times as great as in the United
States. In Australia. Canada and the United States.
the welfare state appears to reduce income in-
equality by 40 per cent, while in the Netherlands,
Sweden and the United Kingdom, inequality is
reduced by around 80 per cent. These results are
a classic illustration of the counterfactual problem.
It is scarcely plausible that underlying income in-
equality in Sweden is twice as great &$ in the
United States. Swedish earnings inequality is
much lower than i n the USA and at the time of
the LIS surveys Swedish unemployment was
much lower than in the United States.
These results simply reflect the fact that more
transfer recipients have zero or extremely low
market incomes in larger welfare states. In effect,
middle income groups in large welfare states are
treated as if they plunge into poverty on retire-
ment, simply because the government provides
their pensions, Higher private provision reduces
measured dispersion in market incomes in
Australia. Canada. and the United States. To the
extent that transfers displace private savings in
larger welfare states, both inequality and redistri-
bution are exaggerated. This effect is exacerbated
in Sweden (and France, Germany, Italy and Lux-
embourg) because private and occupational pen-
sions are aggregated with social insurance in these
countries’ data. That is, occupational and private
pensions should be included in market income,
but are actually included in transfer incomes for
these countries. Given this, it is doubtful whether
the Beckerman measures are precisely meaningful
47
for the purposes used. Apart from the outcome
measure, they are all derived from the pre-transfer
poveny gap, a measure of dubious validity.
Nevertheless, some may argue the general conclu-
sions are still correct. The post-transfer poverty
gap is unaffected by these problems, and post-
transfer poverty is lowest in the highest spending
welfare states. While it may not be valid to cal-
culate precise measures of redistribution, this sug-
gests an association between high levels of
spending and lower poverty outcomes.
V Accounting for Government
There are further issues, however, to be taken
into account before reaching firm conclusions.
The standard framework takes account of only
some government policies. Most income surveys
include information only on cash transfers and
direct taxes (income taxes and employee social
security contributions). This is problematic, as the
effective coverage in LIS of total taxes and ben-
efits varies widely. Income taxes account for 46
per cent of total tax revenue i n Australia, while
social transfers are around a third of government
social spending. Overall, the average transfers
received by Australian households (according to
the LIS data) are around half the average taxes
paid by households. At the other extreme is
France, where income taxes and employee social
security contributions account for only 25 per cent
of revenue, but cash transfers are 55 per cent of
total social spending. Thus. measured French
transfers are around 2.75 times measured taxes in
the LIS data. French households are apparently
getting nearly two-thirds of their social security
system ‘for free’!
Cash transfers are more redistributive than ben-
efits in kind, while direct taxes are more progres-
sive than indirect taxes (Saunders and K h u 1985).
Analysis based on disposable cash incomes there-
fore underestimates the quantum of redistributive
activity, but over-estimates the progressivity of
the tax-benefit structure. Such gaps are important
as the generosity of cash benefits is not independ-
ent of the role of non-cash services or indirect
taxes. For example, Australian public spending on
housing assistance is split between measured cash
supplements for low income households in private
rental and unmeasured assistance through reduced
rents paid by low income public tenants. In the
UK and Germany, in contrast. most housing
assistance is in the form of measured cash
supplements.
48 ECONOMIC RECORD
MHG take account of clawback of cash benefits
through direct taxes, finding clawback is 27 per
cent in Australia, ranging between 12 per cent in
France and 46 per cent in Norway. This measure
is useful, but incomplete. Indirect taxes are also
responsible for clawback, but not included. Taxes
on general consumption account for 2.3 per cent
of GDP in Australia. compared to an OECD
average of 6.7 per cent. In general the measured
generosity of benefits will be greater in countries
with higher levels of consumption taxes, so long
as consumption taxes are not included in the
accounting framework. For example, the proposed
GST compensation package in the 1985 Draft
White Paper would have increased transfer spend-
ing by more than 10 per cent. Most of this higher
spending would have simply offset higher indirect
taxes, and would not improve the real generosity
of benefits. Unless international comparisons take
account of consumption taxes, this ‘churning’ will
make high tax countries look more generous to
the poor than countries with low indirect tax
levels, like Australia.
Another gap is the non-inclusion of employer
social security contributions. These taxes do not
exist in Australia (or New Zealand). and are insig-
nificant in Denmark and Iceland. In all other
OECD countries they exceed 8 per cent of
revenue, and they exceed 20 per cent of revenue
in Belgium, France. Italy. Spain and Sweden. As
these taxes finance a large part of social security
spending, their absence from most studies of
income redistribution is particularly problematic.
Differing interpretations of the incidence of
employer contributions can have a substantial
impact on the measured generosity of cash bene-
fits (Whiteford 1995). For example, an average
Australian manufacturing production worker earns
about 30 per cent more than similar workers in
France or Sweden, when gross earnings are
adjusted by OECD Purchasing Power Parities
(PPPs), even though France and Sweden are
somewhat wealthier countries than Australia. In
France and Sweden, however, employers are
paying social security contributions between 30
and 35 per cent of gross wages, so that producers’
wages are similar to those in Australia. Because
these contributions are not included in the stan-
dard framework. the measured gap between ben-
efits and earnings is artificially narrowed in
countries with high levels of employer contribu-
tions. In fact, low benefit replacement rates in
Australia are the basis of the view that the Aus-
tralian system is not generous to the poor (Esping-
MARCH
Andersen 1990). But when the purchasing power
of basic benefits is compared rather than replace-
ment rates, the Australian system is significantly
more generous to the poorest than the OECD
average (Whiteford 1995; Eardley, Bradshaw,
Ditch. Gough and Whiteford 1996).
VI The Accounting Period
The comparisons made by MHG are also viti-
ated by the period over which redistribution is
measured. Transfers have both insurance and
redistributive elements, so the redistributive
element cannot be examined using only annual
information (Creedy 1994). This point is of
crucial importance in comparing the effectiveness
of different welfare systems, since the mix of
insurance and redistribution differs between
countries.
This point is made by MHG (p. 324). although
its implications are not explored in detail. Falk-
ingham and Harding (1996) estimate that in the
targeted Australian system 38 per cent of lifetime
benefits received by individuals are paid for at
another stage in their life, with 62 per cent being
redistribution between individuals. In the UK only
38 per cent of benefits is redistribution between
different individuals. For example. assume that
Australia spent 10 per cent of GDP on transfers,
while the United Kingdom spent 15 per cent of
GDP. If we notionally separate out the redistrib-
utive and self insurance components, then Austra-
lian redistribution would be 6.2 per cent of GDP
(0.62*lo), while UK redistribution is 5.7 per cent
of GDP (0.38*15). That is. conrrary to the stan-
dard approach, actual redistribution would be
greater in Australia than in the UK. Other OECD
countries would achieve even less redistribution
between income groups. because their eamings-
related formulae are stronger than in the UK.
While the Australian social security system is
the most ‘radically redistributive’ (Aaron 1992) of
all developed countries. it still retains an element
of lifecycle redistribution. The problem with the
standard approach is that a single-year accounting
period effectively assumes that all observed redis-
tribution is between income groups. In a single-
year accounting period taxes and social security
contributions are treated as a burden, rather than
as a source of future income entitlements. This
produces the result that middle class households
in larger welfare states appear worse off than
similar households in smaller welfare states,
because their tax liabilities are higher. The bene-
 I997 TARGETING WELFARE A COMMENT
fits that accrue to these households are not
counted because they arise as future entitlements
(or are substitutes for private expenditure such as
health insurance or home purchasing). Because
future benefits to the middle and higher income
groups are not measured, low income groups
appear relatively better off in larger welfare states.
By separating the processes of redistribution
between income groups and redistribution across
the lifecycle more than other countries, the Austra-
lian system has the paradoxical effect of making
outcomes look more unequal than in countries with
more 'middle class' welfare. A greater proportion
of redistribution across the lifecycle in Australia is
through private means. including home purchase,
private superannuation, endowment insurance and
other savings. The costs of these savings are not
included in the standard framework, because they
are private. In contmt. the costs of redistribution
across the lifecycle through social insurance are
included, because they are financed from taxes and
employee contributions. The standard framework
is systematically biased to make high taxing welfare
states look more equal than low taxing countries,
such as Australia.
These biases could be corrected with lifetime
incidence studies (Harding 1994; Stdhlberg 1985).
To date, few studies compare the lifetime impact
of benefits systems in different countries on a con-
sistent basis, apart from Falkingham and Harding
(1996). An alternative is to bring all public and
private redistribution within the compass of a
single year's accounting period. This involves a
comprehensive k o m e measure, covering all gov-
ernment activities, including imputed wealth in
public pension rights, as well as private provisions
such as imputed income from owner-occupied
housing. To date, there are two studies broadening
the LIS income concept ( h e e d i n g . Saunders et
al. 1992; Whiteford and Kennedy 1995). to
include government health, education and housing
benefits, plus imputed income from owner-occu-
pied housing. Both find the extent of poverty and
inequality declines under broader measures,
although the ranking of countries is not greatly
affected. These measures are still incomplete,
however. Adding indirect taxes would increase
inequality in all countries, although to varying
degrees. The addition of imputed pension or
benefit rights is likely to change differences
between countries as well as their ranking. It
could be expected that inequality would increase
by a smaller amount in Australia, because of its
targeted benefit system.
49
Vll Conclusion
This comment argues that the measures used by
MHG are not valid measures of the degree of
redistribution achieved by transfer systems, due to
the fundamental counterfactual problem affecting
such studies. Comparisons are affected by incom-
plete coverage of government redistributive activ-
ities in most income surveys. The period over
which income redistribution is measured results in
systematic biases tending to make Australian
welfare arrangements look less effective than
those in other countries. The standard framework
makes outcomes look less unequal in large
welfare states that give greater prominence to
redistribution across the lifecycle. Broadening the
income definition to take account of these factors
will narrow the difference between measured out-
comes in different countries, but the methodology
of comparative analysis of welfare state outcomes
still requires considerable development. It follows
that strong conclusions about welfare outcomes
should be tempered by an appreciation of weak-
nesses of the analytical frameworks producing
these outcomes.
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