Measuring fiscal sustainability in the welfare state: fiscal space as fiscal sustainability

Abstract

This study measures the fiscal capacity of welfare states to derive parameters for a sustainable welfare state. To secure fiscal soundness, it is critical to maintain affordable welfare spending by ensuring public capacity. Adapting the concept of fiscal space, defined as the difference between the current level of public debt and the debt limit implied by the country’s historical record of fiscal adjustment by Ostry et al. (2010) and Ghosh et al. (2011), this research measures and compares the fiscal sustainability of 17 welfare states. To derive this fiscal space, the debt limit of each country is set, primarily based on the estimating of fiscal reaction function and selecting interest schedule (Ghosh et al. 2011, p. F13). We use a pooled-time-series-cross-sectional model to estimate fiscal reaction function and the vector regression model to set the interest schedule. It is found that Southern European welfare states are unsustainable if they do no immediately change their fiscal policies. Countries outside of Southern Europe are generally financially sustainable. However, the UK, the US, and France have in their recent actions exacerbated their financial sustainability. For their part, the social democratic states remain financially sound, despite high levels of welfare spending. This indicates that welfare spending does not necessarily weaken fiscal soundness, which depends on the type of welfare state.