Abstract
The disincentive effects of social insurance have recently become a major point of debate in Western Europe, leading to cuts in benefits and renewed focus on providing incentives. I study the evolution of the welfare state in a context of cultural transmission and endogenous taxes. Insurance allows agents to spread risk between different states of nature, but it creates moral hazard opportunities that some agents take advantage of. This static cost of moral hazard is augmented by a dynamic cost: social insurance tends to reduce the number of productive agents in the population and can lead to its complete unraveling over time. I show that a long period of high taxes and generous welfare benefits is not sustainable, and is usually followed by reduced generosity in order to provide incentives to work. Even when the economy eventually reaches a state without any free riding the transition to this state is costly.
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