Efficiency and Equality in a Welfare State Economy

This paper studies the effects of social insurance policies on the level and distribution of welfare and resources in a general equilibrium model of a closed economy with a continuum of agents and moral hazard. In order to simulate the welfare-state tradeoff between efficiency and equality, I characterize and compare efficient allocations and invariant distributions of utility entitlements, capital, labor supply, and consumption in stationary recursive equilibria for economic regimes with different guaranteed minimum consumption levels (welfare-state regimes). First, I describe a general way how to introduce capital accumulation into models with heterogeneous agents with private information and show that private information lowers the equilibrium interest rate below agents' discount rate. Second, increasing level of social insurance (welfare state) leads to inefficient allocation of resources and lower productivity. Third, higher level of social insurance delivers greater equality as well as greater expected utility of the agents. These results constitute the tradeoff between efficiency and equality in a welfare state economy.