Increases in Risk and the Welfare State

According to many observers the world is currently becoming more risky in many ways. In this paper we analyse how the welfare state, i.e. social insurance which works through redistributive taxation, should deal with this trend. We distinguish between risks that can be insured by the welfare state and those that cannot (background risks). Insurable risks can be reduced either by individual self-insurance or through pooling, by social insurance. Both ways are costly in terms of income forfeited. We show: (i) The more costly the welfare state is and the larger the background or insured risks are, the higher self-insurance will be. (ii) Full risk coverage by the welfare state can only be optimal in a costless welfare state. (iii) The optimal size of the welfare state is larger the higher the risks are that it cannot insure. The impact of the size of risks that cannot be insured is however unclear