The welfare state, thresholds, and economic growth

Can a growing welfare state induce a regime switch in the growth rate of an economy? This paper constructs a dynamic political economy model of economic growth and the welfare state in which both variables are nonlinearly related and jointly endogenous. Using a Markov switching framework over the period 1950-2001, we find that the structural decline in growth rates that several welfare state economies experienced during 1970-1975 is preceded by movements to a high welfare state regime. This suggests that expanding welfare state regimes are associated with low economic growth regimes, while contracting welfare state regimes are associated with high growth regimes. However, we also find that the structural decline in growth rates leads to a downward structural break in the welfare state for many welfare state economies. This suggests that declining growth regimes are associated with contracting welfare state regimes, as lower growth forces politicians to cut the size of the welfare state. We also report strong evidence that both expansion and contractions in the welfare state affects growth nonlinearly. These results are able to characterize a predictable and general pattern of welfare state-growth evolution. (c) 2004 Elsevier B.V. All rights reserved.