External Habit Formation and Dependency in the Welfare State

External habit formation explains why welfare states can be expected to exhibit increasing dependency over time expressed in the share of the population receiving welfare transfers. At the same time, the average number of hours worked decreases. Under plausible parameter values, the rate of taxation and the welfare expenditure share of national income monotonically increase over time and asymptotically approach a steady state. A positive interactive feedback loop between slow-moving external habits and welfare policies makes the extent of redistribution a “moving target”. Consequently, setting arbitrary redistributive goals may never satisfy redistributional demands in future periods. Technological progress may mask the underlying dynamic effects of the welfare state.

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