A Pareto Efficiency Rationale for the Welfare State

Is there a Pareto improving rationale for a welfare state in dynamic economies with unobservable agent heterogeneity, when missing credit and insurance markets affect incentives to invest in human capital? If so, should the state provide transfers to the poor in the form of cash or in-kind transfers? In an occupational choice model, we show (a) every competitive equilibrium is interim-Pareto dominated by a policy providing education subsidies financed by income taxes, and (b) transfers conditional on educational investments similarly dominate unconditional transfers. The policies also result in macroeconomic improvements (higher per capita income and upward mobility, lower wage dispersion). Boston University, and University of Bayreuth respectively. We acknowledge helpful comments by participants of the Oslo THRED conference in June 2013, to Jianjin Miao for directions to the macro literature, and to Brant Abbott for providing us with details of the nature of inter vivos transfers in Abbott et al. (2013). We also thank Marcello d’Amato for numerous discussions and ideas concerning occupational choice and role of the welfare state.