29 July 2015

Scandinavian Unexceptionalism #6: Taxes matter


A few years ago the US National Public Radio ran a story “about a country that seems to violate the laws of the economic universe.” It had “one of the lowest poverty rates in the world, low unemployment, a steadily growing economy and almost no corruption” although it had high taxes. The country in question was Denmark.

A popular notion is that the Scandinavian countries manage to defy standard economic logic, by prospering despite a high-tax model. Sweden’s former social democratic Prime Minster Göran Persson has compared the country’s economy to a bumblebee: “With its overly heavy body and little wings, supposedly it should not be able to fly – but it does”.  In reality however the economic development that has occurred in Nordic nations is anything but mysterious. The nation’s prosperity developed during periods characterised by free market policies, low or moderate taxes and limited state involvement in the economy. Today, the Nordic countries compensate for their high tax rates and large welfare states by having unusually free-market oriented policies in other areas.

If anything, the Nordic countries are perfect illustrations of the ideas of economist Arthur Laffer. In 1974 Laffer was meeting with Ford administration officials Dick Cheney and Donald Rumsfeld. The economist reportedly sketched a simple curve on a napkin, explaining that higher tax rates do not always lead to increased revenues. At some point, when taxes reach a high enough rate, they become so damaging to the economy that tax incomes actually shrink as taxes go up. The same idea was proposed by 14th century Muslim scholar Ibn Khaldun, who analyzed how dynasties fell as the size of government bloated.

Development of tax rates (percentage of GDP), OECD

  1955 1965 1975 1985 1995 2005 2013
Denmark 23 30 38 45 48 50 49
Finland 27 30 36 39 45 42 44
Sweden 24 31 39 45 46 47 43
Norway 28 30 39 43 41 43 41
UK 30 29 34 36 32 34 33
US 24 24 25 25 27 26 25

Today, the Nordic countries embody the idea of Arthur Laffer (and hopefully not also those of Ibn Kahldun). A study published by the European Central Bank for example finds that Sweden is on the tip of the Laffer curve when it comes to average taxes on incomes. This means that increasing taxes further on labour would have such a damaging effect on the economy that revenues would not increase. Tax rates in Denmark and Finland are also shown to be close to this extreme case (Norway is not included in the analysis). For capital taxation, Denmark and Sweden are shown in the same study to be on the wrong side of the Laffer curve. This means that capital taxes in the two countries are so damaging that reducing them would actually lead to more money being levied by the tax authorities.

Several other studies support the idea that Swedish taxes are at, or close to, the tip of the Laffer curve.  For instance, economist Åsa Hansson calculates the efficiency loss for each additional Swedish Krona levied and spent by the government. This loss can, according to Hansson, be up to 3 additional Krona if the money is spent on welfare payment which reduce the incentives for work.

To understand why taxes can have such significantly negative effects on the economy, one can consider the situation of a Swedish worker paying the maximum marginal tax rate and consuming his earnings. A payroll tax of 32 per cent is paid on the gross wage. There is then an average municipal tax of 32 per cent and a state tax of 25 per cent. Finally there is an average consumption tax of 21 per cent. A government report has calculated that the total effective marginal tax rate is 73 per cent. The report reaches the conclusion that a lower tax rate could in fact lead to higher public revenues.

A number of Danish studies point in the same direction. The think tank CEPOS in Copenhagen has, for example, calculated the effects of reducing the top marginal tax rate on labour from 56 to 40 per cent. The total effect of increased working hours amongst the affected groups would correspond to adding between 20,000 to 55,000 extra individuals to the labour force.

Rather than being bumblebees that defy traditional economic knowledge, Nordic countries re-inforce the idea that high tax levels are damaging to the economy. The nations teach us that tax rates can in fact become so high that they defy the very idea of income-maximization for the state coffers. Yet again, the experience of the Nordic countries are in line with the normal laws of the economic universe, as proposed by economists such as Arthur Laffer. Perhaps US National Public Radio should run this as their next story?

Dr. Nima Sanandaji is a research fellow at CPS, and the author of Scandinavian Unexceptionalism. The entire book is available through the Institute of Economic Affairs which has published it.