18 October 2019

Sweden’s great tax hoax – a story of fiscal illusions

By Nima Sanandaji

With the support of the Atlas Network, CapX is publishing a new series of essays on the theme of Illiberalism in Europe, looking at the different threats to liberal economies and societies across the continent, from populism to protectionism and corruption.

Why is it that people in Sweden, as well as other parts of Europe, are willing to pay such high taxes?

Tax revenue as share of GDP are around 45% in places like France, Denmark, Belgium and Sweden. This is considerably higher than places like Ireland, the United States, Australia and Switzerland where taxes make up less than 30% of GDP.

Throughout the world, proponents of big government point to European countries, not least Sweden and its Nordic neighbors, as the proof that high tax policies are workable. The reasoning goes that if only politicians in places such as the United States would have the courage to finance generous welfare systems with taxes, people would soon accept a much higher tax burden.

There is of course some truth to this. People in countries with higher tax burdens are willing to pay more in tax, since they receive more services from the government. But there is another explanation: high tax countries tend to hide the true level of taxation from the general public.

Ask a Swede why people with normal wages are paying around half of their income to the tax man and you might be rewarded with a puzzled face. Most Swedes think that normal earners are paying around a third of their income in taxes. Only recently have campaigns from advocates of limited taxation begun to spread the knowledge about the true tax burden. These campaigns in turn can explain why attitudes towards taxation are shifting in Sweden, with the current social democrat government slashing the 5% top marginal tax rate.

A historical perspective can help us understand the development of hidden taxes in the Nordics. Before policies steered to the left in the late 1960s, the tax levels in the region were around 30% of GDP—quite typical of other developed nations at the time. Until then, most taxation occurred through direct taxes, which showed up on employees’ pay stubs. However, politics started changing. Over time, an increasing share of taxation was to be raised through indirect taxes.

The most important form of indirect taxation is the employer’s fee. This is a tax on labor, which has a very similar effect to income tax. The difference is that it is called a fee rather than a tax, and that its name suggests that the employer rather than the employee is paying it. In effect, when somebody receives a wage of 10,000 kronor in Sweden, the employer has to pay an additional 10,000 kronor to the government. Half of this is the tax on labor, and the other half is the employer’s fee. On their pay stubs people see that their official wage is around 15,000 kronor, out of which 5,000 have been paid in taxes. The other 5,000 kronor, which has been paid to the tax authority, is often not even included on the pay stub.

Of course researchers and government records acknowledge that the employer’s fee is an indirect tax on labor, but people who don’t know the fine print of the tax system are largely unaware of the fact that both direct and indirect taxes on labor exist. Thus, many ordinary citizens think the tax on labor is around a third of the income (5,000 kronor out of 15,000) rather than the actual rate of around half the income (10,000 kronor out of 20,000).

Another form of an indirect tax is the value-added tax (VAT). In the United States, a sales tax is added to sold goods and services. Nordic countries used to have the same system. Over time they have moved toward a VAT, wherein the tax is hidden in the final price of the goods or service.

The graph below shows the evolution of taxes in Sweden. The OECD historical tax data starts in the mid-1960s, at a time when the total tax burden in Sweden was just above 30%. Then gradually taxes rose to 50% of GDP, before falling somewhat as governments on both the right and the left realized that the high tax policy was seriously hindering economic development. But a closer look shows that it is the hidden taxes, namely mandatory social security and VAT, that have risen over time.

A fiscal illusion has been created, wherein the rising level of taxation has been kept hidden from the voters. In Debunking Utopia: Exposing the Myth of Nordic Socialism, I show that the same overall trend is true for the Nordic countries as a whole. Politicians in this part of the world did not introduce large welfare states by raising the direct taxes. Instead they hiked revenues by expanding indirect taxes.

Compare this with the United States, where the total tax level has risen recently, but remained broadly at around 25% for the period as a whole. Hidden taxes have grown somewhat in the US over time, but remain at a low level.

So far this might all be dismissed as anecdotal reasoning. Can we find an overall international trend? I have calculated the hidden taxes, as share of total taxation, for 23 modern economies based on OECD tax data. The following graph shows the relationship with hidden taxes at one axel, and the total tax burden at another. There is a clear correlation, with countries that rely less on hidden taxation (mandatory social security and VAT) having a lower overall tax burden than countries that rely less on these taxes. Denmark is the clear outlier, having high taxes without significant share of the taxes being hidden.

There is a theoretical literature which supports the notion that hiding the tax burden works as a strategy for implementing larger taxation than voters might otherwise have accepted. Interestingly, this policy strategy was predicted a long time before it linked to a massive tax raise in countries such as Sweden. In 1903 Italian economist Amilcare Puviani explained that politicians would have incentives to hide the cost of government by levying indirect rather than direct taxes. By doing so, the public would be fooled into underestimating the true cost of having a large public sector

Nobel Prize winners James Buchanan and Bertil Ohlin have also written on the subject, describing how the Social Democrats in Sweden had realized that the general public were not keen on embracing higher taxes, and had thus chosen to hide the true rate.

In a survey conducted in 2003 by my brother Tino Sanandaji and his co-author Björn Wallace, the Swedish public was asked to estimate the total amount of taxes they paid. Respondents were reminded to include all forms of direct and indirect taxation. On average Swedes believed that taxes on work and consumption amounted to 40% of the wage of an average worker. The true level at the time was 60%. In 2015 the survey was repeated, this time through a study that I wrote for the Confederation of Swedish Enterprise. At this point the tax level of Sweden had been reduced to 52%. In the survey, after having been reminded to include all taxes, the average respondent believed the level to be 34%.

So, both surveys found that a third of the actual tax burden was hidden from the general public. This all shines a new light on Nordic-style social democracy. It is only a half-truth that the people in this part of the world are willing to put up with high taxes in return for generous welfare. If politicians hadn’t hidden the tax bill, they would likely have been unable to raise the revenue to its current rate.

During recent years, campaigns by think tanks and business organizations have aimed at informing the Swedish people of the true level of taxation. As a result, the public’s perception of taxation is gradually changing, and currently a government led by the social democrats is cutting the 5% top marginal tax rate.

When taxes are simple to understand, voters can exercise pressure to keep them low. Those with an interest in expanding the size of government can turn towards the strategy of fiscal illusion (hiding taxes from the paychecks of the employees) as well as fiscal obfuscation (naming a tax, which is levied mainly on the wage of employees, as employers tax) – thus giving the false sense that it is not a tax on wage.

Such obfuscation is disingenuous but as Sweden’s experience shows, it’s something that works. Proponents of liberty and streamlined states should take note, and work to expose the true burden of government in the much-lauded Nordic model.

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Nima Sanandaji is an academic and author of books on Swedish policy issues, including 'Debunking Utopia: Exposing the Myth of Nordic Socialism'