15 January 2015

The Nordic model is about more than high taxes


How can Scandinavians tax so much? This is the question that Henrik Jacobsen Kleven, professor of Economics at London School of Economics, explores in a new paper. The author gives a number of valuable insights. To begin with, Scandinavian welfare policies are not as progressively tilted towards income distribution as foreign observers might assume. Much of public spending is “subsidization of goods that are complementary to working”. This means that governments pay for programs such as care of children and the elderly, so that working age individuals can focus more effort on their careers.

Several programs, such as child care and social safety nets, are tailored for those who work or who recently have lost their jobs. Long-term unemployed individuals and those who have never entered the labor force can typically rely on less generous systems. Conservative ideals about workfare have for long underpinned Nordic welfare systems. Also, pragmatic system design plays in. For example, in the UK and the US families that make the transition from unemployment to work can lose not only welfare support but also the benefits of subsidized housing. The welfare systems create poverty traps through skewed incentives. Scandinavian systems have more generous income safety nets, but have largely avoided stacking means-tested benefits on top of each other.

Kleven notes that Scandinavian countries have efficient systems for tax collection. International comparisons such as “Paying Taxes” confirm that the Nordic models have less tax bureaucracy. The same medium sized firm that would spend 175 hours on making eleven tax payments in the US would spend 107 hours on seven payments in the average Nordic country. As a comparison, eight payments and 110 hours are needed in the UK. In addition, Scandinavian tax systems are broad, based on taxing even those with medium and low incomes at relatively high levels. Anglo-Saxon countries have more re-distributive systems, relying less on taxing those with meager incomes. The flat tax nature of the Scandinavian countries, coupled with a welfare system tailored to work, reduces the effects of taxes on incentives. Proponents of Nordic welfare models in Anglo-Saxon countries often forget that the policy would entail considerably higher taxes on those with low incomes, and a range of public subsidies to middle-class families. Scandinavian welfare policy is not the same as progressive liberal policy.

Having said this, it is important to remember that the affluent Nordic countries would have been even more affluent with lower tax rates. 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 on labour would have such a damaging effect on the economy that not even tax revenues are expected to 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 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.

Other research supports that reductions of the highest tax rates would not only boost growth, but have little if any impact on tax revenues. As an example, economist Åsa Hansson has calculated the efficiency loss for each additional Krona levied and spent by the Swedish government. This loss can according to Hansson be up to three additional Krona if the money is spent on public handouts which reduce the incentives for work.

As I have argued in the paper “The surprising ingredients of Swedish success – free markets and social cohesion” published by the Institute of Economic Affairs, history and culture also matters. Sweden for example did not become wealthy through social democracy, big government and a large welfare state. The nation developed by adopting free-market policies in the late 19th century and early 20th century. It also benefited from positive cultural norms, including a strong work ethic and high levels of trust. These norms, which had been built up during several generations, gradually deteriorated as a consequence of the shift towards generous welfare and high taxes. In response, Swedish politicians reduced taxes and benefits to strengthen workfare.

The Danish Social Democratic government has been keen on following in the same steps. A report published by the government in 2013 concluded that fully 400 000 citizens have little economic incentives to participate in the labour market. This is a significant figure in a country whose working age population is below three million. The reason is that the combination of taxes and benefits means that these individuals lose 80 percent or more of their incomes when entering the labour market. Through extensive reforms of taxes and benefits the Danish government hopes to reduce this group to 250 000 individuals.

So, although true that system design matters, Nordic countries are not immune to the effects of high taxes and generous welfare. It is no coincidence that the generosities of the welfare systems have been scaled back over time in particularly Sweden, Denmark and Finland. Oil‑rich Norway remains alone in clinging to a system with little incentives for work. The result is amongst others a sharp deterioration of working ethics amongst the youth and high levels of dependency on public handouts. After the recent center-right victory, even Norway seems on the path of workfare reform. Relying on overly generous welfare and high taxes is not a winning strategy. Not even in Scandinavia.

Dr Nima Sanandaji is an academic and author of books on Swedish policy issues, including tax law, welfare, and women's career opportunities. He has also worked on reports for the Centre of Policy Studies and the Institute of Economic Affairs.