Taxes reduce the payoff to entrepreneurship, investment, and work effort. If taxation is too heavy, these disincentives will weaken a nation’s economy. But at what point does the harmful impact kick in? And how large is it?
A puzzle
Half a century ago, in 1960, taxes totaled about a quarter of GDP in Denmark, Sweden, and the United States. The tax take then began to rise in Denmark and Sweden, reaching half of GDP by the mid-1980s, where it has remained. In America it has barely budged, hovering between 25% and 30% of GDP throughout the past five decades.
Has heavy taxation hurt the Danish and Swedish economies? If so, how much?
Begin with GDP per capita. America’s is higher than Denmark’s or Sweden’s. But that’s a legacy of the distant past. Growth of per capita GDP in the three countries has been virtually identical, both in the five decades since 1960 when the divergence in tax levels began and in the three decades since the 1970s (shown in the chart) when the tax difference has been most pronounced.
(Here and throughout I use 2007, the peak year of the pre-crash business cycle, as the end point. Adding the crash and its aftermath would improve the standing of Denmark and Sweden relative to the U.S.)
Each year since 2001 the World Economic Forum has scored most of the world’s countries on a “competitiveness” index. The index aims to assess the quality of twelve components of a nation’s economy: institutions, infrastructure, macroeconomic stability, health and primary education, higher education and training, goods market efficiency, labor market efficiency, financial market sophistication, technological readiness, market size, business sophistication, and innovation. In 2007 Denmark and Sweden were judged to be nearly identical to the United States in competitiveness. That was true throughout the decade. It also was true for the “innovation” components of the index in particular.
Employment, measured as average hours of paid work per working-age person, is a little lower in Denmark and Sweden (more here ). A larger share of working-age Danes and Swedes are employed — around 76%, compared to 72% in the U.S. But employed Danes and Swedes tend to work fewer hours than employed Americans — about 1,600 per year versus 1,800. This is due in large part to the fact that Danes and Swedes have more than five weeks of legally-mandated paid vacations and holidays, whereas Americans have none. This gap, in turn, is a function of historical differences in the strength of unions.
Employment hours increased between 1979 and 2007 in all three countries. The rate of growth was fastest in Denmark, followed by the U.S. and then Sweden.
Household income (after taxes and transfers) is higher in the United States at the ninetieth percentile (p90) of the distribution and at the median (p50). This owes to differences in per capita GDP, in income inequality, and in the degree to which citizens receive their income in the form of (tax-financed) public services. Here too the U.S. has not gained ground in recent decades. Household incomes in the middle of the distribution have grown more rapidly in Denmark and Sweden than in the U.S. (shown in the chart), and at the ninetieth percentile they’ve increased at about the same pace.
At the tenth percentile (p10), incomes are higher in Denmark and Sweden. And they’ve increased more. (See here and here.)
Denmark and Sweden have done better than the United States at keeping government debt in check.
Have high taxes required a sacrifice of liberty? Not according to the Freedom House measure of civil liberties or the Heritage Foundation-Wall St. Journal measure of economic freedom.
Finally, consider two social indicators of well-being: life expectancy and life satisfaction. On both counts, Danes and Swedes fare, on average, just as well as or better than their American counterparts.
If heavy taxation has harmful economic effects, why have Denmark and Sweden performed similarly to the United States during a period of several decades in which their taxes were much higher than America’s?
Three explanations that sidestep the puzzle
One common explanation is that small size facilitates administrative efficiency. The Danish and Swedish governments can function effectively because their scale is manageable. They are “big” governments, but in small countries. This might be true, but to say that heavy taxation isn’t a problem if government works well is to say that heavy taxation isn’t in and of itself a problem.
A second explanation looks to the mix of taxes countries use. The Nordic countries rely disproportionately on consumption taxes; in 2007 consumption taxes totaled 16% of GDP in Denmark and 13% in Sweden, compared to just 5% in the U.S. These are said to create less in the way of investment and work disincentives than do taxes on individual and corporate income.
Yet there is a sizeable difference in income taxation too. In the U.S. income taxes were 14% of GDP in 2007, versus 19% in Sweden and a whopping 29% in Denmark. More important, to suggest that heavy taxation isn’t harmful given an effective tax mix is to suggest that a high level of taxation per se is not necessarily harmful.
A third explanation points to tax compliance. Each April most Swedes receive a pre-prepared tax form. The relevant information about income, deductions, and the amount still owed or to be refunded has already been filled in by the Swedish Tax Agency. If the information is correct, the taxpayer simply confirms that by mail, telephone, or text message. Pre-prepared tax returns not only are more convenient for taxpayers; they also reduce cheating. Greater compliance, in turn, is likely to make heavy taxation more workable. If cheating is extensive, tax rates need to be higher in order to raise a given quantity of revenue, which increases the likelihood of disincentive effects on entrepreneurship, investment, and work effort. In a tax system with minimal cheating, more revenue can be raised at moderate tax rates.
This can’t be done in the United States, so the argument goes, because the American tax code (unlike its Swedish counterpart) has too many available deductions and rebates. But the U.S. could simplify its tax code to enable pre-preparation. Moreover, even with this advantage, income tax rates in Denmark and Sweden are a good bit higher than in the U.S. And a large portion of Danish and Swedish tax revenues come via payroll and/or consumption taxes, which are less vulnerable to evasion, in those countries and in the U.S. as well.
Two explanations that attempt to address the puzzle
Here are two accounts of Danish and Swedish economic performance that don’t sidestep the question of tax levels’ impact.
The first is hypothetical; I don’t know of anyone who’s offered this argument explicitly. It says that the adverse effect of taxation kicks in once a country passes 15% or 20% or 25% of GDP, and it doesn’t worsen the farther beyond that you go. Denmark, Sweden, and the United States each exceeded 25% already by 1960, so in this story we would expect the three countries to have experienced similar (poor) economic performance in subsequent years.
This hypothesis doesn’t strike me as especially compelling. None of the world’s rich nontiny democracies have had tax levels below 25% of GDP since the 1970s, and only a few have been below that level since 1960. Yet a number of these countries have had relatively good economic outcomes during this period.
A second explanation says the Danish and Swedish economies have performed similarly to America’s despite heavier taxes because they have some advantage(s) that I haven’t adjusted for. This certainly would be true if I had chosen Norway as one of the comparison countries. Norway’s economy has been boosted by extensive oil resources. Has Denmark or Sweden had any such advantage?
One possibility is catch-up. Laggard countries can get an economic growth boost by borrowing technology from the leaders. But this has become less relevant for Denmark and Sweden in recent decades, as they’ve invested heavily in education and R&D and become technological leaders in their own right (more here).
Ethnic and cultural homogeneity is sometimes mentioned as a key economic asset of the Nordic countries. This might help, though in rich nations diversity may have some benefits as well.
Corporatist policy making, which features institutionalized participation by business and labor representatives, is associated with faster economic growth in affluent countries in recent decades. This may have helped Denmark and Sweden. Yet both countries have made their share of policy mistakes.
Of course, the United States has some important advantages of its own, including a huge domestic market, excellent universities, a culture that prizes innovation and entrepreneurship, a well-developed venture capital system, bankruptcy laws that facilitate risk-taking, a tradition of regional mobility, and an attractiveness to talented immigrants. The question is: If taxation at Danish and Swedish levels has a significant negative economic effect, do Denmark and Sweden have advantages relative to the U.S. that are large enough to have fully offset that effect in recent decades? It’s a difficult question to answer with any certainty, but I think probably not.
A challenge
At what point does the harmful impact of taxes on the economy kick in? And how large is it? The Danish and Swedish experiences over the past generation pose a challenge for those who believe the answers to these two questions are “somewhere below 50% of GDP” and “large.” It’s a challenge that in my view has yet to be met.
perhaps the answer simply lies on the expenditure side – taxes pay for government expenditures, public goods, that complement private sector activity (and maybe even transfers that limit costly social problems, if you buy such stories).
A way to change open minds is Socratic questions.
In the case of taxes, ask not about the peak of Laffer curves for income taxes, but ask what difference would there be if the topic was instead poverty traps.
How high can effective marginal withdrawal rates go on unemployment benefits, family allowances and old age pensions and so on before they have major effects on the labour supply?
Making work pay is the theme in that literature.
One could also add that both of Denmark and Sweden had substantial surpluses on their government budgets for many years before the crisis.
The US consistently had deficits.
So sound policy in Denmark and Sweden. Using the good years to prepare for the tough ones.
Military expenditures are a large and unproductive part of USA GDP. Without that, money could go towards productive education, research and infrastructure investment. That would tilt the scales in the USA’s favor. Factoring in the physical resources advantages of the USA would have the opposite effect. Robust regression analysis of a wide range of potentially causal mechanisms for all of the top 100 or so economies should provide reasonable quantitative estimates of causal mechanisms and the shape of the taxation response curve.
Three questions:
(1) How do marginal tax rates compare? This is what’s most relevant for incentives, not taxes as a share of GDP.
(2) It seems that you swept the catch-up effect under the rug. If these countries have lower GDP per hour worked, then they either have lower technology or they have lower capital per person. If the former, they can grow faster by adopting technology (that they are a leader in some areas is irrelevant here), and if the latter they can grow faster by accumulating capital. So in either case, they should be growing faster, but they aren’t. Why not?
(3) Why are we focusing on just 2 countries? There will always be outliers when we’re trying to fit a pretty simple model to a lot of countries. If we compare tax rates, growth rates, and employment across all European countries and the US, we will see a pretty consistent pattern, yes?
@Jon: “If we compare tax rates, growth rates, and employment across all European countries and the US, we will see a pretty consistent pattern, yes?”
I doubt it very much. If high taxes and socialism were so bad, if the european model were so awful and the US were so great, we should see big differences in productivity between the US and Europe, the way we did between the US and USSR. You just don’t see such obvious differences. Which to me means that all the scaremongering by the American right is just what it looks like: total BS. As our host says, it’s a challenge yet to be met.
@Jon: “(2) It seems that you swept the catch-up effect under the rug. If these countries have lower GDP per hour worked, then they either have lower technology or they have lower capital per person.”
But how do you know they have a lower GDP per jour worked? Not from the statistics above. They only tell us that while working hours per worker are comparable, GDP per head (not per worker) is lower. So this could also be the outcome of fewer “workers per capita”, i.e. longer education & earlier retirement.
It was wise to choose Scandinavia as a case study because the evidence about at what point does the harmful impact of taxes on the economy kick in is far more compelling for the EU members further south.
During the 1970s Sweden was the fourth richest OECD country. During more recent decades, Sweden’s position has varied both down to 14th place and up again to 9th after economic reforms in the 1990s brought on by prior stagnation and an economic crisis.
Building on the post by Chris, Richard Rogerson, 2008. “Structural Transformation and the Deterioration of European Labor Market Outcomes”, Journal of Political Economy found that:
1. Hours worked per adult in France, Germany, Italy Europe decline by almost 45% compared to the US since 1956
2. The decline occurs at a steady pace from 1956 until the mid 1990s, in contrast to the fact that the relative increase in unemployment occurs in the mid 1970s.
3. The decline in hours worked in Europe is almost entirely accounted for by the fact that Europe develops a much smaller service sector than the US.
4. Relative increases in taxes and technological catch-up can account for most of the differences between the European and American time allocations to the market and outside over this per.
Ohanian, Rao and Rogerson 2008 in “Work and taxes: allocation of time in OECD countries” found
1. A steep decline in average hours worked per adult and large variations across OECD member countries in the magnitude of this decline.
2. Changes in labor taxes accounted for a large share of the trend differences.
3. Countries with high tax rates devote less time to market work, but more time to home activities, such as cooking and cleaning.
4. This reallocation of time from market work to home work is much stronger for females than for males.
The failure to apply gender analysis in progressive left defences of high taxing welfare states is deeply disappointing.
The higher elasticities of labour supply of women, and married women and mothers are beyond dispute. Modern empirical labour economics as led by Mincer was built around explaining female and joint labour supply.
Richard Rogerson, 2007 in “Taxation and market work: is Scandinavia an outlier?” Economic Theory, found that how the government spends tax revenues when assessing the effects of tax rates on aggregate hours of market work.
1. Different forms of government spending imply different elasticities of hours of work with regard to tax rates.
2. While tax rates are highest in Scandinavia, hours worked in Scandinavia are significantly higher than they are in Continental Europe with differences in the form of government spending can potentially account for this pattern.
3. There is a much higher rate of government employment and greater expenditures on child and elderly care in Scandinavia.
Examining how tax revenue is spent is central to understanding labour supply effects.
1. If higher taxes fund disability payments which may only be received when not in work, the effect on hours worked is greater relative to a lump-sum transfer.
2. If higher taxes subsidise day care for individuals who work, then the effect on hours of work will be less than under the lump-sum transfer case.
Scott Sumner has done work on this very point.
In general, his argument is that underneath the high tax rates, both Sweden and Denmark are more classically liberal economies than almost all other places.
As an example, recently, when Ford wanted to unload Saab the Swedish rather said that “well, if no one wants to buy it then it should close rather than get government support” which contrasts quite nicely with GM/Chrysler.
Wirth looking around for his formal papers on the point.
Thanks Tim for the reminder,
Sweden and Denmark are good examples of Gary Becker’s idea that political systems converge on efficient modes of regulation and income redistribution as their deadweight losses grow.
The deadweight losses of taxes, transfers and regulation limit inefficient policies.
Policies that are found to significantly cut the total wealth available for redistribution by governments are avoided relative to the germane counter-factual, which are other even costlier modes of wealth redistribution.
The rising deadweight cost of taxes and regulation progressively enfeebled the subsidised groups, allowing others to regain the initiative after the 1970s.
Post-1980 trends in taxes, spending, and regulation across the OECD reflect demographic shifts, more efficient taxes, more efficient spending, a shift in the political influence from the taxed to the subsidised, shifts in political influence among taxed groups, and shifts in political influence among the subsidised groups.
A commitment to flat marginal tax rate structures, high VAT rates, and light taxes on income from capital and companies are common in Nordic countries.
More on the Nordic Left and, more importantly, the Nordic median voter are more alive to the power of incentives and to not killing the goose that laid the golden egg.
Jim:
The Rogerson 2007 (Economic Theory) paper is the most relevant of the ones you mention. The problem he tries to resolve is that the (negative) correlation between tax levels and work hours is strong for the U.S. and continental Europe but breaks down when the Nordic countries are included. Rogerson points to different ways governments spend their tax revenues: “the elasticity of hours worked with regard to tax rates is very much dependent on how tax revenues are spent, and the distinctive features of Scandinavian government spending programs can account for much of the apparently different effects of taxes in Scandinavia” (p. 60). Specifically, the Nordic countries provide a lot of child care and other family services that both employ people directly and facilitate employment by mothers.
The idea is that high taxes push Scandinavians out of work, but government jobs and child care pull them in. This is quite plausible in principle, but I don’t think it’s what’s actually going on. First, the argument Prescott, Rogerson, and others make about the impact of tax levels on work hours focuses on willingness to work, rather than availability of jobs. If taxes are high and that discourages people from working (longer), the effect should apply no less to a public-sector job than to a private-sector one. Second, the child care argument also doesn’t work well. Child care is abundant and affordable in the U.S. Much of it is low quality, but that hasn’t deterred Americans from using it (see David Blau’s book, The Childcare Problem).
The Denmark-Sweden vs. United States difference in work hours owes mainly to mandatory paid vacations and holidays, which is largely a function of unions and social democratic parties. We could tell a story in which Danish and Swedish unions lobbied hard for more vacation time because they recognized that high taxes were severely reducing the payoff to work for their members, whereas American unions refrained because they realized that low taxes made work a wiser choice than leisure for their members. I don’t think that story fits well with actual history. The difference is union (economic and political) strength, not (tax-influenced) union preferences.
Lane
High taxes are most certainly bad for the only economy that matters: my personal economy. More taxes means I have less money to spend on food, shelter, transportation, and recreation. High taxes have forced me to do less activities that enrich my life. My tax dollars are being spent on wars and banker bailouts and other shit that is of no use to me.
Taxes hurt all 310 million economies in the USA, and all 6 billion economies in the world.
Thanks Lane for your detailed and most thoughtful reply. Hit the mark well.
Prescott and many that followed him were indeed truly puzzled by the lack of a role for employment mandates, employment protections and product market regulation in European economic performance. I am too.
Rogerson is a very sharp fellow indeed and most any thing he writes is worth a look.
A non-technical note by Rogerson similar to what you have blogged is at http://www.american.com/archive/2010/july/labor-pains with these key points:
1. Europe’s taxes punish working outside the home, so Europeans don’t work as much as they would otherwise.
2. dramatic differences in the overall change in hours worked per person aged 16 to 64 across countries between 1960 and 2000;
3. At one extreme the U.S., with an increase of 10 percent between these two dates;
4. At the other extreme are Germany and France, with declines of more than 30 percent;
5. For the U.S. and France, the difference is staggering—more than 45 percent;
6. Richard Freeman and Ronald Schettkat (2001) studied time allocation by married couples in Germany and the United States.
7. Their striking finding is about total time devoted to work (i.e., market work plus home production) turns out in the two countries is virtually the same.
In The Impact of Labor Taxes on Labor Supply: An International Perspective (AEI Press, 2010) Rogerson finds that:
• a 10 percentage point increase in the tax rate on labor leads to a 10 to 15 percent decrease in hours of work.
• Even a 5 percent decrease in hours worked would mean a decline in labor output equating to a serious recession.
• While recessions are temporary, permanent changes in government spending patterns have long-lasting repercussions.
• Although government spending provides citizens with important benefits, such benefits must be weighed against the disincentive effects of increased labor taxes.
• Policymakers who fail to account for the decrease in labor output risk expanding government programs beyond their optimal scale.
Jim, as I recall that Schettkat paper went even further (please note I’m not an economist, rather a part time journo who enjoys writing contrarian pieces and that paper is one I wrote on) and stated that the average German housewife is doing more labour hours than her US equivalent. Only 30 minutes a week, but still….
And still very much as an amateur I do wonder about those who say that it doesn’t really matter the division between household and market hours. For only in market hours can we have anything more than the most basic division and specialisation of labour. Which would imply that 40 market hours would offer us a greater return than 40 hours of household production in actual output that can be consumed.
Thanks Tim,
Estimating and comparing time use inside and outside of the workplace is hard to do. plenty of doubtful data.
Rogerson and others are investigating the relative size of service sectors and the lack of low-paid service worker jobs in Europe because these are proxies for doing it for yourself at home because there is no income tax and VAT to pay.
I was just thinking that legal mandates for longer annual vacations, more public holidays and strong employment protections in Europe could be part of the effects of their higher taxes. They are not independent phenomena.
Interest groups including unions lobby for durable benefits that are hard to tax such as more leisure time and greater job security.
My previous attempt at originality about mandates for longer annual vacations, more public holidays and strong employment protections in Europe being an effect of their higher taxes turned out to be a flash-back.
• Mincer (1981) attributed this magnification in the demand for fringe benefits to the fact that union members are more highly paid and hence face higher marginal tax rates.
Unions will lobby governments for what they cannot win in collective bargaining.
Unions in countries with high marginal tax rates have even more reason to seek mandated fringe benefits.
Fringe benefits such as longer annual vacations, more public holidays and strong employment protections benefit the median voter in unions. These voters will be more senior in job tenure and, as insiders, are less sympathetic to the costs of these fringe benefits to outsiders.
Legal mandates for more annual and public holidays and stronger employment protection are all part of the deadweight losses of high marginal tax rates.
The debt numbers seem too idiosyncratic. The USA fought two wars recently which if I remember correctly cost O($1 trillion).