There are lessons to learn and not to learn from the Old Country
In 2008, with the rubble from Wall Street’s collapse still smoldering, pundits on both sides of the Atlantic trumpeted the death of American-style capitalism. In 2010, after the Greek debt crisis, journalists and scholars have been penning obituaries for European social democracy. Meanwhile, Republicans continue to warn that President Obama’s agenda would “Europeanize” the United States.
But what exactly does that mean? Western Europe is hardly a monolith. Taxes are low in Ireland but high in Norway, and labor markets are much more flexible in Denmark than in France. The region has innovation leaders (Switzerland, Sweden) and innovation laggards (Italy, Spain). Though allusions to “European health care” were ubiquitous during the Obamacare debate, health regimes vary significantly from country to country. All provide some type of universal insurance coverage, but the Swiss and Dutch systems are far more market-oriented than those in Britain and Scandinavia.
Across the pond, Washington has severely distorted health-care costs and incentives through tax subsidies (the employer exclusion) and government-run programs (Medicare, Medicaid). The public sector’s share of total U.S. health spending is already hovering around 50 percent. America does not guarantee universal coverage — yet — but it does not have a genuine free-market system, either. Instead, it relies on a wildly inefficient third-party-payer scheme, which has fueled rampant cost inflation. A 2008 McKinsey & Co. study found that “the United States spends $650 billion more on health care than might be expected given the country’s wealth and the experience of comparable members of the Organization for Economic Cooperation and Development (OECD).”
This is not meant to disparage American medicine — which remains a wellspring of innovative drugs and technologies — but rather to put the debate over “Europeanization” in context. The U.S. economic model emerged from unique historical, ethno-cultural, and geographical circumstances. Yet in contemporary policy debates, transatlantic differences are often exaggerated or misunderstood. Indeed, America’s vaunted commitment to free markets and limited government is less robust than is commonly believed.
That was true before Barack Obama entered the White House. Even after one controls for income inequality, a 2008 OECD study found, household taxes are more progressive in the U.S. than they are in any Western European country save Ireland. The World Bank and PricewaterhouseCoopers reckon that, through May 2009, the average total tax rate on U.S. companies was 46.3 percent, while the equivalent rates were 44.9 percent in Germany, 41.6 percent in Norway, 39.3 percent in the Netherlands, 35.9 percent in the United Kingdom, 29.7 percent in Switzerland, 29.2 percent in Denmark, and 26.5 percent in Ireland. According to the most recent World Bank list of the easiest places to pay business taxes, the U.S. ranks 61st out of 183 economies, behind France (59th), Sweden (42nd), Holland (33rd), Switzerland (21st), Norway (17th), the United Kingdom (16th), Denmark (13th), and Ireland (sixth).
Among all developing countries, only Japan has a higher average statutory corporate-tax rate than America. OECD figures show that, by mid-2009, the U.S. rate (including both federal and state corporate taxes) was 39.1 percent. In Western Europe, the corresponding rates ranged from 34.4 percent in France, to 26.3 percent in Sweden, to 12.5 percent in Ireland. As Tax Foundation economist Robert Carroll has observed, America’s combined corporate-tax rate went from nearly ten percentage points below the weighted OECD average (excluding the U.S.) in 1988 to more than eight points above it in 2009. America is the lone OECD member, Carroll adds, that taxes its multinational corporations on their foreign earnings from labor and services rendered at a rate greater than 30 percent.
In general, those earnings are not subject to U.S. taxation until they are repatriated. The Obama administration wants to scrap this policy, arguing (correctly) that it encourages U.S. multinationals to keep their profits abroad. Yet Carroll emphasizes that, given America’s steep corporate-tax rate, the deferral rule “helps place U.S. companies on a more level playing field with their foreign competitors.” Most OECD countries now have “territorial” tax systems, meaning they don’t tax their domestically based companies on their earnings from labor and services rendered abroad.
While U.S. corporate taxes are partially offset by assorted deductions, they are still quite onerous. After accounting for deductions and other tax breaks, University of Calgary economists Duanjie Chen and Jack Mintz estimate that the effective U.S. corporate-tax rate on new capital investments in 2009 was 35 percent, the highest in the OECD. Even when Chen and Mintz include the temporary “bonus depreciation” tax benefit that expired at the end of last year, the U.S. rate stood at 27.2 percent. By comparison, in high-tax Scandinavia, the effective rates were 23.8 percent in Norway, 19.6 percent in Finland, 19.5 percent in Sweden, and 18.2 percent in Denmark.
America’s corporate-tax regime has skewed investment decisions, hindered capital formation, and suppressed wages. It has also contributed to excessive leveraging on Wall Street: A 2005 Congressional Budget Office study found that the effective tax rate on equity-financed corporate capital income is 42.5 percentage points higher than that on debt-financed corporate capital income. In an era of increased capital mobility that will demand increased financial prudence, the U.S. should seek to reduce these distortions and bring its overall statutory rate down to a much lower level.
If that requires introducing a federal value-added tax to recoup lost revenue, the tradeoff is probably worth making. A 2008 OECD working paper concluded that corporate taxes are “most harmful for growth, followed by personal income taxes, and then consumption taxes.” Thus, a revenue-neutral, pro-growth tax overhaul would “shift part of the revenue base from income taxes to less distortive taxes such as recurrent taxes on immovable property or consumption.” As Urban-Brookings Tax Policy Center director Donald Marron puts it, “Not all tax increases — or tax cuts — are created equal.” Broadly speaking, the U.S. needs to tax consumption more and corporate income less; in that sense, it needs to become more like Western Europe.
As for labor income, the fact that Americans work longer hours than people in Germany and France — countries with higher labor taxes — suggests that the labor supply can be sensitive to marginal tax rates. Indeed, Nobel-laureate economist Edward Prescott has determined that “virtually all the large differences between the U.S. labor supply and those of Germany and France are due to differences in tax systems.” Back in the early 1970s, he notes, when labor-tax rates in the three countries were more comparable, Americans actually worked fewer hours per person than did the Germans and French. Prescott calculates that if France lowered its effective tax rate on labor income to the U.S. level, “the welfare of the French people would increase by 19 percent in terms of lifetime consumption equivalents. This is a large number for a welfare gain.”
Economist Richard Rogerson, a colleague of Prescott’s at Arizona State University, is another proponent of the idea that U.S.-European variations in labor supply are primarily attributable to variations in labor-income taxes. He cites Holland as an instructive example. The country’s average labor-tax rate climbed fairly steadily through the 1970s and reached its peak in 1983; since then, it has fallen substantially. Meantime, Dutch work hours declined consistently from the 1960s until the late 1980s, when they began a persistent upward trajectory. Holland offers “very persuasive evidence,” writes Rogerson, that labor taxes are closely associated with hours worked.
Given this association, it is no surprise that expanding government can harm economic output. Based on a detailed analysis of the recent empirical literature, Swedish economists Andreas Bergh and Magnus Henrekson conclude that, above a minimum threshold, government size in rich countries is negatively correlated with GDP growth. More specifically, when tax revenues increase by ten percentage points (as a share of GDP), annual economic growth tends to shrink by anywhere from half a percentage point to one percentage point — a major drop.
Government spending represents a heftier chunk of GDP in Scandinavia than it does in America, although this gap has been narrowing. To be sure, Denmark and Sweden are successful countries with impressive levels of income mobility. (Norway’s vast oil wealth makes it sui generis.) But Bergh and Henrekson stress that government size is not the sole determinant of economic prosperity. Institutional quality, tax-system efficiency, and culture also play key roles. “The United States is much more diverse than Scandinavia in ethnicity, level of education, competencies, and social fractionalization,” they write. “Hence, to the extent that a larger government blunts private incentives for productive activity, the behavioral effects are likely to be larger in the United States.”
For that matter, neither Denmark nor Sweden is as “socialist” as many people imagine, thanks to significant liberalization over the past three decades. Denmark is virtually tied with America in the 2010 Index of Economic Freedom (compiled by the Heritage Foundation and the Wall Street Journal), and its labor markets are the most flexible in Europe. After being rocked by a financial meltdown during the early 1990s, Sweden implemented a series of market-friendly structural changes, including bold pension reforms. The Index of Economic Freedom reports that both countries offer greater business freedom, trade freedom, monetary freedom, investment freedom, financial freedom, and property-rights protection, as well as lower levels of corruption, than does America, whose score has gone down partly because of government bailouts and interventions, and the lack of “transparency and accountability” in those actions.
World Economic Forum (WEF) data tell a similar story. As part of its annual Executive Opinion Survey, the WEF asks global business leaders to grade their country’s performance in a variety of areas. In the 2009 survey, America ranks far behind Denmark and Sweden in the following categories (among others): “property rights” (Denmark second, Sweden fifth, America 30th); “public trust of politicians” (Denmark second, Sweden sixth, America 43rd); “favoritism in decisions of government officials” (Sweden first, Denmark third, America 48th); “wastefulness of government spending” (Denmark 14th, Sweden 17th, America 68th); “burden of government regulation” (Sweden 19th, Denmark 27th, America 53rd); “transparency of government policymaking” (Sweden second, Denmark fourth, America 31st); and “regulation of securities exchanges” (Sweden first, Denmark seventh, America 47th).
In short, while the public sector consumes a larger slice of GDP in Scandinavia than it does in the U.S., the Danish and Swedish governments appear to operate more efficiently than their American counterpart. As the U.S. seeks to rejuvenate its economy while moving toward fiscal consolidation and addressing future demographic challenges, there are many lessons it can draw from Western Europe. But the virtue of big government is not among them.