The Agenda

Lane Kenworthy on the Impact of Heavy Taxation

Lane Kenworthy, a sociologist at the University of Arizona and by a considerable margin my favorite left-of-center blogger, has written a very insightful and data-rich post on whether “heavy taxation is bad for the economy“:

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.

Kenworthy suggests that a heavy tax burden hasn’t had a strongly negative, or indeed any discernibly negative, impact on the economies of Denmark and Sweden. 

(1) Though employment levels are lower in Denmark and Sweden than in the U.S. as measured by average hours of paid work per working-age person, Kenworthy attributes this to legally-mandated paid vacations in the northern European countries. Moreover, hours worked increased in all countries from 1977 to 2007.

(2) On household income, Kenworthy shares the following:

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.

I do wish that Kenworthy shared the absolute numbers here, as they are stark. 

At this point, Kenworthy asks the question on everyone’s mind:

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?

He advances a number of hypotheses:

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.

This strikes me as true enough — but it is trivially true if improving government performance is extremely difficult if not impossible given greater scale. If the growing tax take in Denmark and Sweden were channelled into a highly inefficient public sector, one assumes that the economic consequences would have been dire.

I’d also want to know the extent to which heavier taxation reflects net transfers. How much money is being taken out of one pocket and put back in the other? Moreover, public sector reforms that enhance choice could also play a confounding role. In Sweden, for example, the advent of comprehensive school choice could be seen as the functional equivalent of a (heavily discounted) tax cut. If the federal government were to charge me $10,000 more in taxes, but it then handed me an $8,000 voucher that I could spend on anything but firearms, alcohol, and crack cocaine, I wouldn’t be happy about it. But I’d be much happier than I would be if the federal government charged me $10,000 more in taxes and spent the money on a JDAM that was subsequently dropped on Winnipeg, just for laughs. This is an extreme example, but it is a reminder that initiatives like vakantiegeld in Holland — vacation loot that the government “gives” to you to spent on rest and relaxation — represent a kind of government-mandated consumption smoothing that are meaningfully distinct from other forms of public spending. 

If some form of Scandinavian exceptionalism is at work, Kenworthy’s findings could prove misleading to policymakers. 

 

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.

We have good reason to believe that flat consumption taxes are a relatively good way to generate revenue, so there is no dispute on that point. I will again ask, however, if we’re thinking about the Danish tax burden in the right way. How much of it constitutes out-of-one-hand, into-the-other pseudo-taxation?

Kenworthy hints at an explanation grounded in Scandinavian exceptionalism:

 

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.

A few questions I’d want to see answered before drawing any conclusions — I’ve benefited from a discussion of these issues with Arpit Gupta and from reading Tino Sanandaji:

(a) Kenworthy mentions homogeneity per se as an asset. But Scandinavian exceptionalism could be operating at a different level, i.e., social practices embedded in Danish and Swedish culture could foster the development of cognitive and noncognitive skills that facilitate economic success. How do Americans of Danish and Swedish origin fare economically relative to the median American? 

(b) Do Americans of Danish and Swedish origin derive economic benefits from living in regions with a high concentration of coethnics — are there gains from coordination?

(c) Might a history of enslavement and segregation have had a durable impact on the ability of a large share of the American population to accumulate assets and to flourish economically? 

(d) Family structure in Denmark and Sweden is markedly different than in the United States. Ellwood and Jencks find that while half of American 15-year-olds are raised in disrupted families, two-thirds of Swedish 15-year-olds live with both biological parents. Is it safe to assume that these differences in family structure will have no consequences for the earning potential of Scandinavian children as opposed to their American counterparts? Given what we know about the intergenerational transmission of assets and human capital, that seems unlikely. 

(e) And if we assume that differences in family structure have at least some negative consequences for Americans, why aren’t Denmark and Sweden much richer than the United States? Given the acknowledged superiority of Danish and Swedish public sector institutions, and particularly the greater efficacy of Danish and Swedish schools, wouldn’t we assume that these countries would be much richer than our own in a world of free capital flows?

My intuition should be fairly clear. Denmark and Sweden should be much, much richer than the United States. They are not. This is an interesting puzzle. One reason the U.S. is punching above its weight, so to speak, could be its relatively modest tax burden. 

All that said, I do think the U.S. can learn a great deal from the Danish and Swedish public sector. 

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