Misconceptions about the Nordic economies
24 October 2016
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The Nordic countries are usually mentioned in the Spanish political debate as examples of well-functioning and efficient Welfare States where the government provides citizens with a large range of social benefits. (The terms “Nordic” and “Scandinavian” will be employed interchangeably to refer to Sweden, Finland and Denmark. Norway and Iceland are excluded from my analysis.) Politicians, especially on the left side of the political spectrum, look at Sweden, Denmark, or Finland as successful social democratic experiments in which social entitlements are guaranteed by the benevolent and caring hand of the State. Their existence is conclusive evidence that those who question the sustainability of an unlimited expansion of the welfare state are wrong.
However, there exists a generalised misperception about the functioning of the Scandinavian economies. They are usually regarded as highly interventionist countries with hyper-regulated economies and very progressive taxation systems in which the upper classes sustain the welfare state by paying their so-called fair share. This widely-held view is fundamentally wrong for two main reasons. Firstly, far from being socialistic, the economic recipes that have led Denmark or Sweden to have sustainable welfare states are those usually identified with the free market: deregulated economies and flexible labour markets. Secondly, the burdensome taxation system in the Scandinavian countries is rather regressive; hence, the fiscal burden is essentially borne by low and middle classes.
Working in Scandinavia vs. Spain
The Nordics are ranked highly in the Index of Economic Freedom compiled every year by the Heritage Foundation. If one looks at the Business Freedom indicator, which shows the efficiency of governmental regulations of the private sector, Denmark, Finland, and Sweden appear in the top 15, whereas Spain is placed in the 44th position between Thailand and Uruguay. It seems obvious that there is a strong correlation between economic freedom and prosperity: those countries with greater economic, political, and social development occupy the top positions in the ranking. In fact, economic freedom (which includes a legal framework that enforces contracts and protects property rights) is the starting point that triggers the virtuous circle of economic growth: economic freedom leads to more investments in human and physical capital, which in turn results in higher productivity and, ultimately, in higher wages and increases in GDP per capita.
Since the GDP per capita based on PPP of the Nordic countries is, on average, 30% higher than that of Spain, due essentially to their higher degree of economic freedom, the amount of taxes collected to pay for their social spending is, in absolute terms, considerably higher; and would still be higher even if Spain and the Nordics shared the same tax rates, which is not the case.
In terms of flexibility of the labour market, Denmark stands out above both Spain and its Nordic neighbours. To begin with, firing costs in Denmark are very low. For instance, a white collar worker who was unfairly dismissed today would receive a compensation of maximum four months of salary after working for 10 years in the company. On the other hand, if the dismissal was considered to be fair, the employee would receive no compensation. In addition, there is no minimum wage established by law, and social contributions paid by employers on behalf of employees do not exceed 2% of the gross salary.
In contrast, the severance pay that the same employee would receive in Spain would amount to between 13 or 21 months of salary (depending on whether the new or the old legislation is applied), a fair dismissal would result in around eight months of pay in compensation, the legal minimum wage is 756€ a month (although the cost for the company is substantially higher), and social contributions borne by the company account for one-fourth of the gross salary.
Putting the Tax Burden on the Poor
As for the taxation system, Scandinavian citizens are compelled to endure heavy tax burdens. For instance, the tax burden in Sweden, that is, the tax revenue as a percentage of GDP, is 42.8 percent, far higher than the tax burden in Spain. However, contrary to what is widely believed, this large difference is due to the regressiveness of the Swedish taxation system when compared to the Spanish one. In other words, it is not so much high-income earners who pay the Welfare State bill, but the lower and middle classes via indirect taxes, which are obviously more regressive than taxes on labour or on capital gains. As shown by the graph below, the most striking difference between Spain and Sweden in this regard lies in the higher tax rate on consumption applied in the Nordic country.
Source: Rallo, J. R. (2016). La pizarra de Juan Ramón Rallo: Los 40 mitos de la economía española. Barcelona: Deusto.
As shown in the analysis above, free-market economic policies and regressive taxation systems are the pillars on which the Nordic economies rest. The fiction, deeply embedded in the social democratic consensus à la Spain, that an expanding welfare state is compatible with an overregulated economy, an inflexible labour market, and a progressive taxation system (all of them typical characteristics of the dysfunctional Spanish economy) is untenable. The advocates of the Welfare State on both sides of the political spectrum should realize that the only way to make it viable and sustainable in the long term is to undertake reforms that liberalize the economy and to further increase the already heavy tax burden that low and middle classes have to bear.
This article was first published by the Foundation for Economic Freedom (FEE).
However, there exists a generalised misperception about the functioning of the Scandinavian economies. They are usually regarded as highly interventionist countries with hyper-regulated economies and very progressive taxation systems in which the upper classes sustain the welfare state by paying their so-called fair share. This widely-held view is fundamentally wrong for two main reasons. Firstly, far from being socialistic, the economic recipes that have led Denmark or Sweden to have sustainable welfare states are those usually identified with the free market: deregulated economies and flexible labour markets. Secondly, the burdensome taxation system in the Scandinavian countries is rather regressive; hence, the fiscal burden is essentially borne by low and middle classes.
Working in Scandinavia vs. Spain
The Nordics are ranked highly in the Index of Economic Freedom compiled every year by the Heritage Foundation. If one looks at the Business Freedom indicator, which shows the efficiency of governmental regulations of the private sector, Denmark, Finland, and Sweden appear in the top 15, whereas Spain is placed in the 44th position between Thailand and Uruguay. It seems obvious that there is a strong correlation between economic freedom and prosperity: those countries with greater economic, political, and social development occupy the top positions in the ranking. In fact, economic freedom (which includes a legal framework that enforces contracts and protects property rights) is the starting point that triggers the virtuous circle of economic growth: economic freedom leads to more investments in human and physical capital, which in turn results in higher productivity and, ultimately, in higher wages and increases in GDP per capita.
Since the GDP per capita based on PPP of the Nordic countries is, on average, 30% higher than that of Spain, due essentially to their higher degree of economic freedom, the amount of taxes collected to pay for their social spending is, in absolute terms, considerably higher; and would still be higher even if Spain and the Nordics shared the same tax rates, which is not the case.
In terms of flexibility of the labour market, Denmark stands out above both Spain and its Nordic neighbours. To begin with, firing costs in Denmark are very low. For instance, a white collar worker who was unfairly dismissed today would receive a compensation of maximum four months of salary after working for 10 years in the company. On the other hand, if the dismissal was considered to be fair, the employee would receive no compensation. In addition, there is no minimum wage established by law, and social contributions paid by employers on behalf of employees do not exceed 2% of the gross salary.
In contrast, the severance pay that the same employee would receive in Spain would amount to between 13 or 21 months of salary (depending on whether the new or the old legislation is applied), a fair dismissal would result in around eight months of pay in compensation, the legal minimum wage is 756€ a month (although the cost for the company is substantially higher), and social contributions borne by the company account for one-fourth of the gross salary.
Putting the Tax Burden on the Poor
As for the taxation system, Scandinavian citizens are compelled to endure heavy tax burdens. For instance, the tax burden in Sweden, that is, the tax revenue as a percentage of GDP, is 42.8 percent, far higher than the tax burden in Spain. However, contrary to what is widely believed, this large difference is due to the regressiveness of the Swedish taxation system when compared to the Spanish one. In other words, it is not so much high-income earners who pay the Welfare State bill, but the lower and middle classes via indirect taxes, which are obviously more regressive than taxes on labour or on capital gains. As shown by the graph below, the most striking difference between Spain and Sweden in this regard lies in the higher tax rate on consumption applied in the Nordic country.
Source: Rallo, J. R. (2016). La pizarra de Juan Ramón Rallo: Los 40 mitos de la economía española. Barcelona: Deusto.
As shown in the analysis above, free-market economic policies and regressive taxation systems are the pillars on which the Nordic economies rest. The fiction, deeply embedded in the social democratic consensus à la Spain, that an expanding welfare state is compatible with an overregulated economy, an inflexible labour market, and a progressive taxation system (all of them typical characteristics of the dysfunctional Spanish economy) is untenable. The advocates of the Welfare State on both sides of the political spectrum should realize that the only way to make it viable and sustainable in the long term is to undertake reforms that liberalize the economy and to further increase the already heavy tax burden that low and middle classes have to bear.
This article was first published by the Foundation for Economic Freedom (FEE).
3 thoughts on “Misconceptions about the Nordic economies”
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via indirect taxes, which are obviously more regressive than taxes on labour or on capital gains
Indirect taxes aren’t regressive. They are flat. If you mean less progressive, then you should say that.
Unless there is some class of goods that the rich buy and the poor don’t then everyone is paying the same rate. (I know savings aren’t taxed — except they are when they are spent, so they are taxed after all. Unless you think holding money in the bank and never using it is an option.)
In NZ at least the VAT (GST) isn’t regressive, because land and rent are charged at zero. Since a poor person spends comparatively more of their money on rent than a richer one, the poor are slightly advantaged. If food is charged at a lower rate than say air fares and cars, then the VAT will actually be slightly progressive.
Implicit tax rates are a very silly way of comparing things – percentages are only meaningful if you are comparing apples and apples, and not always then. The rich spend more and so pay more consumption taxes. The fact that the poor save very little and so pay tax on most of their spending whereas the rich save and pay no tax on that reduces the headline rate but produces a meaningless result because it doesn’t actually tell you what is going on.
And as the first poster comments, if (like the UK) essentials (e.g. rent, food, children’s clothes) are free of tax, then the poor will be paying very little tax at all.
A quick check of your claim about tax as a percentage of GDP would show you that the tax burden cannot possibly be mostly on the poor, as the poor produce very little GDP. That’s why there are poor.
Hi Chester Draws & Tim Hammond,
First of all, thanks for your insightful and respectful comments. Also, my apologies for not replying before, I didn’t even know that the IEA had published my article on the Nordic economies!
Chester Draws,
Strictly speaking, you’re totally right. That’s the reason why I use the expression “more regressive than” and I talk about “the regressiveness of the Swedish taxation system WHEN COMPARED TO the Spanish one”. Maybe I should have used the expression “less progressive than.” Nonetheless, bear in mind that, even though they pay the same tax rates, lower and middle classes spend a higher percentage of their income in consuming goods and services, so consumption taxes have a higher impact on them. Therefore, indirect taxes tend to be more regressive for this reason.
Regarding your last comment, it’s true that in some countries like Spain, food and other goods are taxed at lower rates than, say, books or movies. However, this is not the case in Denmark where the VAT is 25% for all goods and services.
Tim Hammond,
Eurostat uses implicit tax rates to compare the tax systems in different countries because it gives you an accurate picture of how taxes are distributed. In other words, it tells you where taxes come from: consumption, labor or capital. For a more detailed explanation of how these implicit rates are calculated, see http://ec.europa.eu/taxation_customs/sites/taxation/files/resources/documents/taxation/gen_info/economic_analysis/tax_structures/2014/report.pdf , pp. 281-284.
As I mentioned above, in Denmark, for instance, there is only one rate for all goods and services: 25%. In Sweden, it is true that there are three rates, but the reduced rates are applied to a few things and the standard rate is also 25%.
I don’t say in my article that the tax burden is mostly on the poor but on “the lower and middle classes”. And this is so in all modern Welfare States, but it is more pronounced in the Nordics due to two factors: first, their reliance on indirect taxes to fund their Welfare States; second, the higher labor tax rates that lower classes pay in the Nordics. In fact, the 6 percentage-point difference between Spain and Sweden (see graph) comes essentially from the lower classes paying more taxes on labor.
Thanks again for your respectful comments.
Kind regards,
Luis Pablo de la Horra