Today, I’ll be summarizing this paper by Henrik Jacobsen Kleven. As usual, my notes will be in brackets [like this]. Let’s jump right in!
As many reading this well know, Scandinavian countries (Denmark, Norway, and Sweden here) face famously high tax rates. Top tax rates are in the range of 60–75% [and kick in at much lower incomes, as shown below].
[Taxes are high for lower incomes too, with Sweden having a VAT of 25% and a flat payroll tax of over 30%, for example).] The effective tax on entering employment (so combining normal taxes on labor income with withdrawal of benefits like unemployment insurance) is over 75%.
Yet, these countries still have high incomes and normal employment to population ratios. We’ll examine four major elements of their tax regimes in turn to explain this.
- Low tax evasion
- Low tax avoidance
- Public provision of goods that increase labor supply
- Social motivations
1. Third party information and tax evasion
Third party reporting is key to the Scandinavian system. Employers report taxes on employees, and the financial sector reports taxes on clients. Additionally, “tax enforcement benefits from information created by market transactions between the taxpayer and third-party agents. These are verifiable information trails created for non-tax purposes — credit cards, loan contracts, business partners, and so on — that potentially could be obtained by the tax authorities in order to construct true tax bases”. [The structure of value-added taxes similarly has an enforcement component built in.] These information trails increase as countries develop, so tax evasion is likely to get harder over time for a modernized system. This is especially relevant for folks like the self-employed, who otherwise have an easier time dodging taxes. Data from a field experiment backs up that information reporting matters a lot:
Denmark is a particularly strong case here: 95% of income is subject to third-party information reporting, and tax evasion among these incomes is only 2.2%! And when there is both substantial information reporting and withholding of taxes in the US, tax evasion is similarly small.
2. Tax bases, tax avoidance, and ETI
As I’ve discussed before, how much revenue you bring in from taxes relies on the ETI, or elasticity of taxable income. And, bigger tax bases and lower tax evasion lead to lower elasticities, and therefore raise revenues and lower economic distortions. “The more recent [ETI] estimates for Denmark fall in the range of 0.05–0.15, which is much smaller than the most-cited US estimates of around 0.4–0.5”. For reference, an ETI of 0.05 corresponds to a revenue-maximizing flat rate of 95%, compared to 67% for an ETI of 0.5 (formula proven here). But the estimates for the elasticity of broad income, which ignores tax expenditures that lower taxable income, are much lower in the US compared to ETI, while they are fairly close in Denmark. This suggests that the US’ high ETI is largely due to these expenditures. Research also finds that while these high top tax rates can lead top-earning foreign immigrants to move, the same is not true for natives, who make up the vast majority of the population.
3. Expenditure policies: Transfers and work subsidies
“The efficiency of a tax system cannot be fully understood without considering how the revenue is spent.” Scandinavian countries spend large amounts of money on childcare, elder care, transportation, and preschool. These are examples of welfare benefits that encourage work, rather than discourage it. If it’s easier for you to get to work and have time to work, you’re more likely to work. Cheap education, also well-funded, increases labor supply in the long run too. It’s fairly easy to gather data on labor participation rates and taxes to measure elasticity along the extensive margin (basically, how much taxes discourage working at all, vs. the intensive margin of how much taxes discourage working for a higher pay or longer hours). Shockingly, increased taxation is POSITIVELY correlated with labor participation for 20–59 year olds, especially for women. This suggests that the effect of the aforementioned government spending in increasing participation must be large. [And I’m sure the Nordics’ spending on active labor market policies serves a role too!]
Tax literature sometimes implies that we should have low or negative participation tax rates at the bottom of the income distribution, and programs that phase-in like the EITC (which overwhelmingly give benefits to families with kids) have been hailed on these grounds. However, Scandinavian countries have no such programs, yet better participation! The literature often overlooks that spending on these public services is possible, which is something to keep in mind while reading other papers. I’ll quote at length:
First, assuming that childcare demand is positively related to working, subsidies to child care boost labor supply and thus enhance the efficiency of income redistribution. … Second, because childcare subsidies represent a subsidy to labor force participation (by lowering the total effective distortion of labor supply on the extensive margin), it directly reduces the need for a low or negative tax rate on labor force participation through a policy like the EITC. If the optimal childcare subsidies are large, then it becomes very difficult to justify a policy like the EITC under realistic parameters.
In addition, investments in childcare and preschool are also investments in childhood development and education, the returns of which seem to be large. This only strengthens the argument for subsidized or even free childcare and preschool.
4. Social and cultural influences
Some suggest that the tax and welfare policies of Nordic countries are only possible due to a uniquely trusting and generous culture. While “Scandinavia features higher levels of trust than anywhere else in the world”, this could be a result of these very same policies. [While the authors discuss “willingness to pay taxes that finance redistribution to the poor”, Nordic countries generally have more universal welfare programs, which are likely not thought of as redistribution to the poor.] Overall, 10–15% of the Scandinavian population think poor people are lazy, compared to 60% of Americans. The overall tax rate in a country is positively correlated with what the authors call a social capital index, measuring civil participation, voting, and crime levels all together. It should be noted that it’s hard at a glance to determine causation between these factors [though the history of labor movements in these countries I think are instructive here, something I tend to write about in the future].
The success of Nordic taxation isn’t an accident. It’s backed by reliable ways to report income and collect taxes, and good economic theory on what goods the government should provide. There may be current cultural differences that separate out the Nordics as well, but what came first is a question outside the scope of this paper. [Personally, I find it shocking that the authors don’t mention the strong role that unions play. Union membership is high in the Nordics, and they increase solidarity, voting, and political knowledge.]