Worthwhile Canadian Initiative

Is a need for fiscal stimulus a symptom of a poorly-designed social safety net?

In the debates on the need for a fiscal stimulus, both sides generally agreed that this particular policy instrument is one of the clumsiest available to policy makers. The dangers are well-known and well-documented: getting the timing wrong, getting the targets wrong, political interference, the risk of seeing a temporary spending program turn into a permanent one, et cetera. Those who advocated stimulus accepted all this, but argued than once monetary policy hit the zero interest rate bound (ZIRB), it was the only counter-cyclical measure available to us.

(I'm going to interpret "us" fairly broadly here. Ex post, it's not clear that Canada really needed much in the way of fiscal stimulus; monetary policy seems to be working. Ex ante, we didn't have the luxury of a lengthy discussion on this topic; the ZIRB was coming up fast, and we needed to think about what would happen if we hit it. In the US, of course, things have turned out much less well.)

But here's a question: Why was a discretionary fiscal policy necessary? Why weren't the automatic stabilisers enough?

This question is promoted by the following passage:

The Nordics in the global crisis: [T]he Nordic model itself contributes to resilience. The comprehensive safety net, one of the attributes of the Nordic model, has proved to be robust also in times of crisis. The entitlements are not tied to the fate of individual companies or particular markets, and risks are widely shared in the society. While forest plants are shutting down in Finland and car manufacturing is sharply contracting in Sweden, the governments are firmly rejecting requests for support of ailing industries. Still, there are no crowds protesting in the streets, largely because flexible work arrangements, based both on general and company-specific agreements between businesses and labour, alleviate a rise in unemployment. Structural change is enhanced by the employment protection legislation, which is more liberal than in most other EU countries. A well-educated labour force, another of the attributes of the Nordic model, facilitates adjustment by making it easier to upgrade skills through additional training.

Why doesn't our fiscal stimulus look like this? Wouldn't these sorts of programs be a better use of public money than setting up photo opportunities with oversized cheques?

Ethnic diversity and the Nordic model

There seems to be a consensus of opinion on the Nordic model around two points:

1. It's admirable.
2. It can't be exported to countries that aren't as small and ethnically homogeneous as the Nordic countries.

In a recent interview in the New Perspectives Quarterly (h/t to New Economist's very helpful series on the Nordic model), Milton Friedman summarises the argument in this way:

Revisiting Robin Hood's agenda: Be less concerned about taking from the rich and focus on giving to the poor

Ed Broadbent had an op-ed in Tuesday's Globe on a plan to reduce child poverty, and he offers this proposal:

In the next budget, let's impose a six-point increase in income tax on those earning more than $250,000 a year (whose average taxable income is $600,000). While leaving them with very high incomes, this would provide $3.7-billion in additional revenue. All of this should be used to increase the National Child Benefit Supplement and thus help our poorest children. With this single act, we would significantly make up for two decades of neglect and make a major dent in child poverty.

I'm happy to endorse the $3.7b increase to the National Child Benefit Supplement - the costs are small (less than 2% of federal spending), and the gains are huge. But for reasons I'll explain shortly, the tax proposal is not particularly persuasive.

In his article, Broadbent asks

Why is it that Finland, Sweden and Denmark have almost wiped out child poverty, and we have not?

Below the fold, I'll try to provide a partial answer to that question. And I'll explain why the conventional Canadian Left's preoccupation with using the tax system as a way of dealing with inequality and poverty should be rethought.

Cross-country comparisons of inequality in market and disposable income: Policy matters

This graph is taken from a recent Luxembourg Income Study (LIS) working paper (45-page pdf):

The countries are arranged in ascending order of inequality in disposable income, and  the Nordic countries take four of the top five positions. What strikes me is the extent to which this is due to government policy: the Gini coefficient for market income in Canada is the same as Denmark's, and is quite a bit lower than in Sweden. Indeed, Sweden is closer to the US than it is to any of the other Nordic countries.

A recurrent theme in discussions of the Nordic model takes the form of "That's all very well, but those policies won't work here without [insert some feature of Nordic countries here]." Libertarian types who would otherwise approve of the free market dynamism of the Nordics assert that the Nordic model can only work in small, homogeneous countries. As a general argument, I'm not convinced - but I can see why it would be hard to export the Nordic model to the US.

At the other end of the spectrum - those who would otherwise approve of Nordic levels of spending on social programs - some (eg: this commenter) point to the role of trade unions. But it's hard to conclude from this chart that union density matters much when it comes to reducing inequality. For example, look at Germany (where unions play a crucial role in setting wages) and the US (where they are decidedly less important): both have identical levels of inequality of market income. The distribution of disposable income is lower in Germany because of its redistributive policies, not because unions are more powerful.

That's not to say that cross-country institutional/cultural idiosyncrasies aren't important; they are. But there's little reason to believe that these factors have to be  changed before the Nordic model can work.

Nordic vs American exceptionalism

Megan McArdle ponders the Nordic model, and gets pretty much everything wrong.

• She indulges in the oft-repeated and almost-never-substantiated claim that "things that work in small homogeneous countries don't work in big, heterogeneous ones". The Nordics are applying standard textbook rules of taxation. There's nothing exceptional about that.
• Germany is cited  as evidence for the above point. Germany's problem is inflexible labour markets, not heterogeneity. Flexible labour markets are part of the Nordic model.
• The US really is exceptional when it comes to tax policy: it's the only OECD country that doesn't have a broad-based consumption tax. Alone among rich countries, discussions about US tax policy are framed as higher taxes = slower growth.

The social spending and GDP per capita graph redux

For reasons unknown to me or to Mark Thoma, The Economist blogger doesn't seem to be willing to engage me directly in the interpretation of the following graph from this post:

My original comment on this graph was: 'These are countries whose per-capita incomes are greater than the OECD average. The point here is that there's no trade-off between high levels of national income and high levels of social spending.'

Now, it seems obvious enough - to me, at least - that

• The Nordic countries are rich, and
• The Nordic countries spend lots more on social programs than do Canada or the US.

I could have left it at that, I suppose, but I also wanted to illustrate the range of variation of the horizontal axis. To my mind, the variation in the GDP per capita numbers says more about the vagaries of cross-country GDP data than it does about comparing living standards: the countries plotted in the graph are rich, and that's pretty much all you need to know.

The interesting question is *how* the Nordic countries accomplish this feat, and that's what the post was about.

Doing it by the (text)book: The Nordic approach to financing the welfare state

These are the slides I prepared for the session on 'Taxation and Social Democracy', organised by the Progressive Economics Forum at the Canadian Economics Association meetings; the invitation was based on my blog posts on the nordic model.

One of the things that distinguishes blogging from research is that although academia frowns on recycling ideas, the blogosphere seems to thrive on it. So nothing here is really new: it's in the textbooks, several blogs, and described in great detail in Peter Lindert's Growing Public. But since I took the time to prepare the presentation, I'm going to post it here.

Update: Marc Lee reprises his role as discussant. Here's hoping that more and more presenters will find a way to post their seminar slides (which are generally easier to follow than the papers they're based upon), and that more and more discussants will post their comments (which are generally an easier way to understand what the paper is really saying).

Why focus on progressive taxes and not on progressive transfers?

Many posts in the economics blogosphere on the subject of progressive taxation today: Greg Mankiw discusses this paper, Mark Thoma points us to a WSJ article, and Brad DeLong  links to Mark's post twice (here and here).

Inequality - both its level and the rate at which it has been increasing in Canada and the US - is a serious issue. But taxing the rich (and dealing with the resulting incentive effects) isn't the only policy instrument at our disposal; we can also reduce inequality by directed transfers to low-income households.

A couple of weeks ago, at the meetings of the Canadian Economics Association, Andrew Jackson presented a paper with the following table:

I've just ordered the Pontusson reference upon which this table was based, so I'll come back to this point as soon as I can. But it looks very much as though the Nordic countries - which are rich, devote a large fraction of their income to social programs and which do fairly well in reducing inequality - seem to have given up on tax policy as an instrument for income redistribution.

Welfare states can be competitive

Jim Stanford sets aside our shared scepticism about the WEF competitiveness rankings to make two points in his column in today's Globe and Mail:

Get real about Canadian competitiveness:

Nine of the 15 countries ahead of us on the WEF list collect higher taxes than Canada. Indeed, the Scandinavian welfare states cleaned up this year: Finland was second in competitiveness, Sweden was third, Denmark fourth, and Norway and Iceland also placed ahead of Canada.

Governments in these countries rake in 50 per cent or more of their respective GDP.

This is a point that deserves to be made more often (see, for example, here). There's no reason to think that we have to choose between social programs and economic growth.

But he misses a crucial element of the Nordic model:

You'd never know from this weak effort that Canada's corporations received bigger tax breaks since 1999 than any other stakeholder: The average effective corporate income tax rate fell to 25 per cent from 35 in that time (eating up $20-billion of the total tax cuts our governments delivered).This utter lack of correlation between taxes and competitiveness, however, did not stop Canadian business commentators from ascribing our weak performance to (what else?) high taxes, and demanding still more cuts. The National Post's coverage was prototypical: The headline decried high taxes, and the article carried on the good fight -- never even mentioning that Finland, Sweden, and Denmark took three of the four top spots.

You might be led to believe from this that corporate tax rates in the Nordic countries were higher than in Canada. This would be a wrong conclusion to draw. Here are the 2006 corporate tax rates for the 4 Nordic countries and Canada (2000 rates in parentheses):

Canada: 36.1 (44.6)
Denmark: 28.0 (32.0)
Finland: 26.0 (29.0)
Norway: 28.0 (28.0)
Sweden: 28.0 (28.0)

Notwithstanding the round of cuts in the past few years, Canada's corporate tax rates are still higher than in the Nordic countries.

(More on the Nordic countries and corporate taxes here and here.)

Federalism and the race to the bottom

Yesterday's headline in the Globe and Mail provides a nice segue from my post on ethnic diversity and the Nordic model to how Canada's federal structure could be a useful tool in generating the sort of public consensus that the Nordic model requires. Unfortunately for me, the source of the headline is somewhat problematic:

Empower provinces, CEOs say: Ottawa should scrap the GST and eliminate health and social transfers to the provinces, Canada's top CEOs suggest, as part of a proposal that would overhaul the country's fiscal federation.

The Canadian Council of Chief Executives suggests eliminating the goods and services tax as part of a move to shift tax power to the provinces. This would give premiers the surplus tax room they need to raise extra revenue on their own to replace federal health and social transfers, the group says.

Of course, the fact that this proposal comes from a bunch of CEOs is enough for some progressives to condemn it in no uncertain terms. The counter-argument goes as follows: if social programs are devolved to the provinces, they will be obliged to compete with each other for investment, and cutting social programs is the price they'd have to pay to play this game. This 'race to the bottom' can only be prevented by centralising control over social programs at the federal level.

My immediate reaction to this story is one of scepticism: we already know that when it comes to economic performance, government size doesn't matter. If there's no reason for a government to have to choose between being attractive to investors and having social programs, then why would they see the need to sacrifice the latter for the former?

Even so, the 'race to the bottom' hypothesis sounds plausible enough to be accepted as conventional wisdom in certain circles. But the more you examine it, the less credible it appears.

Ethnic diversity and the Nordic model

There seems to be a consensus of opinion on the Nordic model around two points:

1. It's admirable.
2. It can't be exported to countries that aren't as small and ethnically homogeneous as the Nordic countries.

In a recent interview in the New Perspectives Quarterly (h/t to New Economist's very helpful series on the Nordic model), Milton Friedman summarises the argument in this way:

Gardels: Perhaps the Scandinavian countries are a model to look at. They are high-tax but also high-employment societies. And they have freed up their labor markets much more than in Italy, France or Germany.

Friedman: Though it is not as true now as it used to be with the influx of immigration, the Scandinavian countries have a very small, homogeneous population. That enables them to get away with a good deal they couldn’t otherwise get away with.

What works for Sweden wouldn’t work for France of Germany or Italy. In a small state, you can reach outside for many of your activities. In a homogeneous culture, they are willing to pay higher taxes in order to achieve commonly held goals. But “common goals” are much harder to come by in larger, more heterogeneous populations.

That sounds reasonable, and Friedman may well be right. And it would appear that there are reasons to believe that the Nordic model can't be applied to the US in the near future. But it's less clear that those reasons apply to Canada, notwithstanding the fact that we are far from being ethnically homogeneous.

The Irish exception

In some circles (such as on the pages of the National Post), whenever the virtues of the Nordic model are cited, a standard riposte is "What about Ireland?"

Well, indeed. When I was putting together the graphs for this post, I found that Ireland was quite literally off the chart.

 

Nordic Canada: The tax mix

The 'Nordic model' has many admirers, and I'm one of them. It appears to have the best of both worlds: the wealth that markets provide best, combined with the social programs that governments provide best. As I noted earlier, there's no obvious tradeoff between these two objectives: we can have both, if we want. For many, this may seem to be a surprising claim, but it's really just a result from basic textbook economics.

So where does the notion that generous social programs mean lower economic growth come from? Because a large govt sector requires correspondingly large tax revenues. The story as it is usually told goes as follows: Increasing taxes distorts incentives. If people face higher tax rates on employment income, they will work less. If investors face higher rates on capital income, they will invest less. Since both factors of production have been reduced, output goes down as well. Conclusion: raising taxes will reduce output and total income.

That story is correct, so far as it goes.