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.

The only substantive qualifier would be that empirically, there’s almost no evidence that workers work more when take-home wages increase. In fact, there’s quite a bit of evidence that many workers will respond to an increase in wages by reducing their hours worked. Instead of taking the increase in income, they take it in the form of extra leisure.

So it's probably unsurprising that Nordic countries have high tax rates on employment income. Here are the top marginal income tax rates, graphed against social spending in rich OECD countries (all data are taken from the OECD):

But the point about corporate taxes is much more pertinent, especially for small open economies such as Canada and the Nordic countries. Such a country must take the real rate of return on investment as a given: it’s determined by world capital markets. Suppose that there are a certain number of investment projects (that is, the kind that employs workers and produces stuff), each with a different projected rate of return. If a project’s rate of return is greater than the going world rate, it is implemented. An increase in corporate tax rates lowers after-tax profits, so the after-tax rate of return (after-tax profits divided by the size of the investment) goes down. If the rate of return on a given project in Canada drops below the required world rate, the investor will withdraw transfer his capital out of Canada and invest elsewhere. (See also this post.)

Here is a graph of various rich countries' levels of social spending plotted against their corporate tax rates:

So the policy-makers in the Nordic countries appear to have grasped this point. And it may not be just a coincidence that Germany and France - who appear to be trying to use high corporate taxes to finance high social spending - are having such a difficult time these days.

The other thing that the Nordic countries do is tax consumption. Income taxes reduce the rate of return on savings, so they reduce savings. Savings rates aren’t affected by consumption taxes, since they don’t affect the rate at which current consumption can be exchanged with future consumption – the same tax rate applies, so it doesn’t affect the relative costs and benefits of the consumption-savings decision. Although it is true that if global capital markets were absolutely perfectly flexible, an increase in domestic savings wouldn’t affect investment, available evidence suggests that there is a ‘home bias’: more domestic savings generally lead to more domestic investment.

Here are the statutory VAT/GST rates, graphed against social spending.  The US is excluded, since there is no federal sales tax, and there is just too much regional variation to get a useful number. For Canada, I used 15% because I live in Quebec:

If Canada were to emulate the Nordic model, this would involve:

1. Increasing the tax rate on labour income.
2. Reducing the tax rate on capital income.
3. Increasing the tax rate on consumption.

There's an election on these days - is anyone advocating the Nordic model? Well, no. I think the Liberals and the Conservatives are promising 2), but that could change the next time they run a focus group. The NDP - which would seem to be the most likely to be in favour of the Nordic model - isn't offering any new taxes. But that's actually good news: until this election, the NDP consistently campaigned against the GST and in favour of increasing corporate taxes. Although they haven't managed to bring themselves to advocate policies that would be consistent with the Nordic model, they've at least stopped advocating policies that would have taken us in the opposite direction.

Comments

[tomslee]

Interesting post. The stuff about corporate taxes goes against my prejudices, so I'll have to think about them more before believing you :-). I do notice that your argument is based on ranking - it is the relative amount of tax in different coutnries that is important, not the absolute magnitude. Does this mean we are caught in a "race to the bottom?"

On the personal taxation side, I would think that the effect (and acceptability) of high consumption taxes depend on the level of inequality in society (as well as on the breadth of essentials or near-essentials that are taxed)? That is, in a relatively egalitarian society -- such as the Nordic countries? -- the mix of income taxes and consumption taxes is not that important, while in a very unequal society different mixes make a big difference.

[Stephen Gordon]

I wouldn't characterise emulating the Nordic experience as a 'race to the bottom'; they're among the richest countries in the world, and they generally do very well in international rankings for productivity.

And I'd also argue that the egalitarianism in Nordic countries is a *result* of their policies, not a prerequisite for putting them in place.

[Stephen Gordon]

I don't think the 'race to the bottom' is a real problem. Nor do I think that there's any reason why progressives should oppose lower corporate taxes.