In Fiscal Policy Lessons from Europe, the Heritage Foundation has produced a nice report that warns, if we don’t learn from the failing European welfare states, we will become them, by as early as 2050. Below are extensive excerpts.
While much of the world was and still is crippled by the absence of functioning market economies, Europe and the United States have enjoyed centuries of remarkable growth thanks to property rights, the rule of law, and minimal government.
Beginning in the late 1960s and early 1970s, politicians in most European nations increased the size and scope of government. Government also expanded in America during that period, but the increase was more muted. More important, beginning in 1980, America began to liberalize its economy and curtail the growth of government.
As a result of these historical differences, the burden of government in Europe is substantially larger than it is in the United States. The growth of government in Europe has resulted in considerable economic damage because both spending and taxes undermine incentives to engage in productive behavior.
On the spending side of the ledger, bigger government encourages people to rely on handouts rather than individual initiative. On the revenue side, the higher marginal tax rates needed to finance programs reduce incentives to work, save, and invest.
Not surprisingly, these divergent policies resulted in different economic outcomes. Simply stated, the United States is now substantially outperforming Europe. As the following statistics indicate, this has dramatic consequences for the economic well-being of citizens on both sides of the Atlantic.
Some stats from the report:
- Americans enjoy more leisure than Europeans because they can afford to purchase labor and goods that reduce the amount of time spent working at home. According to one German study, ‘overall working time is very similar on both sides of the Atlantic. Americans spend more time on market work but Germans invest more in household production.’
- A comparative study by Timbro, a Swedish think tank, found that
EU countries would rank with the very poorest American states in terms of living standards, roughly equal to Arkansas and Montana and only slightly ahead of West Virginia and Mississippi, the two poorest states.
- In the United States, more than 70 percent of the working-age
population has a job, compared to less than 65 percent in the European Union.
- Not only is the unemployment rate in the U.S. significantly lower than the EU-15 unemployment rate, but there is also a stunning gap between the percentage of unemployed who have been without a job for more than 12 months – 12.7 percent in the U.S. versus 42.6 percent in the EU-15.
- Emigration to the US: Thanks in part to lower tax rates and the opportunities created by an economy with less government, ‘millions of Italians, Irish, Germans, and other Europeans have voted
with their feet in favor of Americas balance between work and leisure, with no discernible flow in the opposite direction.’
- Thanks to higher levels of economic output and lower levels of taxation, Timbro found that the average person in the U.S. enjoys about $9,700 more yearly consumption than the average EU resident, a difference of 77 percent
- Adjusting for household size, one finds that poor households in the United States have slightly more dwelling space than the average European household.
- Women lag behind in Europe. Reporting on a study from the International Labor Organization, Newsweek noted that ‘women account for 45 percent of high-level decision makers in America, including legislators, senior officials and managers across all types of businesses. In the U.K., women hold 33 percent of those jobs. In Sweden – supposedly the very model of global gender equality – they hold 29 percent. Germany comes in at just under 27 percent, and Italian women hold a pathetic 18 percent of power jobs.’ Europe is killing its women with kindness ‘enshrined, ironically, in cushy welfare policies that were created to help them.’
So, is spending the problem?
Of course, they ask the question, is all government spending equally bad, or some worse than others?
Some types of outlays, especially government consumption and transfer spending, are particularly harmful to growth. Other outlays, such as those for defense, administration of justice, infrastructure, and education, impose less damage. Europe is further disadvantaged because politicians spend more money on consumption and transfers.
And what about taxes?
Tax revenues consume more than 40 percent of GDP in European Union nations, compared to about 26 percent in the United States. (See Chart 10.) Just as different types of government spending impose varying degrees of economic damage, the same principle applies for taxation.
…tax rates and tax revenue sometimes have an inverse relationship. If a nation has very high tax rates, taxpayers will have a much greater incentive to change their behavior in ways that reduce taxable income.
This Laffer Curve effect means that a nation collects very little revenue in absolute terms or as a share of GDP, even though the burden of taxation is very high. Ireland and Germany illustrate this phenomenon. Germany has Europe’s highest corporate tax rate at 38 percent, yet corporate tax collections are only 1.3 percent of GDP. By contrast, Ireland’s 12.5 percent corporate rate generates revenues totaling 3.8 percent of GDP
Marginal tax rates are a better measure of the tax burden because the disincentive effect of taxation is determined by the tax rate on incremental units of income. For instance, if taxpayers are allowed to earn $40,000 with no tax but then face a 100 percent tax rate on every dollar above that amount, they are highly unlikely to choose to earn more than $40,000 because the marginal tax rate on those additional dollars would be confiscatory. This extreme example highlights the
importance of marginal tax rates, which is why the top tax rates on personal income and corporate income are good measures of whether a nation has a competitive tax regime. It is also important to compare the degree to which nations impose extra layers of taxation on income that is saved and invested, since the effective marginal tax rate on that income will be higher if governments are allowed to tax it more than one time. (For a discussion of the argument that Europeans are choosing leisure over work, see Appendix 2.)
Ireland as a Role Model for Europe
By global standards, European nations enjoy comfortable living standards, but this is due largely to strong growth before the expansion of the welfare state. Since then, economic performance has stagnated. Many of these nations now suffer from high unemployment and widespread pessimism about the future, but this does not mean that reform is hopeless. Even France and Germany, Europe’s least competitive economies, could restore economic growth by implementing the right policies.
The role model that they should follow is Ireland. Twenty years ago, Ireland was an economic basket case with double-digit unemployment and an anemic economy. This weak performance was caused partly by an onerous tax burden. The top tax rate on personal income in 1984 was 65 percent, the capital gains taxes reached a maximum of 60 percent, and the corporate tax rate was 50 percent. Then policymakers decided to reduce the burden of government. Tax rates, especially on capital gains and corporate income, were slashed dramatically. Today, the personal income tax rate is 42 percent, the capital gains tax rate is just 20 percent, and the corporate income tax rate is only 12.5 percent.
These aggressive free-market reforms yielded enormous benefits. The Irish economy has experienced the strongest growth of all industrialized nations, expanding at an average of 7.7 percent annually during the 1990s. In a remarkably short period of time, the ‘sick man of Europe’ has become the ‘Celtic Tiger.’ Unemployment has dropped dramatically, and investment has boomed.
Scandinavia Is Not a Role Model
Some argue that inefficient government, not big government, is the problem. Proponents of this view frequently cite the ‘Scandinavian model,' which they claim combines both efficiency and equity. Scandinavian nations certainly are among the world’s richest nations, but the relevant question is how they became rich and whether the welfare state aids or hinders their economic performance.
Scandinavian nations generally enjoy considerable economic freedom….Scandinavian nations are market-oriented. With the
exception of fiscal policy, they score high. So it is hardly surprising that they are among the world’s wealthiest nations.
Yet how would they rank if there were no welfare state? Almost surely, the expansion of government in the 1960s and 1970s exacted a high price. As noted by a Belgian think tank:
In 1970, Sweden’s level of prosperity was one quarter above Belgium’s. By 2003 Sweden had fallen to 14th place from 5th in the prosperity index, two places behind Belgium. According to OECD figures, Denmark was the 3rd most prosperous economy in the world in 1970, immediately behind Switzerland and the United States. In 2003, Denmark was 7th. Finland did badly as well. From 1989 to 2003, while Ireland rose from 21st to 4th place, Finland fell from 9th to 15th place.
Sweden is often cited as the main role model, but Swedish economists are not so sanguine. The director of Timbro warns:
There are nine million people in Sweden, and some 1.5 million people of working age don’t go to a job. The unofficial total unemployment is some 20 percent. In the EU-15 between 1995 and 2003, employment grew more in 11 EU countries than in Sweden. In 2004, according to UNCTAD [the United Nations Conference on Trade and Development], only 12 countries out of 183 in the survey had a net outflow of investments ‘the basis for any job creation’ and one of them was Sweden.
The Swedes still enjoy high living standards, but this is largely
because of rapid growth before implementation of the welfare state. As one examination of the Scandinavian model noted:
Between 1890-1950, [Sweden] had one of the highest growth rates in the world, with an average tax burden (taxes collected as a percentage of gross domestic product) of 10-20%. This period explains much of today’ s wealth. Of Sweden’s 50 largest companies, only one was started after 1970. That’s no big surprise as by 1980, the average tax burden had reached 50% (where it remains today) while the labor market became highly regulated and the size of the welfare state reached epic proportions. Sweden would pay dearly for these follies. According to the OECD, the country’s per capita GDP ranking slid from fourth place in 1970 to 13th place today. Officially, unemployment hovers around 6% but once all those on sick-leave, early retirement or otherwise subsisting on state aid are included, the figure balloons to around 20%. Between 1995-2003, 11 of the EU-15 countries saw greater employment growth than Sweden.
Interestingly, even the Scandinavians understand that government has become too big. With the exception of Norway, which uses oil revenues to finance much of its welfare state, the burden of government has been reduced substantially.
Fiscal reforms started in earnest after 1993 when the government passed three successive ‘consolidation packages’. The strategy proved successful due to discretionary measures that combined revenue-enhancing tax increases with substantial reductions of public expenditure by almost 16 percentage points in the course of seven
years. As fiscal balances improved and turned into surpluses, public debt also started coming down rapidly.
The Scandinavian model is hardly a route for prosperity.
Even though these nations generally rely on free markets in most sectors, high tax rates and excessive government gradually reduce competitiveness. Scandinavian governments have sought to reduce the burden of government, but the reforms are just a small step on a long journey. Other nations would be well advised to avoid the mistakes that Scandinavians are now trying to undo. The Swedes, at least, seem to understand this lesson. In the September election, voters rejected the incumbent government, giving the Social Democrats their lowest share of the vote since 1914. High unemployment and stagnant living standards were key issues.
So there you have it. I suspect we will see more fiscal indicators that socialism and liberal welfare states, while well meaning, are poorly conceived and don’t work in the real world.