sou · H3B353en · 2015-06-04 00:00:00 — Actually it can do more when it is front-loaded in the sense that the early in life net-benefits in present value terms matter more than later contributions and benefits, as they do empirically. It implies that the investments early in life matter more than passive support later in life, which in turn has positive effects on economic performance. The reasoning above brings out the importance of decomposing public expenditures and their financing into categories, rather than looking at gross numbers when discussing how the public sector affects economic performance. At some simplification, some expenditures may be termed “” and others “passive” depending on their effects on performance indicators like employment and income. An expenditure would e.g. be labour market relevant education, while an early retirement scheme allowing healthy workers to retire early would be a passive scheme (but may be motivated on other grounds than economic performance). Similar, some modes of financing are less distortionary than others. The importance of these distinctions is supported by recent empirical evidence. A large number of empirical studies have tried to shed light on the relation between the size of public sector and economic performance measured in terms of e.g. per capita income or growth. Despite the intensive research, this branch of the literature leaves weak support for any strong relation between the overall size of the public sector and economic growth. However, more recent work having decomposed expenditures and their financing find more clear empirical evidence. or productive expenditures have a positive effect on economic performance if financed by the least distortionary modes of taxation, and vice versa for passive expenditures financed by distortionary taxation. This shows why the discussion on the role of the welfare state for economic performance cannot be answered simply, but has to take into account the structure and orientation of the welfare state. Bilaga 4 till LU15 empirical evidence shows that the Nordic countries not only have large public sectors, but also have a stronger orientation of their expenditures towards spending. However, the mode of financing is not similarly aligned since e.g. property taxation contributes a relatively small share of tax revenue, despite this being one of the least distortionary modes of taxation. Turning to the equity side of the welfare state, the distinction between and passive modes over. Traditional (re)distribution policies may be characterized as passive since they via taxes and transfers attempt to transform a distribution of market incomes considered unfair into a more fair distribution of disposable income and thus consumption possibilities. A more approach to redistribution would be to design education and labour market policies so as to ensure that the distribution of market incomes meets the distributional objectives. The Nordic countries are known to be among the countries with the most equal distribution of disposable income. Although passive redistribution plays a role, it is often overlooked that the basis for the egalitarian outcome is created already in the labour market in the sense that the distribution of market incomes is among the most equal. Moreover, evidence shows that an equal distribution of market incomes relies on an equal distribution of qualifications. This points to the importance of education in its broad sense as being important for equality. An equal distribution of income requires a relatively equal distribution of qualifications. Education possibilities may be constrained by both financial and social factors. Public education can overcome both and in this way contribute not only to more human capital but also to a more equal distribution of qualifications and thus income. While passive redistribution puts the public budget under pressure, it is opposite for the approach which over time reduces the number of people being unable to support themselves at a politically acceptable level. The implicit or social contract encompassed in the welfare state has also a strong intragenerational link. Various elements of the social safety net ensure income in the case of events like unemployment, illness, loss of working capabilities etc. At a given movement this entails redistribution from those not being affected by these events to those being affected. However, since such events Bilaga 4 till LU15 may arise for all, these arrangements also constitute an insurance function. All individuals know that the social safety net and welfare services are there if they are exposed to an event reducing their ability to support themselves. This is an implicit insurance effect which has a direct positive welfare effect if agents are risk averse and have no access to other means by which to diversify such shocks. It may also be conducive to risk taking and flexibility, which in turn improves economic performance. , even for the social safety net it is not possible to make a sharp distinction between effects on economic performance and equality. There is a tradition in the Nordic countries of an orientation of the social safety net – the workline – by stressing that these arrangements are only available to individuals unable to support themselves and by including various employment conditionalities (requirements on job-search, participation in activation programmes etc.). This is a contributory factor in explaining why the labour force is so large and employment rates are so high in the Nordic countries, despite a relatively generous social safety net. The flipside is that such programmes are resource demanding. The Nordic comparative position with respect to both economic performance and inequality reflects thus policy designs. Underlying this are several factors. One is that an extended welfare state relies on a high employment rate. If the employment rate falls, tax revenue decreases and social expenditures increase. Therefore the model has a built-in requirement of an employment focus. Likewise, being small and open economies facing international competition has been a background factor all along. The demise of the Nordic model has been predicted several times. As for it may be said on behalf of the Nordic welfare model that rumours on its death are widely exaggerated. The Nordic model is not crisis free, and deep economic crises are part of the history for the Nordic countries. Despite the turbulence, the model has proven resilient and stands out in international comparisons as an example of how to reconcile social objectives with a well-functioning economy. Accordingly, the Nordic countries rank in the top in most international league tables comparing country performance. Part of this is a strong legacy ingrained in institutions and policies, constituting a social and Bilaga 4 till LU15 political capital also making it possible to implement far reaching reforms in due time to ensure the viability of the model. In a forward perspective some of the trends to be coped with are ageing, globalization and requirements to publicly provided services. These challenges are as such global and not specific to the Nordic model, and some countries face larger challenges than e.g. and , which have been front-runners in pension reforms. The quest is to find solutions in accordance with the goals of the Nordic model. Ageing, as an example, is a challenge, and changes in pension systems (including retirement ages) are inevitable. The main driver is increasing longevity, in itself a welfare improvement. Having retirement ages increasing with longevity ensures that the balance between years contributing to and benefitting from the social contract underlying the welfare state is maintained. Reforms along those lines cannot in any meaningful way be categorised as retrenchments of the welfare state. Although there is a substantial element of healthy ageing, the changing age composition puts pressure on the health and old-age care system – two key responsibilities of the welfare state. Ageing thus induces an upward pressure on passive expenditures which may squeeze public spending. Given the tight public finances and the upward pressure on passive expenditures, tight prioritization is called for in the future. To this end it is important to clarify which public sector activities may support productivity, employment possibilities and thus competitiveness for the private sector. This also brings the financing of the public sector in play; are there any ways to reduce the negative incentive effects of tax financing and are there alternative modes of financing? Globalization is not a new phenomenon for the Nordic countries, and the constraint to remain competitive is deeply ingrained in policies. However, it poses ongoing challenges. Globalization in combination with technological advances tends to widen the wage distribution and thus create more inequality. A major reason is an upward drift in the demand for qualifications. One response would be passive redistribution to counteract this trend, but pressure on public finances and the possible distortionary effects of such a move make this a less attractive solution. measures aiming at improving education along Bilaga 4 till LU15 both the qualitative and quantitative dimension have a different perspective. In particular, a reduction of the “residual” group not receiving any labour market relevant education may be the single most important factor in improving employment and ensuring a more equal distribution of incomes. Migration – including migrating workers – is another important aspect of globalization. Migration may introduce selection mechanisms in the implicit or social contract underlying the welfare state if immigrants tend to benefit from the system and emigrants tends to be net contributors. The empirical evidence on direct welfare driven migration is scant. However, irrespective of the motive for immigration, a large inflow of individuals with low qualifications would put the model under pressure by either challenging the distributional goals or the possibilities of maintaining a high employment level. Finally, the needs and demands to the welfare state are not static. This not only applies to changes in the labour market, but also to the service provision. The objective is to deliver welfare services of contemporary standards meeting the needs of most people. Alongside developments in society this is a moving target, most visible due to steady improvements within lifesciences which clearly have tremendous welfare effects but also tend to increase health expenditures and thus putting public finances under pressure. At the same time it may be difficult to improve productivity for some services – those intensive in human interaction like care – and they thus tend to become relatively more expensive. These developments imply a continuous debate on how to finance and produce services, including how to make the public sector more productive and efficient. It is a recurrent theme in policy debates whether an extended welfare state impedes or promotes economic performance measured by e.g. per capita income or growth. Viewpoints on this issue are often closely aligned with political observations, but what can research teach us about this question? In debates on these questions, the Nordic countries – and in particular – are often highlighted as examples of countries which have shown that an extended welfare state can be reconciled with a strong economic performance in comparative perspective. In the wake of the financial crisis, the appraisal of the Nordic model has revived.1 The purpose of this paper is to take stock of what can be said about the role of the Nordic welfare model for economic performance in light of recent theoretical and empirical work. Much debate on these issues takes an outset in the standard textbook case of an income tax distorting labour supply. , focus has been on the tax burden measured in various ways and on empirical assessments of the labour supply elasticity. From this, rather wide ranging policy conclusions are sometimes made. This is problematic both for theoretical and empirical reasons. Crosscountry evidence does not provide ready support for the devastating consequences of high tax rates – actually the Nordic countries are, despite high tax burdens, characterized by high 1 It may be worth reminding that the Nordic model is not crisis free and its popularity has had its cycles. In 1995 (1995) wrote about the rise and fall of the Swedish model. (2004) gives several examples of the change from praise to demise of the Swedish model in newspapers like , etc. During the 1990s the Danish labour market was repeatedly referred to as a bad example, while it during the 2000s gained popularity under the heading of flexicurity. The recent international interest in the Nordic model is illustrated by the cover of (February 2nd 2013) “The next supermodel – why the world should look at the Nordic countries”. Bilaga 4 till LU15 employment rates and are among the richest countries in the . On a theoretical level it is often overlooked that the simple textbook case considers a tax levied on labour financing activities which do not in any way affect production or consumption possibilities. Likewise the social safety net is often portrayed as offering either lump-sum transfers or transfers conditional on not working. Both are far off the mark relative to both how taxes are spent and how social safety nets are designed in the Nordic countries. The point is not that taxes do not matter – they do, and they can have large detrimental effects on economic activity. The point is that the effects of public sector size and taxes depend critically on policy design. The effects of taxes in general cannot be seen independently of what they are financing and how the entire welfare model is structured. This introduces an important distinction of what may be termed a “passive” and “” welfare state.2 The passive version resembles the textbook case of a government finding the market distribution of income unacceptable and redistribution via taxes and transfers. The version also aims at affecting the distribution of market incomes. Inherent in this distinction is the role of market imperfections. In the textbook case of the passive welfare state, the only distortion is the taxes arising from the need to finance redistribution. Allowing for market imperfections, the perspective becomes very different, as will be expounded below. To understand the performance of the so-called Nordic welfare model, it is necessary to consider more carefully what should be understood by this model. In policy debates the welfare state is often associated with specific policy instruments and designs. This view leads to a strong status quo bias and a perception that most policy changes are retrenchments of the welfare state. This view is misleading for several reasons. The Nordic countries – as explained in more detail below – differ significantly in specific policy arrangements despite similar overall objectives and performance. This strongly suggests that the Nordic welfare model is defined in terms of overriding objectives and principles rather than specific policy instruments. Moreover, there have been important policy 2 This is related to the discussion of the social investment state, cf. Giddens (2000). Bilaga 4 till LU15 shifts and reforms over the years, and still the Nordic countries stand out in the same way in international comparative perspective. The model is not the result of a plan implemented at a point in time, but rather a result of a dynamic development where the overarching objectives have remained stable but the means of achieving them have been changing alongside changes in economic structures and possibilities. This paper offers a survey of the findings from theoretical and empirical analyses to extract some lessons on how to account for the performance of the Nordic model. Focus is on two key aspects associated with the model, namely the strong role of the life-cycle pattern in services provided by the welfare state and the redistribution via transfers and expenditures. There is a voluminous literature on the need and scope for public intervention both in general and in specific policy areas. It is beyond the scope and space of the present paper to offer a comprehensive overview. The paper is thus selective in focusing on aspects important to understanding the economic performance of the Nordic model. This is important not only to account for the historical development but also as a guidepost for future policy settings. Space also excludes specific discussions of important topics from the long list3 of policy challenges including globalization of product and labour markets, migration, demography, efficiency/productivity in public service production, increasing demands for services, as well as the political economy aspects related to support for welfare arrangements and reforms. It is also beyond the scope of this paper to elaborate on the history and development of the Swedish and Nordic welfare model. The paper is organized as follows: The economic performance of the Nordic countries is briefly chartered in Section 2. Some key characteristics of the Nordic welfare model are laid out in Section 3. Section 4 starts out by clarifying some basic insights from economic theory on the effects of taxation before turning to the implications of the cradle-to-grave welfare model for economic performance. This section also reviews empirical evidence on the role of the public sector for economic growth. Distributional policies may be directed at repairing on the distribution of market 3 Some of these are addressed in e.g. Valkonen and Vihriälä (2014). Bilaga 4 till LU15 outcomes or at influencing the distribution itself, and this is explored in Section 5. The social safety net and its implications for insurance are discussed in Section 6, and Section 7 gives some concluding remarks. The essence of how countries perform economically is encapsulated by average income and its distribution. This is also underlying the most essential trade-off in economics,that between efficiency and equity dubbed the big trade-off by Okun (1975). Average income can be taken as a proxy measure for efficiency and income distribution (e.g. the coefficient) as a measure of equity. Clearly, many more elements are relevant for living standards and welfare, but these two measures capture the essence of the debate. The standard textbook reasoning is that redistributive policies distort incentives and thus lead to efficiency losses in terms of lower employment and thus income, see Section 4.1. , more equity can be attained, but at the cost of less efficiency. An immediate corollary of this is that countries with a large and extended tax financed welfare state may succeed in lowering inequality but at the cost of a much less efficient economy and thus lower average material living standards.4 Average income and income inequality are plotted in Figure 2.1 for countries. This cross-plot does not reveal any clear pattern or trade-off. There is a weak, though insignificant, negative correlation between inequality and income which at face value suggests that more equity is associated with more efficiency (or vice versa), see e.g. the widely cited book “The Spirit Level” by 4 Prescott (2004) is an exponent of this view arguing that the lower income level in some countries compared to the US can be attributed to a higher tax burden. Other arguments have been that Europeans have a stronger preference for leisure, that the welfare state via generous benefit levels lowers labour supply, and the role of imperfect competition (unions), see e.g. Alesina, Glaeser and Sacerdote (2005), and Sargent (2007), and (2006). Note that the Nordic countries are an outlier in this context. Bilaga 4 till LU15 Wilkinson (2009) and the (2011).5 However, this interpretation may be contested. Figure 2.1 Income and inequality, countries 2010 Note: Income measured as GDP per capita, current prices, current PPP. Income inequality is given as the coefficient defined on equivalent disposable income for the entire population. For GDP is for mainland . is considered an outlier and not included. The dotted line illustrates the best practice frontier estimated in and Maibom (2015). Data source: Based on data from . One way to interpret evidence of the type given in Figure 2.1 is that the position of a given country reflects not only the extent of the welfare state (size and composition) but also political and institutional factors. In some countries there may be scope for improvements in both efficiency and equity since policies due to political economy factors or other reasons may be inoptimal. Care should thus be taken in interpreting such cross plots (see below on empirical work on inequality and growth), and they should not be confounded with the trade-off prevailing in the absence of political or institutional impediments on the determination of economic policies. To filter out political and institutional barriers, it is of interest to identify the best-practice frontier in the efficiencyequity space. This is done by use of a so-called stochastic frontier 5 There is also a literature exploring whether inequality and growth are related, see Section 4.3. Bilaga 4 till LU15 analysis in and Maibom (2015) based on data for the period 1980-2010. The frontier is illustrated in Figure 2.1 by the dotted locus. The analysis shows that i) the elasticity of the frontier is close to minus one, i.e. a one percent lower equality is associated with a one percent higher income level, ii) the slope of the frontier has not become more steep over the sample period (1980–2010), but some countries have moved towards the “northeast” implying higher income and less equality, and iii) for the countries at or close to the frontier (best practice countries), there is a significant negative effect of taxes on both income and inequality, as predicted by standard theory. Whether the slope of the best practice frontier identified in this way is “steep” or “flat” is in the eyes of the beholder. interesting in this context is the fact that the Nordic countries belong to the best-practice countries, and stand out by having achieved a high income level and a low level of inequality in comparative perspective. The key question – which will be pursued in the following - is thus how to design the welfare state so as to achieve both high income and low inequality (flattening the slope of the trade-off)? Related to the above is the question whether countries with an extended welfare state have a lower growth potential (empirical evidence on the nexus between economic growth and public sector size and structure is further discussed in Section 4.3) than countries with a lower tax burden. Figure 2.2 gives income levels for the Nordic countries relative to the income level in the US6 over the period 1970–2012. While there are variations in this ratio (some driven by country specific factors and some by US variations), it displays no trend for the Nordic countries. Clearly there have been crises and policies have been adjusted, also in the Nordic countries, but it is to be expected that policies would have to be adjusted to remain among the best-practice countries, cf. further discussion below. 6 Cross-country comparisons are often used in academic research and the media frequently report “league tables” ranking country performance for various indicators. This approach is not unproblematic. As a case in point is often used as a benchmark. One reason is that it consistently has been among the high income countries in the , and in this way constitutes a benchmark.