Economics
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Taxing the poor
to pay the poor
ECONOMISTS, who prize efficiency above equity, have long given warning of the dangers of redistribution. England's poor laws, which paid a pittance to the destitute out of taxes, earned David Ricardo's condemnation in the early 19th century. “The principle of gravitation is not more certain than the tendency of such laws to change wealth and power into misery and weakness,” he claimed. Modern economists have raised similar concerns about today's redistributive welfare states: by subtracting from the rewards of work and adding to the consolations of idleness, social transfers sap economies of their vigour. Some American conservatives have sought to “starve the beast”, cutting the taxes that feed social spending.
In the Nordic countries and much of Europe, however, the beast remains well fed. According to the OECD, Sweden, Denmark and Finland devote almost a third of their GDP to social transfers. Germany and France devote about a quarter. America redirects only 14% or so of its national income in this way.
The costs to Europe of overgrown welfare systems are plain: its citizens pay for redistribution with high taxes, which may be one reason why Europe's economic performance has lagged behind America's. The average French worker produces 5% more per hour than his American counterpart, but produces less in total because he works fewer hours—in part because those high taxes reduce his incentive to work. Yet Europe's redistribution has not led to the “plague of universal poverty” predicted by Ricardo. Far from it: European countries are rich.
How can this be? Peter Lindert, of the University of California, Davis, offers an answer towards the end of his new book, “Growing Public”*, a monumental history of two centuries of social spending. The big European and Nordic welfare states are undoubtedly expensive. But their economic costs are held down by the perhaps surprisingly efficient tax systems with which they are financed. Once the means of finance are taken into account, they are also less redistributive than you might expect.
Economic theory has a lot to say about efficient systems of taxation. One guiding principle is that it is better to tax consumption than income, because taxing what is spent rather than what is earned does less damage to incentives to save. If wages are taxed, and the interest on savings is taxed also, then anything saved out of your wages is, in effect, taxed twice. Compared with the Americans, the Europeans place far more of their tax burden on consumption than income.
A second principle dates from a 1927 paper by Frank Ramsey, a Cambridge polymath. In essence, Ramsey's theory says that those goods or services most sensitive to price should be taxed the least; those least sensitive to price should be taxed the most. Scandinavian tax systems, in particular, are close to the spirit of the Ramsey rule. They lean on labour rather than on capital, because capitalists are deterred from investing more easily than workers are discouraged from labouring. They tax habits, such as smoking and drinking, more than luxuries, because the addicted or habituated will buy at almost any price.
In general, Europe's big social spenders tax capital relatively lightly. On some measures, indeed, Europeans treat capital better than supposedly more sympathetic Americans. According to an OECD study, the grabbing hand of the American state took an average of 31% of capital income between 1991 and 1997. The corresponding figure was about 20% in Germany, Norway and Finland, and 24% in France. In 1998, rich Americans faced a marginal tax rate on dividends of over 46%. Rich Belgians, Finns and Norwegians paid much lower rates. While Americans were arguing about Reaganomics in the 1980s, Swedish households were enjoying a negative tax rate on capital income, once generous deductions and adjustments for inflation were taken into account.
This style of taxation is efficient, but it is clearly inequitable. Taxing luxuries less heavily than, say, alcohol is likely to be regressive. Suppliers of capital, who tend to be richer, get off lightly, while labour carries a heavier burden, through both lower net income and higher unemployment. The income and payroll taxes that support Europe's large welfare states drive a deep wedge between a worker's take-home wage and the much higher cost of employing him. Generous minimum wages and unemployment benefits also put a floor under wages, pricing many people out of the labour market. The result is that just 68% of the European Union's working-age citizens are employed, compared with 77% of America's.
But surely this is evidence of the inefficiency of Europe's welfare systems and the taxes needed to finance them? Mr Lindert, however, is keen to stress the other side of the tax-and-spend ledger. Returns to some of Europe's social expenditures, such as child-care subsidies, are probably quite high, he says. He also claims, rather unkindly, that unemployment benefits and generous retirement schemes both “harvest lemons”—ie, they pluck the least productive out of the labour force. Discarding these workers subtracts little from the nation's output, he argues; it also flatters the productivity figures of those with jobs.
America, Mr Lindert conjectures, can get away with an inefficient tax code because its tax burden is quite low. Bigger welfare states have to be smarter, because the stakes are so much higher. The “Swedish model”, for example, has been declared dead more than once, but each time has reinvented itself and survived. Europe's other welfare states are now ailing, blamed for weak growth and high unemployment. Some foresee their slow demise. Survival through adaptation seems more likely.
* “Growing Public: Social Spending and Economic Growth Since the Eighteenth Century”. Cambridge University Press, 2004
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