Taxation, Globalization, and the Future of the Welfare State

Date May 13, 2003
Speaker Sven STEINMO(Professor of Political Science, University of Colorado)
Moderator Gregory JACKSON(Fellow, RIETI)


My previous research had found a strong positive relationship between the size the welfare state and the size of a state's tax base. Also rich countries, across the board, have been modernizing their tax policies. My research found consistent patterns of change: you find the massive expansion of the tax base (mostly through bracket creep) that funds the welfare state, for example. I argued that these changes are related to the world economy.

Tax authorities believe that current tax systems are unsustainable because of capital's ability to move across boarders (globalization). The feeling is that governments cannot do what they used to do. For example, Chancellor Helmut Schmidt of Germany said, "The welfare state is such a good idea... (but given globalization,) there will be a need to reduce the burden of social services." Lots of pundits made the same argument: that there will be a race to the bottom.

But these expectations were not borne out in the data. Among the members of the OECD, for example, there has been no race to the bottom. The rate of tax increases has not slowed much. A vast majority of countries have increased their tax burden as a percentage of GDP. This finding went against my expectations. After running econometric regressions, we found there was no statistically significant correlation between tax levels or tax types and economic growth or FDI or domestic investment or virtually any measure.

The argument that is commonly made is that taxes would have multiple negative effects on economic performance: for example, high levels of marginal income tax rates on high income earners would drive them to lower tax domains (such as to Korea); or higher levels of taxation would drive up the costs of production, making those companies less efficient and less competitive with companies that are located in domains with lower taxes. These are reasonable assumptions. But, in fact, there has been no statistical relationship between economic performance and the level of taxation (the R-squared showed no correlation). In fact even though the difference between the high tax countries and the low tax countries is now bigger, the correlation is smaller now than there was 30 years ago.

So in my current book, I looked at four very different countries: the US, Japan, Sweden, and Germany. I looked at their welfare systems to see if I could find out what is happening. The conclusion is this: the assumptions of the convergence hypothesis are wrong; instead of a convergence (or race to the bottom), I have found an increased divergence in tax policy and welfare states.

The four countries reduced their marginal tax rates. Average tax rate is what you pay on average as a percentage of your income. The marginal tax rate is what you pay on the last dollar earned. After the War, most countries had high marginal tax rates. But, as you know, nobody paid those high rates. Policymakers came to believe that these high marginal rates were inefficient and inefficacious. They did not collect revenue and created a system where there was an incentive to cheat (a "country of cheaters").

The threat of capital exit allowed policymakers to reconsider the instruments to attain their goals. High marginal tax rates are a tool to obtain the goal of redistribution; they are not goals in themselves (the political Left forgets this). It is clear that leaders in countries like Sweden reconsidered how they were going to achieve their goal of creating a more equal society. They discovered that they could broaden the tax base to achieve their ends.

In the 1990s, the Swedes increased tax rates (including marginal tax rates, like Bill Clinton did), invested in technology, and became what I call a "top-feeder." Instead of trying to race to the bottom, they are racing to the top. Sweden did not want to compete with China; they wanted to compete at the high end. The way to do this was to invest rather than reduce. The only country that out-competes Sweden in the OECD is the US.

Why would you not want to race to the bottom? The welfare state is an insurance system and can be economically efficient. Taxation finances public spending on infrastructure and education, which can be social investment. Capital flows to where it will make a profit, not to where costs are lowest. Individual mobility is very limited, so people cannot move to where taxes are lowest. Taxes are a small part of costs. And voters tend to oppose cuts in public spending. The solution to Japan's economic problems is not to reduce spending on education; but Japan's public works spending is probably not a good way to use public money.

The implications of this story are that there is a race to the bottom on the part of the US and perhaps Japan, and a race to the top of the part of Sweden and other Social Democrat countries. So there has been a divergence. Why is there no convergence? First, the demographic situations differ in each state. The US and Sweden are in better fiscal situations, as a product of policy choices in the past. While the US allows a lot of immigration, Japan does not and Germany has net migration. Political choices in time one affect the political challenges in time two. In Sweden the government is the largest employer; so, it is politically difficult to cut government jobs or wages. In other words, the second reason for divergence is political commitment. The third reason is political trust; the lower the government spending, the lower public's trust in the government becomes.

Questions and Answers

Q: Of your three reasons for the lack of convergence, I feel reason number three is the most important: public trust. Economists say taxation is evil. And there is a vicious cycle between trust and the ability to tax. Japanese trust in government is on the decline. It is fashionable to distrust the bureaucrats. How can we improve this situation?

A: Demographic change (the change in women's role, aging, etc.) is an element of political commitment. Trust in government is common to all of these countries, including to Sweden. One way to restore trust would be to reduce spending on public works, which citizens see as a waste. There are beautiful tunnels in Japan without any cars in them. Japan should increase the spending on things people want and reduce on things people do not want. Japan's wasteful spending has to do with its institutions, such as voting districts. I would suggest that the country should invest in the future rather than in short term constituencies. The Japanese are scared of losing their social security, so raising taxes to support that system would make sense.

Q: Questionnaires can be misleading. You will get different perspectives on "politicians" as opposed to "bureaucrats." In Japan, there is an acceptance of sacrifice for the public good.

A: I do not mean to say that Japan should roll back the state. In fact, I believe the state can be productive. The Ministry of Finance is following a "global standard," which is really the American standard; and from this, MOF has understood American economic success to be a result of the 1981 tax cuts. This is crazy. MOF wants to follow Ronald Reagan and George W. Bush to tie the hands of the government. If you believe that the state can do one good thing, then tying its hands can be the worst policy. Japan should find what worked in the Japanese system.

Q: Have you been able to calculate the effects of tax increases or decreases on the level of redistribution?

A: I have tried to do that calculation but I will probably have to give up. The problem is that it is difficult to do a broad comparative analysis, as tax policy is spread over time and tax brackets. One thing that is sure is that there is no correlation between inequality and growth. The current Bush tax cuts are based on two assumptions: first, government is bad; second, inequality is good. But the logic ignores the insurance element of government. US success has largely been due to risk taking, which was made possible by the wealth of the nation or insurance.

Q: Which policies should Japan pursue? How do we strengthen the welfare state in Japan in order to improve the level of trust in the state?

A: Japan cannot become Sweden or the US. But developing a welfare state that could release Japanese firms from their burdens would be good for the economy. Japan would need to increase taxes and give more power to the leadership (get the power out of the hands of short term political interests).

Q: Today's waste might be tomorrow's investment. The Alaskan Purchase was first seen as waste in America.

A: Certainly one could argue that Japan distinguished itself after the war by its massive investments in public infrastructure. Sure, public investment is not necessarily wasteful. What is questionable is whether the character of the spending is desirable from the point of view of the citizens.

Q: Europe is the region that is trying hardest to tie the hands of the government. You have to disaggregate your data.

A: It is true that Germany has not decided what kind of state it wants to be. I am not saying a large or small welfare state is good. The Swedes followed market-based reforms rather decisively; capital taxation has been lower there than in the US since 1965. One reason why the Swedish pension system is doing well is because part of it was privatized, which could have only been done with high public trust in the state.

*This summary was compiled by RIETI Editorial staff.