by Paul Gregory
Peter Diamond and Emmanuel Saez (Wall Street Journal High Tax Rates Won’t Slow Growth) offer a beguiling Leftist narrative: The 1% will cough up incremental tax revenue up to a 70 percent rate without cutting the things they do to generate economic growth.
We can then use their money to fund “higher-return public investments” (such as Solyndra and the public-education black hole?) without cutting back the entitlement state.
Although Diamond’s Nobel Prize and Saez’s J. B Clark Award make them eminently credentialed, Alan Reynolds (Of Course 70% Tax Rates Are Counterproductive) exposes the convoluted contortions behind their counter-intuitive finding that a tax that leaves you 30 cents on every extra dollar does not affect your decisions to start a new business, assume extra risks, or take on new clients. That’s a hard sell for anyone who thinks about it.
Note that tax guru, Saez, sings a less confident tune when he writes for fellow economists that: “There are no convincing estimates of long-run elasticities of taxable income and marginal tax rates.” My translation: “We really do not know how taxable income responds to high marginal rates, but we are guessing we can go up to 70 percent.” It pays to read the fine print before making the purchase.
Economists can use different data sets and methods to debate forever how people react to marginal tax rates. “Natural experiments,” however, provide conclusive answers because they represent real-world experience. It is hard to ignore what your “lying eyes” (to use Groucho’s expression) see.
As described by Assar Lindbeck, Sweden’s social democrats and their union allies experimented with steroidal marginal tax rates to support an unbridled entitlement state from the late 1960s through the early 1980s. Sweden then reversed course when confronted with the disastrous consequences of its policies. The Swedish story ends on an up-beat note. Sweden and Germany are today the two best performing European states, both governed by center-right parties.
In 1970, Swedish high earners paid marginal tax rates of 70 percent, rising to 85 percent by 1980. Marginal tax rates on dividends and capital gains were only slightly lower, if at all. Sweden’s entitlement state featured universal benefits replacing 90 percent or more of lost income, a state monopoly of social services, and a union-inspired ‘solidarity wage” that featured (as the Swede’s scornfully put it) “equal pay for all work.” Sweden’s distribution of income was as equal as the communist countries of Eastern Europe. Government spending rose to 60-70 percent of GDP versus the 45 to 50 percent in the rest of Europe at the time. Fifty percent more Swedes were “tax financed” than worked in the private sector.
According to Diamond and Saez, Sweden’s tax revenues should have grown faster than the rest of Europe as it raised its tax rates to unprecedented heights. In fact, Sweden’s growth of government revenues was one quarter less than the OECD average. We have plenty of anecdotes to explain why. More than half of Sweden’s billionaires live abroad according to Forbes. ABBA joined tennis star Bjorn Borg, film maker Ingmar Bergman, and many other Swedish notables abroad when the Swedish government took 85 percent of their earnings. The Swedes voted with their feet. We do not know how many, but each departure lowered tax revenues.
Diamond and Saez should note that Sweden’s high marginal tax rates (and the associated Swedish welfare system) had a disastrous effect on economic growth. From 1850 to 1950, Swedish productivity growth was the fastest in the world. Sweden’s stellar economic performance made it the fourth richest OECD economy in 1970. By 1995, Sweden had fallen to sixteenth place – the most dramatic relative decline of any affluent country in history. Notably, Swedish firms operating outside of Sweden remained competitive. They were not the problem. The Swedish model was.
The Swedish experiment also shows the importance of what the government does with its money. Universal benefits destroyed the work ethic. Instead of “high return public investments,” Sweden raised public employment and expanded cradle-to-grave entitlements. The solidarity wage destroyed incentives to acquire skills or enroll in higher education. Regional subsidies slowed the movement of people from stagnating to growing regions.
Sweden began to reverse course in the early 1980s, and its per capita income ranking has since risen to eighth in the OECD. Sweden’s relative recovery was aided by the fact that a number of its European neighbors moved towards the Swedish model as Sweden abandoned it. Sweden’s reversal has been constrained by the fact that the vast majority of its people depend on the state for employment and benefits rather than on the private sector. The situation must have been dire to convince such an electorate to reverse course.
The Swedish model also reveals one of the closest-held secrets of the Obama administration: Taxing the 1% will not pay for the welfare state. Swedish workers were saddled with marginal tax rates in the fifty percent range. They responded by working less, having more subsidized spells of unemployment, taking subsidized parental , permanent disability, or early retirement, or otherwise gaming the system. Swedish employees averaged a month of fully-paid sick days per year in addition to a month or more of paid vacation.
The parallels between the Swedish Social Democrats and their labor allies of the 1970s and the Obama administration are striking. Both share a “strong suspicion of markets, economic incentives, and private entrepreneurship.” A century of growth based on free enterprise made both countries rich. This hard-won affluence gives a cushion to survive the negative effects of exorbitant tax rates and entitlements.
The realities of the U.S. electorate temper the Obama model, but calls for Swedish-style marginal tax rates by Obama’s tax gurus suggest the distance between the two models is not as great as we think.
Sweden shows the stakes are high. Sweden’s ranking fell by eleven points during the greatest excesses of the Swedish model. A similar drop today would place the United States right above Taiwan.
I wonder if Diamond and Saez would be willing to place a wager on their claim that a 50 to 70 percent top marginal tax rate would not affect economic growth as it did in Sweden. If economists could be sued for malpractice, the loss associated with an eleven point decline in the U.S. per capita income ranking would be around $10,000 per person, for a total of three trillion dollars. That’s serious money.
By the way, Diamond was nominated to be a Fed governor but withdrew due to Republican opposition. Democrats howled: “That’s no way to treat a Nobel laureate.” It looks like the Fed may have dodged a bullet.
Paul Roderick Gregory’s latest book, ”Politics, Murder, and Love in Stalin’s Kremlin: The Story of Nikolai Bukharin and Anna Larina, ” can be found at amazon.com.
Paul R. Gregory is a Research Fellow, Hoover Institution Cullen Professor of Economics, University of Houston. Gregory has a regular blog http://blogs.forbes.com/paulroderickgregory/at Forbes.com