Utopia, you are standing in it!

Sweden is a common example of a generous welfare state that is compatible with a prosperous society. One interpretation of the UN Development Index is you improve your national ranking by becoming more like Sweden.

Assar Lindbeck has shown time and again in the Journal of Economic Literature and elsewhere that Sweden became a rich country before its highly generous welfare-state arrangements were created

Sweden moved toward a welfare state in the 1960s, when government spending was about equal to that in the United States – less that 30% of GDP.

Sweden could afford this at the end of the era that Lindbeck labelled ‘the period of decentralization and small government’. Sweden was one of the fastest growing countries in the world between 1870 and 1960.

Swedes had the third-highest OECD per capita income, almost equal to the USA in the late 1960s, but higher levels of income inequality than the USA.

By the late 1980s, Swedish government spending had grown from 30% of gross domestic product to more than 60% of GDP. Swedish marginal income tax rates hit 65-75% for most full-time employees as compared to about 40% in 1960.

Swedish economists named the subsequent economic stagnation Swedosclerosis:

• Economic growth slowed to a crawl in the 1970s and 1980s.
• Sweden dropped from near the top spot in the OECD rankings to 18^th by 1998 – a drop from 120% to 90% of the OECD average inside three decades.
• 65% of the electorate receive (nearly) all their income from the public sector—either as employees of government agencies (excluding government corporations and public utilities) or by living off transfer payments.
• No net private sector job creation since the 1950s, by some estimates!

In 1997, Lindbeck suggested that the Swedish Experiment was unravelling.

Sweden is a classic example of Director’s Law of Public Expenditure. Once a country becomes rich because of capitalism, politicians look for ways to redistribute more of this new found wealth.

Studies starting from Sam Peltzman (1980) showed that government grew in line with the growth in the size and homogeneity of the middle class that became organised and politically articulate enough to implement a version of Director’s law. Director’s law augmented by Gary Becker’s 1983 model of competition among pressure groups for political influence explain much of modern public policy.

Government spending grew in many countries in the mid-20^th century because of demographic shifts, more efficient taxes, more efficient spending, shifts in the political power from those taxed to those subsidised, shifts in political power among taxed groups, and shifts in political power among subsidised groups.

The Swedish economic reforms from after 1990 economic crisis and depression are an example of a political system converging onto more efficient modes of income redistribution as the deadweight losses of taxes on working and investing and subsidies for not working both grew. Improvements in the efficiency of taxes or spending reduce political pressure to suppress the growth of the welfare state and thus increase or prevent cuts to both total tax revenue and spending.

After the rise of Swedosclerosis, the taxed, regulated and subsidised groups had an increased incentive to converge on new lower cost modes of redistribution. More efficient taxes, more efficient spending, more efficient regulation and a more efficient state sector reduced the burden of taxes on the taxed groups. Most subsidised groups benefited as well because their needs were met in ways that provoked less political opposition.

Reforms ensued led by parties on the Left and Right, with some members of existing political groupings benefiting from joining new political coalitions.

The Nordic median voter was alive to the power of incentives and to not killing the goose that laid the golden egg. The deadweight losses of taxes, transfers and regulation limit inefficient policies and the sustainability of redistribution.

For example, while tax rates are high in Sweden and the rest of Scandinavia, hours worked in Scandinavia are significantly higher than in Continental Europe.

Richard Rogerson found in Taxation and market work: is Scandinavia an outlier? that how the government spends tax revenues imply different rates of labour supply with regard to tax rate increases.

Rogerson considered that differences in the composition of government spending can potentially account for the high rate of labour supply in Sweden and elsewhere in Scandinavia. Specifically, examining the conditions on which how tax revenue is returned to Swedes as income transfers or other conditional payments is central to understanding the labour supply effects of taxes:

• If higher taxes fund disability payments which may only be received when not in work, the effect on hours worked is greater relative to a lump-sum transfer with no conditions; and
  
• If higher taxes subsidise day care for individuals who work, then the effect on hours of work will be less than under the lump-sum transfer with no conditions.
  

A much higher rate of government employment and greater expenditures on child and elderly care explain the high rates of Swedish labour supply.

Swedes are taxed heavily, but key parts of this tax revenue are then given back to them conditionally if they keep working. Policies that significantly cut the total wealth available for redistribution by Swedish governments were avoided relative to the germane counter-factual, which are other even costlier modes of income redistribution.