The Changing Face of European Economics: Liberalism Moves North

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Where do we find the nations with the highest tax levels? In the mid-90s the answer was quite clear: in Western Europe. Both Denmark and Sweden had a tax rate of 49 percent of GDP in 1996, followed closely by Finland with a 47 percent level. The tax burden was somewhat lower in France, Belgium, Austria and Italy, where rates ranged from 42 to 44 percent of GDP. Thanks to its oil-wealth Norway could afford a Nordic welfare model with 41 percent taxes, the same level as the Netherlands which had recently slimmed down its welfare system considerably. These Western European welfare states were the nine OECD countries with the highest tax rates. The tenth country was Eastern European Hungary with a rate of 40 percent.

And where do we today find the high-tax nations? Looking at tax data from 2012, the answer is again amongst the Western European welfare states plus Hungary. At first glance, little seems to have changed with time. The only country to leave the top-10 list is the Netherlands, which has recently been replaced by another Western European nation: Luxembourg. But a closer look shows that Western Europe’s welfare states have indeed changed, and are continuing to do so. With time, a significant convergence has occurred.

In 2012 Denmark still lead the tax league, with a 48 percent rate. France and Belgium had climbed to shared second position, with 45 percent tax rates. Rising levels in Italy and lowered ones in Sweden and Finland resulted in the three countries sharing a 44 percent level. Austria and Norway had increased their levels slightly, whilst the Netherlands had implemented further reductions. So, the welfare states with the highest taxes lowered their levels, whilst those with somewhat lower levels raised them. The Netherlands is the exception, as it continued to reduce relatively low taxes. No surprise then that it is the only country to leave the top-10 tax league.

Of course, taxes are far from the only indicator of economic policy. A range of other factors, such as trade openness, business policy and protection of property rights, affect the opportunities for job creation, competition and growth. The Index of Economic Freedom, published by the Heritage Foundation in partnership with the Wall Street Journal, ranks countries based on a broad set of indicators of economic freedom. The Western European welfare states can overall be said to combine large public sectors and high taxation with relatively free economic policies. But the differences between them are significant, and the direction of change has varied considerably during the last decades.

Tax rate % of GDP

1996

2006

2012

Change 1996-2012

Sweden

49,4

48,1

44,3

-5,1

Finland

47,1

43,5

44,1

-3,0

Netherlands

40,9

39,1

38,6*

-2,4

Denmark

49,2

49,0

48,0

-1,2

Austria

42,8

43,0

43,2

0,4

France

44,2

43,6

45,3

1,1

Norway

40,9

43,1

42,2

1,4

Belgium

43,9

44,4

45,3

1,4

Italy

41,6

40,8

44,4

2,8

* Data given for 2011. Source: OECD Stat Extract and own calculations.

When the index of economic freedom was first published in the mid-90s, it showed that the Netherlands and Austria were the most market liberal of the nine Western European countries listed above. Sweden and Italy were on the other hand found at the bottom. In the latest 2014 edition of the index, Denmark – which compensates for high taxes with market oriented policies, including a liberal labour market – has climbed to become the freest economy amongst the group.

In fact, Denmark ranks on 10th position globally, higher than even the US on 12th position and the UK on 14th. The Netherlands ranks on 15th place globally, followed by Finland and Sweden on the 19th and 20th positions. Belgium on the other hand has gone from being one of the more economically free Western European welfare states to becoming the third least free. Today the country scores on 35th place globally. France is found on a dismal 70th position, and is unique in having reduced its economic freedom score marginally between 1996 and 2014. Italy has merely increased its score by 0.1 points, ranking at 86th place– just below Kyrgyz Republic. The Western European welfare states might seem to have similar policies at first glance, but differences in market adaptation are in fact quite significant.

Heritage/WSJ Economic Freedom Score

1996

2006

2014

Change 1996-2014

Sweden

61,8

70,9

73,1

11,3

Finland

63,7

72,9

73,4

9,7

Denmark

67,3

75,4

76,1

8,8

Norway

65,4

67,9

70,9

5,5

Netherlands

69,7

75,4

74,2

4,5

Belgium

66,0

71,8

69,9

3,9

Austria

68,9

71,1

72,4

3,5

Italy

60,8

62,0

60,9

0,1

France

63,7

61,1

63,5

-0,2

* Data for 1997 given. Source: Heritage/WSJ Economic Freedom Index and own calculations.

The change in economic freedom parallels that of change in taxation, since taxation is an important part of economic freedom and since tax-reforms and other market reforms have tended to go hand-in-hand. The major changes have happened in the Nordics, particularly in the three high-tax countries which lack Norway’s oil-wealth. Sweden has lowered its taxes by over 5 percent of GDP between 1996 and 2012, by far the greatest change. The country has also increased its economic freedom score by over 11 points, again the most significant change. If Sweden had retained its 1996 score, it would score as the 78th freest economy today, just below Paraguay and Saudi Arabia.

Finland has reduced its taxes by 3 percent of GDP, and improved economic freedom almost as much as Sweden. Denmark still leads the tax league, but has also implemented major increases in economic freedom – quite impressive given that the country had a high economic freedom score already in the mid-90s. Norway has liberalized overall economic policy, but increased taxation somewhat. France and Italy have stagnated at a low economic freedom score, and relied on increasing taxation rather than growth-oriented reforms to fund public services. Belgium and Austria have implemented some economic liberalization, but increased taxes. 

The welfare states of Western Europe are quite complex. Their social and economic systems have much in common, but also differ in many ways. Today, as well as during the mid-90s, the countries in the world with the highest tax rates are found amongst this group. Still, major changes have occurred, and more seem on the way. In the upcoming 2014 elections of Sweden, it is more likely than not that the left will emerge victorious. But even the social democrats have, after initial resistance, accepted most of the current center-right government’s reforms. The social democratic government of Denmark is currently focused on reducing taxes, as well as government spending and the generosity of the welfare state. Part of the inspiration at least seem to come from the recent workfare policies of the Swedish right.

As I recently discussed in a New Geography article, the current government of the Netherlands has raised the issue of reforming the welfare state further, to a “participation society” by encouraging self-reliance over government dependency. Finnish policies focus on how new entrepreneurial successes can be furthered. Part of the background is that Nokia, which the country relied so much on, has quickly fallen behind the global competition. On the other hand, the small company behind the game Angry Birds has gained global attention and become a symbol of new Finnish ingenuity. France and Italy still struggle with faltering markets and sluggish development. Perhaps with time the countries will follow the lead of the Nordics and the Netherlands, in reducing the scope of big government, and moving towards lower taxes and increased economic freedom?

It is anything but easy to predict the future development of the Western European welfare states. But one thing is clear: the countries in the region that are doing well today are those that have reformed towards free-market policies and lower tax burdens since the mid-1990s. Given the apparent problems in France and Italy, and the continued interest for market reforms in the more vibrant North, it would seem that increased economic freedom is still the recipe for success.

Dr. Nima sanandaji is a frequent writer for the New Geography. He is upcoming with the book "Renaissance for Reforms" for the Institute of Economic Affairs and Timbro, co-authored with Professor Stefan Fölster.

Creative commons photo "Flags" by Flickr user miguelb.