Just how regressive are the tax systems in the social democracies?

Image: George Stephanopoulos says Bernie Sanders "wants the United States to look more like Scandinavian countries," which may mean that Stephanopoulos believes Sanders has a plan to move the Norwegian fjords to America. (source)



A follow-up post (update: here) will consider how the tax systems of the social democracies differs from the tax system of the United States. Here, I'm going to focus exclusively on the question whether the tax systems of the social democracies are progressive or regressive.

This is a very important question because it's very fashionable among conservatives to argue that because the social democracies tax regressively, progressive taxation is incompatible with social democracy.

But the social democracies do not tax regressively, and it only appears that way because would-be tax policy analysts assume too many similarities between the American and social democratic models for tax and social welfare. Many Americans--experts included--assume that the social democratic model is the same as the American model, just more generous. That is flatly false: the social democratic model for taxation and social welfare is not a more generous American model--it's a different model entirely. Superficial similarities betray experts of the American tax system into making very basic mistakes.

Kyle Pomerleau at the Tax Policy Blog is typical in this regard. I could cite examples all day (here and here, for instance) of professionals making a mess of analyzing the tax systems of the social democracies. I myself have fallen into some these traps before. So don't think that Pomerleau has created some uniquely bad analysis. To the contrary, I'm picking on him because he's assembled a uniquely competent analysis. Most American tax policy wonks who try to characterizing the tax systems of the social democracies make such a mess that it's impossible to criticize what they've written; it's simply all wrong. I can use Pomerleau's post as an example because he manages to get enough things correct that I can fill in missing information. Most other examples are so hopelessly muddled as to be beyond repair. Pomerleau gets the raw numbers right, but fails to understand how the tax systems of the social democracies work.

Here is his very suspect summary statement of the tax systems of the social democracies (emphasis added):

In a recent interview on ABC’s This Week, Presidential hopeful Bernie Sanders reiterated his position that he wants the United States to look more like Scandinavian countries policy-wise:

George Stephanopoulos: “I can hear the Republican attack ad right now: ‘He wants America to look more like Scandinavia.’”

Bernie Sanders: “What’s wrong with that?”

Specifically, Sanders wants the United States to adopt a lot of the spending policies that many of the Scandinavian countries (Denmark, Norway, Sweden) are commonly known to have. Policies such as government sponsored college education, paid parental leave, and universal healthcare.

Many of these new government programs would be expensive and necessitate higher taxes. It is instructive to look at how Scandinavian countries structure their tax systems in order to raise revenue for these programs. Interestingly, some of the ways that Scandinavian countries raise revenue may make Sanders, who is a proponent of highly progressive taxation, uncomfortable.

Just how regressive are taxes in the social democracies?
In the above blockquote, I bolded two misleading statements. The first one is very tangential and Pomerleau shouldn't be faulted because he's a tax guy and not a social policy guy. He wrote, "Many of these new government programs would be expensive and necessitate higher taxes." I've spilled much ink on how the American social welfare system is just as expensive as the social democratic model. Aggregate (private plus public) spending on social welfare is basically the same in the United States as the social democracies. It's not a difference in overall cost; it's a difference in how programs are administered and financed. It's a difference of program efficiency and how well the true cost of each system is concealed with out-of-pocket private spending.

The second statement is more problematic:

Interestingly, some of the ways that Scandinavian countries raise revenue may make Sanders, who is a proponent of highly progressive taxation, uncomfortable.

Pomerleau later calls the tax systems of the social democracies "actually rather flat." That's wrong--but before we can continue, we have to be a little bit more specific of what we mean by tax progressivity.

As I pointed out with inequality measures (specifically the Gini coefficient) and gender discrimination, when studying things that affect all society, there can be no single measure that accounts for everything. In particular, the Gini sometimes gives nonsense conclusions, simply because it quixotically attempts to characterize an entire income distribution. Tax progressivity measures are the same: they also attempt to measure an entire income distribution are thus also create nonsense conclusions.

If the rich pay the highest tax rate but the poor pay a higher rate than the middle class, is this a progressive tax system? Or would it be better to say that some parts of the tax system are progressive and some parts of the tax system are regressive? Clearly--as with inequality--we need to look at multiple measures; a single measure will not suffice. We can never say that one tax system is more progressive than another. We are limited to claiming only that certain aspects of one tax system are more progressive or regressive.



It is true that the middle class in the social democracies pay higher tax rates than the middle class in the United States. But that's not what's meant by progressivity; in a progressive tax system, each income level pays higher tax rates than those poorer than them.

Here, let's focus on two features of progressivity: do the richest 1% pay lower or higher tax rates than everyone else? and do the poorest decile pay lower or higher tax rates than everyone else?

These are instructive examples because we'll find one progressive, one regressive, and see how the social democratic model is different from the American system, rather than simply a more generous American system. Let's take these two issues in turn:

Progressivity: comparing the lowest decile with everyone else
Pomerleau doesn't mention the poorest decile, but if we look at their situation, it will become obvious that taxes are not flat in the social democracies.

In a post with the awesome title of "Sweden does soak its rich," Matt Bruenig explains that progressivity measures are complete garbage:

To see why, consider two hypothetical countries, A and B. Suppose that in both countries, there are just two people, a person who has a market income of $10,000 and another person who has a market income of $100,000.

In country A, the effective tax rate of the poorer person is 1% and the effective tax rate of the richer person is 10%. This means that the poorer person gives up $100 in taxes while the richer person gives up $10,000 in taxes. Because the effective tax rate of the rich person is 10x the effective tax rate of the poor person, this would score as a very progressive tax system.

In country B, however, the effective tax rate of the poorer person is 15% while the effective tax rate of the richer person is 30%. At these rates, the poor person would give up $1,500 in taxes while the richer person would give up $30,000 in taxes. The rich person's tax rate is only 2x that of the poor person's and so this is seen as much less progressive than country A.

Would it be correct to conclude from this that country A soaks the rich and country B doesn't? No that's manifestly absurd. Country B extracts triple the amount of taxes from the rich person as country A does. Imagine that all of the tax revenue from the two countries was spent on universal benefits. In country A, that would mean each person gets $5,050 in benefits, giving the poor person a disposable income of $14,950 and the rich person a disposable income of $95,050. In country B, that would mean each person gets $15,750 in benefits, resulting in the poor person having a disposable income of $24,250 and the rich person having a disposable income of $85,750.

Clearly, country B, with the more "regressive" system is soaking the rich by a far greater amount. It, on net, shifted $14,250 from the rich person to the poor person, while country A only, on net, shifted $4,950 from the rich person to poor person. The tax system that is massively more "progressive" and "rich-soaking" (country A) transferred just one-third the amout of money from rich to poor!

Clearly, progressivity measures are fundamentally flawed. But they are especially flawed when we try to use them to compare the tax system of United States to that of the social democracies. These additional problems stem from the fact that social welfare benefits work fundamentally differently in the social democracies. Matt Bruenig again clarifies. For purposes of tax system progressivity measurements, the tax burden of the poorest 10% in the social democracies is indeed very high compared to the rest of the world. He uses the bottom decile of Finland as an example: the average income of the bottom decile is €13,915, and they pay €1314 in taxes--a 9.4% tax rate. Taxing the poorest decile 9.4%?! That sure sounds really regressive.

But wait--of that €13,915 average income, an average of €10,832--that's 77.8% of total household income--was income from government cash social welfare benefits. This is where tax progressivity measures break down. If the Finnish government reduced the tax burden of the poorest decile from 9.4% to 9% while simultaneously reducing government benefits from €10,832 to zero, the result would clearly be regressive--yet the tax system would be considered more progressive(!).

Clearly, tax progressivity measures were designed with the the United States in mind--because in the United States, government cash social welfare benefits (like Food Stamps and Social Security) are exempt from income taxes. Progressivity measures are obviously ridiculous when applied to the social democracies--because government social welfare benefits are subject to income taxes. It makes no sense to think of the Finnish poor being taxed regressively when 77.8% of their taxable income is cash benefits from the government. But that's exactly what these progressivity measures ask us to do.

The problem lies in a fundamental misunderstanding of how the tax and social welfare systems work together in the social democracies. In the United States, the tax system exists only to raise revenue. But in the social democracies, the tax system raises revenue as well as means tests cash social welfare benefits. That's why the tax systems cannot be compared directly--because they were designed to accomplish different goals. In the social democracies, all cash benefits are universal, and the tax system is used as a way to gradually phase out those benefits as household income increases--in other words, to take social welfare benefits away from people who do not need them.

For example, Finland has a universal childhood allowance--a cash payment to all families with children. The point of this allowance is to prevent childhood poverty. Every family with children gets the same dollar amount per child regardless of how rich or poor they are--because that's how universal benefits work. But benefits have to be financed with taxes, so--obviously--the rich and middle class must pay more in taxes than they receive in benefits. That's why the Finnish government collects income taxes on government benefits. For families that were not poor and don't actually need these benefits, the structure of the income tax system ensures that their income taxes are high enough to wipe out the childhood allowance cash benefit. The point of the benefit was to eliminate child poverty, but if a family isn't poor, then they don't need the benefit and have to return it to the welfare state through the income tax system.

This sounds really complicated and stupid. Why give rich families a universal benefit, only to take it away through income taxes? While counterintuitive, this is actually the most efficient, effective, and humane way to deliver antipoverty benefits like the childhood allowance. It far easier, cheaper, and efficient administratively to give everyone a benefit, then tax it away from the rich using income taxes, rather than giving the benefit to the poor alone. This may seem backwards, but it's not--and I've covered the administrative simplicity of universal benefits many times on this blog (eg, 1, 2, 3). Thus, what tax policy analysts are mistaking for a regressive income tax system is really a way for the social democracies to phase out their antipoverty benefits, taking back universal benefits from families who didn't actually need them.

Bruenig drives this home by looking at net transfers--in other words, taking into account income taxes and social welfare benefits, rather than only looking at income taxes. Obviously, if benefits are subject to income taxes, then calculating progressivity based on income taxes alone makes no sense--even if that's the most sensible way to think of taxes in the United States. Here's the graph:

Pretty darn progressive. Note that this is only for cash benefits--the value of social welfare services (like child care or health insurance) is not included on this graph. The poorest four deciles have very little of their cash benefits taxed away; the income tax system starts phasing out those benefits for the fifth decile, and by the seventh decile, cash benefits have been entirely offset by income taxes.

Conclusion: the tax systems of the social democracies are very progressive for the poorest decile.

Progressivity: comparing the richest 1% with everyone else
In the social democracies, the national share of pretax income of the richest 1% ranges from 6-8%. The average tax rate for this group is approximately 30%. Most of the poorest 99% pay approximately 40% taxes; that the richest 1% pays a lower rate than everyone else must reflect a large proportion of income from capital gains, which are taxed around 30%.

In this narrow sense--the richest 1% pays a lower tax rate than everyone else--the tax system of the social democracies is regressive. Clearly, that's not consistent with some of Bernie Sanders' proposals, which rely heavily on taxing the richest 1%.

But let's compare this to the American richest 1%. In the United States the richest 1% receives nearly a quarter of all national income and their average tax rate is approximately 20%--again, because much of this income is capital gains.

The important difference lies not in the tax rates, in the income distributions. For, in the social democracies, the richest 1% accounts for less than 10% of national pretax income. But in the United States, the richest 1% accounts for nearly a quarter of national pretax income. Clearly, the social democracies can afford tax the richest 1% regressively because the poorest 99% accounts for more than 90% of total national income. But in the United States, a welfare state could not be funded in this way; the poorest 99% only accounts for three-quarters of national income. Because the richest 1% accounts for such a massive share of national income in the United States, taxation to support a social democratic welfare state must necessarily be funded by progressive taxation. The richest 1% simply controls too much of the national income for us to tax like the social democracies do. The social democracies can tax their richest 1% regressively because their income distribution is progressive. We must tax our richest 1% progressively because our income distribution is regressive.

Conclusion
It's important to remember that the social democratic social welfare system is a different system from the American social welfare system. When we assume that the social democratic model is the same as the American model but more generous, we are led far astray and make conclusions that are complete nonsense. Coupled with tax system progressivity measures, which are sure to generate nonsense conclusions because they quixotically attempt to characterize an entire income distribution, much analysis of the social democratic model by American tax policy experts is complete garbage.

For the most part, the social democratic model is very progressive. The one part that could be characterized as regressive is taxation of the richest 1%. In the social democracies, the richest 1% indeed pays a lower tax rate than much of the rest of society. However, because the richest 1% accounts for under 10% of national pretax income, the welfare state can still be funded with with lower taxes on the richest 1%--simply because the poorest 99% accounts for over 90% of national pretax income. But in the United States, the poorest 99% accounts for just three quarters of national pretax income. (the richest 1% in the United States also holds over a third of all national wealth and the richest 0.1% has about the same amount of wealth as the poorest 90%).

The major differences in inequality means that an apples-to-apples comparison of the tax systems of the United States versus the social democracies is not possible. The same tax system will get wildly different revenues when income distributions are so radically different.

With such a massive share of national income, two things are clear: First, for the United States to become a social democracy, we must tax the richest 1% at higher rates than the social democracies do. The richest 1% in the United States simply accounts for too much of the total national income. Second, the rich in the United States are so much richer than everyone else that their income and wealth is clearly far out of proportion to their contribution to society.