Blogger of the Week: Josh McCabe
Wellesley College
In his discussion of why Bernie Sanders is talking about Denmark, John Campbell makes several excellent points about the relationship between the size of government and economic competitiveness. He argues that U.S. Republicans, with their emphasis on tax cuts and small government, could learn from a thing or two from Danes, who seemed to have figured out a way to generously tax and spend without hurting the economy. The lesson is that the U.S. could afford to substantially raise taxes and increase spending on programs that reduce poverty.
The literature suggests that he is correct about the relationship between the size of government and poverty reduction (and economic growth) but his discussion neglects one crucial aspect of the tax system that help explains Denmark’s success. In addition to looking at the size of the government’s tax bite, we must look at its structure. How exactly does Denmark collect all that tax revenue to spend on social programs? On this point, its actually Democrats who have more to learn from Denmark than Republicans.
The common battle cry among Democrats is the promise to raise taxes on the much-maligned 1% of top income earners to fund proposed new social programs. This follows a long history of “soak the rich” rhetoric that sees progressivity as a form of tax justice. Republican presidential candidates, on the other hand, are pushing for policy changes that would make federal tax structures more regressive by moving toward a flatter income tax and possibly introducing a broad-based consumption tax. It may come as a surprise to many that the Danish tax system is much closer to GOP proposals in terms of structure.
It turns out that the most generous welfare states also have some of the most regressive tax systems. Prasad and Deng (2009) use Luxembourg Income Study (LIS) to compare the progressivity of thirteen tax systems, including the U.S. and Denmark. They find that U.S. taxes are the most progressive while Danish taxes are the most regressive of those measured. This shouldn’t be very surprising when we think about it. Even in an era of rising inequality, there is only so much the government can squeeze out of the 1%. In order to collect the amount of revenue needed to fund the Danish welfare state, the government needs to squeeze the middle class and even the poor.
Let’s look at income taxes in each country. Although Denmark’s top marginal tax rate on income and payroll taxes combined is much higher than the U.S. (60.4% vs 46.3%), the point at which income earners begin to pay this rate is much lower in Denmark. Only those making 8.5 times the average wage in the U.S. are subject to the top rate. In contrast, Danish wager earners making merely 1.2 times the average wage are subject to the top rate. That amounts to about $60,000 per year. Democratic frontrunner Hilary Clinton has already promised not to raise taxes on those making less than $250,000. This is hardly a recipe for collecting the revenue needed to fund much of anything. They key to Denmark’s success is taxing the working and middle class much heavier than the U.S.
Consumption taxes, like the value added tax (VAT), are the other secret to Denmark’s success. Economists tend to like these taxes because they are less distortionary for the economic factors they see as important to staying competitive. Despite their regressivity (the poor tend to pay more as a proportion of their income), advocates of more generous spending in other countries like them because they’re less salient and enable them to raise large amounts of revenue without the kind of backlash we’ve seen against income and property taxes. Denmark’s VAT is the highest in the world (25%) with very few exemptions or reduced rates on essential items. The U.S. is the only remaining rich democracy that doesn’t have a national VAT. State and local sales taxes collect about 1/5 the amounts collected by Denmark’s VAT. GOP candidate Ted Cruz’s proposal for what he calls a business transfer tax – a type of VAT – would move the U.S. closest to Denmark in terms of consumption taxes. This is part of the reason many Republicans fear VATs as money machines leading to bigger government. Democrats typically shy away from consumption taxes over worries about hurting the poor.
Lastly, measures of the size of U.S. tax and spending can be misleading because of the country’s uniquely extensive reliance on tax credits, exemptions, exclusions, and deductions that don’t show up as either revenues or spending on the budget. Most fiscal sociologists consider policies, like the exclusion of employer-provided health plans, to be de facto social programs – part of the U.S.’s hidden welfare state. When we account for these tax policies, the size of the U.S. welfare state looks much bigger (but also more regressive). Tax reforms eliminating these tax expenditures are likely to raise much more revenue than increases to the top income tax rate. Marco Rubio’s proposal to eliminate almost all itemized deductions is a good start along these lines.
Of course, all of these GOP proposals are aimed at shrinking the government’s tax bite rather than increasing revenues. The question remains of whether shifting the structure of the tax system will actually have this effect though. One argument is that Democrats are undermining their own effort to expand the size of the welfare state by opposing the kinds of broader, regressive taxes needed to raise the required revenues. If this is the case then the proposed shifts in tax structures we see in GOP plans might inadvertently lead to increased social spending down the road. Conversely, if we wanted to limit the size of government, Democratic plans to limit tax increases to the highest income earners might be the best strategy.
It turns out this decoupling of preferences for size and structure is pretty common. There is an ongoing debate in the literature whether increased revenues lead to more support for generous welfare states (in which case one should focus on the tax structure) or whether increased social spending leads to more support for regressive taxation (in which case one should focus on social programs) but the lesson is clear that structure is just as important as size when it comes to tax systems.
Thank you for this thoughtful post, Josh. When it comes to taxation, it is obviously important to consider size and structure both.
Yet, at the end, as Lucy Barnes notes here (http://themonkeycage.org/2012/02/the-facts-about-tax-progressivity/) the reason that US tax system achieves much less in terms of redistribution compared to social democratic regimes of Europe, despite being more progressive, is because “redistribution is not driven primarily by the structure of taxation, but by its level.”
The issue, as I see it, is that size is largely a function of structure. If you have a progressive tax system, preference for a smaller tax bite tends to follow. If you have a more regressive tax system, people don’t mind being taxed as much. There’s still a debate on why this is the case but the long-run tendency seems to be toward one of two policy trajectories, either progressive/small or regressive/large.
Monica Prasad sees the U.S.’s historical lack of fiscal capacity as the reason we don’t have a larger welfare state (Her newest book is an absolute must-read) but I actually think the opposite is true. Americans don’t support higher taxes because they don’t see them necessary for anything worthwhile. When push came to shove, all the other liberal welfare regimes introduced VATs in order to keep their spending up. People valued their family allowances and healthcare more than tax relief. Americans really have no universal, non-contributory programs worth raising taxes over which makes it really hard to make a case for increasing taxes on anybody but the rich.
Josh makes some good points and is right that big welfare states are generally funded primarily by more regressive tax structures, such as VAT in Denmark. I would add one thing: A very important reason why regressive taxes like VAT are so important for bigger welfare states is that they provide a relatively stable source of revenue that doesn’t fluctuate as much as it does with income and profit taxes, for instance, when the economy fluctuates. Regardless of how the economy is doing, people need to buy food, clothing, gas for their cars, etc. So he’s correct that we need to consider both the size and structure of any tax regime (as I noted in Institutional Change and Globalization some years ago).
Fascinating debate. So, should the US adopt a consumption tax? Lane Kenworthy has argued this (anyone who wants to be informed about the state of, and options for, progressivism in American really needs to read his book Social Democratic America).
I still hesitate–quite apart from the question of whether it’s even possible politically–because the reason it generates a lot of money is because it’s less visible. How can we possibly support a tax that people tolerate because they’re not aware of it??
To Monica’s point, indeed, whether any of this is politically possible is the elephant in the room. Issues of fairness aside, whether most politicians are in any mood to impose some sort of national VAT is highly unlikely. Closing loopholes in the current tax code is more likely but still pretty remote politically. Efforts in that direction were made in 1986, as I recall, but Congress was an entirely different animal in those days–people were reasonable, there was greater willingness to compromise, and the amount and nature of campaign finance money and lobbying influence in Washington paled by comparison to today. (And the Tea Party caucus wasn’t around.) All of which is to say that what we may need or want to do, won’t be happening anytime soon.
As to the issue of the visibility or invisibility of taxes, let’s not forget that “tax expenditures” (loopholes) are an integral part of the tax code and an enormous source of lost revenue. They are also for the most part so invisible that you need to hire a tax lawyer or seasoned accountant to find them on your behalf. A national VAT would be far more visible than these things. At least in Denmark, VAT charges show up on your bill (and if you are a tourist you can get a VAT refund on many purchases when you leave the country) so they’re pretty visible in that sense.
My answer would be no, the US shouldn’t adopt a consumption tax, for a few reasons. I take classical liberal concerns about “big government” much more seriously than most sociologists. I’m not closed off to the idea of introducing a federal VAT but there has to be a *very* good reason for it.
First, there’s no guarantee that the money will be used on what I see as legitimate programs (anti-poverty programs versus more military adventures abroad). If the revenues do find their way into anti-poverty programs, there’s little guarantee that it’ll be used efficiently and effectively (refundable CTC versus corrupt public jobs schemes). The spending needs to come first so that policymakers have a specific justification for why they need to introduce a new (less salient) tax.
An additional worry is that the same American proclivity for tax preferences in the income tax code would reproduce itself in a consumption tax code. Much of the current budget shortfall could be met by eliminating most of the “hidden welfare state” but is unlikely to happen because of political obstacles (again, I think related to lack of universal programs). “Tax justice” advocates and business groups already spend a lot of effort on the state level successfully exempting all sorts of goods/services from sales taxes (i.e. controversy over the so-called “tampon tax” in California). A federal VAT full of holes would similarly lose its revenue-generating power while distorting personal and economic choices even more than now. Broad exemptions for basic necessities would also make it less stable than the sorts of VATs that John points to in his comment. I’d rather see reforms aimed at eliminating tax expenditures than the introduction of new tax instruments.
Lastly, there’s the issue of salience as Monica points out. Part of me agrees but part of me has some doubts. As Junko Kato (2003) argues, and recent/current debates over VATs in Canada and Australia suggest, this is less of a problem in liberal countries that only adopted VATs in the post-1973 world. Not only has the introduction of VATs been highly contested but so have proposals to change the rate once introduced. The reason is not so clear but its suggestive of why a U.S. VAT might not as invisible as we think. The other precaution that might be taken is to make sure that prices are displayed VAT exclusive so consumers see the amount when they get to the register. I think Raj Chetty has done some work showing this has an effect (my quiet grumbling over the MA sales tax at the Amazon checkout page back this up) . Traceability may matter as much as salience. That said, the problem still remains and needs to be taken seriously, especially by critics who worry about the non-salience of tax expenditures for democracy.