Size Matters

Is Finland the most competitive economy in the world? So says the World Economic Forum, which each year ranks 102 countries on their competitive environment. Not only does Finland come out on top this year, but all five Nordic countries figure in the top 10.

Finland no doubt has many virtues -- a highly educated work force, a vibrant high-tech sector that includes Nokia Corp., a history of active foreign trade. The Wall Street Journal-Heritage Foundation 2003 Index of Economic Freedom ranks it No. 11 overall. But the Nordic states also shoulder some of the world's highest overall tax burdens. Finland's government expenditure as a share of gross domestic product has been falling, but in 2002 still stood at an unhealthy 45%, down from 47% in 2001. Sweden's state sector spends an amount equal to 53% of GDP, Denmark 51%. (The U.S. figure is 30%.)

Well, it turns out that all of these countries moved up this year because the WEF decided to stop weighing government expenditure in its rankings. It's been replaced with measurements of government "waste" and public confidence in public officials. We're prepared to grant that Scandinavia's state sector is efficient, but it's also massive. And size does matter.

One reason it does is that taxes must be levied to pay for those expenditures, and as another recent study shows, high taxes do after all equate with less work and less output overall. The report, published this fall by the Federal Reserve Bank of Minneapolis, tries to explain why Americans work, on average, 50% more overall than their counterparts in large European countries.

Author Everett C. Prescott does not specifically examine the Nordic nations, but his results are relevant there too. His highly technical analysis examines the effect of marginal tax rates on work and output in G-7 countries in the 1970s and the 1990s, and finds a strong empirical correlation between low marginal rates and work.

Needless to say, we're not shocked. And while direct marginal income-tax rates are not astronomical in Finland at 37%, Mr. Prescott's paper accounts for indirect taxes on labor as well (such as social security "contributions" that are theoretically paid by the employer but are a cost of labor). In most European countries, this total tax burden on labor approaches or exceeds 60% of the cost of labor to employers, and the Nordic states lead the league here.

Ironically, the World Economic Forum's survey of business executives emphasizes this same point. "Tax rates" rank as the No. 1 "problematic factor" for doing business in Denmark, Sweden and Finland. And because the respondents ranked both their biggest gripes and the intensity of their complaints, the results make clear that not only do they consider taxes the biggest problem overall, they consider it a very big problem indeed. In the case of the U.S., Byzantine corporate tax regulations rank as its top problem, but that is still only half as severe a burden as Finland's tax rates, according to the WEF.

The Forum points out that it's absurd to assume that zero government expenditure is optimal, and that's fair enough. But it's equally absurd to assume that the size of government spending doesn't matter. But don't take our word for it; ask the executives they polled for their survey.

Updated November 4, 2003