8 Pressures on the Welfare State

Subhash Thakur, Valerie Cerra, Balázs Horváth, and Michael Keen
Published Date:
May 2003
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Whatever one thinks of its past performance, it is clear that the welfare state is likely to face significant challenges in the years ahead. Increasing internationalization of economic activity seems set to make it more difficult to raise revenue than it has been in the past,69 and at the same time demographic change points towards significantly increased revenue needs. This chapter assesses the extent of the challenges, and their likely impact on the considerable public support that has underpinned extensive government intervention in Sweden.

Increased International Mobility of Tax Bases

There is widespread awareness that the increased internationalization of economic activity may alter the effectiveness of, and hence the proper extent and form of, government intervention, with the prospect of a continued increase in the mobility of tax bases reducing the tax rates that Sweden optimally imposes and the level of revenue it optimally collects.70 Formal and informal obstacles to cross-border transactions in capital, commodities, and labor have been eased, and are likely to be eased still further in the future, both by policy measures—within the context of EU membership and more generally—and by advances in information technology that reduce informational imperfections and transaction costs. As a result, these cross-border transactions are likely to become more sensitive to cross-national tax differentials. This increased elasticity of the tax base with respect to tax rates then tends to reduce the level of tax rates that each country finds optimal to impose—and also to reduce the associated level of revenue that it is optimal to raise—by reducing the revenue raised from, and increasing the excess burden created by, a marginal increase in the tax rate.71 More generally, increased mobility makes it harder to sustain taxes other than benefit taxes (those that finance offsetting benefits received by the taxpayer, whether a company or individual). This implies, in particular, that redistribution—the essence of which is to impose a net fiscal loss on some in order to convey a net fiscal benefit to others—may become harder. This effect will be amplified to the extent that the better-off receive forms of income that derive from more mobile sources.72 These prospective problems are not unique to Sweden, of course73—being faced, in particular, by many other EU members74—but the extensive reliance on government intervention makes Sweden a key case study for others interested in how they, too, might be affected by these developments.

While the general proposition that increased internationalization will put downward pressure on tax revenues is clear enough, the quantitative extent of this effect is not. There remain various subtleties in assessing the impact of internationalization on the design of tax transfer systems. There are complex interactions, for example, between the effects of increased mobility of labor and capital. Increased mobility of labor may actually reduce the downward pressure on capital taxes, since the beneficial effect on wages of attracting more inward investment may be dissipated by the migration it induces (Kessler, Lülfesmann, and Meyers, 2000). Nevertheless, the key qualitative issues are broadly clear. Far less clear is their likely quantitative significance, and it is on this that the rest of this chapter focuses, taking in turn the three key broad tax bases: capital, commodities, and labor.


Sweden has long (and successfully) sought to maintain an attractive tax environment for inward investment, as discussed in Chapter 5. Mobility of real investment is nothing new for Sweden, which has for many years essentially viewed itself as an archetypal small open economy, open to capital movements and with little ability to influence the return that potential investors can earn in the world capital market.

It is quite a robust theoretical prescription that such an economy should not levy any source-based tax on the marginal return to investment.75 For in a small open economy the effective incidence of such a tax cannot be on the owners of capital, since they will ensure that they receive in Sweden the same after-tax return that they can earn elsewhere. It can only be on domestic immobile factors—principally labor—but with the unwanted side effect of raising the gross return to capital and so inducing excessive labor intensity of production. Put differently, increased capital mobility increases the marginal excess burden associated with a source-based capital tax, an effect that Hansson (1987) shows to be potentially significant. This distortion can be avoided by simply taxing the immobile factors directly. Since the key source-based tax is the corporate tax, this prescription translates into that of a marginal effective corporate tax rate of zero. While Sweden has not fully eliminated source-based taxes on all marginal investments, it was seen in Chapter 5 that the average level of such taxes has been low for many years. Although there is scope for achieving this effect by simpler means—establishing more uniform treatment of different kinds of investments—there is little reason to suppose or recommend that this aspect of tax policy will or should change as internationalization intensifies.

The prescription of no source-based tax on marginal investments does not imply, however, that there should be no corporate tax, though there are strong reasons for setting it at an internationally competitive level. Without a business-level tax, tax could be avoided by incorporating, retaining earnings in the corporation, and delaying the realization of the consequent capital gains.76 Moreover, a well-designed corporation tax can raise revenue by taxing the rents earned on intramarginal investments without distorting investment incentives at the margin. For investments from countries that give a credit for taxes paid in the source country—such as the United States, the main single proximate source of direct investment in Sweden—taxes can be levied up to the level of the residence-country tax without imposing any additional burden on the investor, the effect of the credit being that residence-country taxes are reduced one-for-one by source-country payments. The rate of corporation tax cannot be raised too far, however. Doing so will increase the average effective rate of corporation tax (a concept explained in Chapter 6 and the Appendix), even for investments from jurisdictions offering foreign tax credits, since no additional credit will be available once the rate in Sweden exceeds the residence-country rate, thereby making Sweden less attractive to foreign investors. Only rents specific to Sweden can be taxed at high rates without risk of driving investment away, and these are likely to become increasingly limited as the Swedish economy becomes more integrated with the rest of the EU and other countries. Not least, high statutory rates of corporation tax make a country vulnerable to transfer pricing and financial operations that shift paper profits to jurisdictions with lower taxes.

Current arrangements in Sweden appear quite well-adapted to these considerations. The rate of corporation tax is reasonably low by the standards of the major developed economies. Revenue from the corporation tax is somewhat below OECD and EU averages, but nevertheless remains quite substantial, at around 5.7 percent of total tax revenue in 1998, or 2.9 percent of GDP. Nor has there been any clear tendency for receipts to fall: in the latter part of the 1980s they were around 2 percent of GDP. This apparent resilience of corporate tax revenues relative to GDP has been observed in many other countries and is something of a puzzle (Devereux, Griffith, and Klemm, 2002). It reflects the consequences of reforms that, like the 1991 reform in Sweden, have lowered statutory rates of corporation tax (so minimizing the erosion of the base as a result of transfer pricing devices) while broadening the base (so bolstering revenue, at least from relatively immobile domestic investments). Nevertheless, continued downward pressure on the rate of corporation tax in Sweden can be expected. While the 28 percent statutory tax rate established in 1994 was then among the very lowest of developed economies, this is no longer the case. The U.K. rate, for instance, is now 30 percent; that in Germany was reduced dramatically by their 2000 reform from 40 percent (on undistributed profits) to 25 percent;77 the Irish rate is to be reduced to 12.5 percent by 2005; and Estonia, a potential EU member, has no corporation tax at all.

The likely extent of these pressures on corporate tax revenues is hard to gauge, but, in the absence of effective international coordination, the direction is clear. With the MECT averaging close to zero, there is little prospect of painlessly replacing corporate taxes by an explicit increase in the tax on employment income. In this sense the whole of the corporate tax revenue is at stake. The pressures on these revenues would be mitigated to some degree if the EU were to adopt a minimum rate of corporation tax (as proposed, for example, by the Ruding Committee, 1992) or, perhaps, move towards some system of formula apportionment78 (a possibility raised by the European Commission, 2001). These remain remote prospects, however, and in any event, pressures from low tax rates outside the EU would remain. Recent experience and Sweden’s long-established expertise in preserving an attractive tax environment while sustaining revenues both imply a limited risk of a dramatic erosion of corporate tax revenues in the near future. But it would be prudent to factor in a modest reduction into medium-term fiscal planning.

In contrast, openness per se does not imply that taxes on personal savings are optimally zero. In Sweden, as is the norm, capital income accruing to individuals is taxed on a residence basis; that is, Swedish residents are liable to Swedish tax on their capital income (and, under the wealth tax, on their assets) wherever in the world it arises (generally with a credit for foreign taxes paid on that income). In sharp contrast to the result for source taxes referred to above, there is no intrinsic reason for a small open economy to set a low or zero residence-based tax. There may well be other arguments for doing so, in terms of the impact of savings on capital accumulation, or the structure of consumer preferences,79 but openness as such does not directly affect the optimal tax treatment of personal savings. The real issue is simply the difficulty of enforcing the residence principle, given the opportunities—which are likely to continue to increase—that internationalization creates for individuals to locate their savings in low-tax jurisdictions and simply fail to report the associated income and/or capital to the authorities of their residence country. Evasion of domestic savings taxes by this route jeopardizes revenue and creates pressure to reduce the tax rates applied.

Though reliable information is naturally hard to obtain, the revenue loss from undeclared assets abroad is likely to be relatively small at present. There are few obstacles to Swedish residents investing abroad, as they have been able to legally acquire foreign equities since 1989 and to hold foreign bank accounts since 1993. Assessing the extent to which these opportunities are used to evade Swedish tax is, by the very nature of the activity, extremely difficult. The Social Democratic Party has produced estimates, based on the discrepancy between financial and national accounts, suggesting that households’ undeclared savings abroad amounted to about SKr 350 billion in 1997.80 This is equivalent to about 16 percent of the sector’s total measured financial assets, and nearly double the corresponding level of estimated undeclared savings in 1992. Assuming that these assets earned an average return of 8 percent, and that they would be fully taxable in Sweden—so ignoring, for instance, any tax withheld for which a credit would be available in Sweden—the implied revenue loss is about SKr 8.4 billion, or around 0.8 percent of general government revenue in 1997. Assuming further that one-third of these assets were also liable to wealth taxes, the implied revenue loss is still less than 1 percent of total revenue.

While the revenue loss would rise if the extent of evasion were to increase, it is unlikely to be dramatic. Taking the extreme case to illustrate possible orders of magnitude, if all interest and dividend income that was taxed in Sweden in 1998 had instead arisen abroad and been undeclared, general government revenue would have been lower by about SKr 11.6 billion, or 1 percent of the total. Grossing up (using an assumed 10 percent return) and taking one-third of the implied asset base to be properly liable to wealth tax, the revenue loss rises to about 1.2 percent.81 Since individuals are likely to continue to hold a substantial portion of their wealth in real estate and Swedish equities, the opportunities for evading individual taxes on wealth and capital gains by taking income abroad, though not zero, are likely to be less. If a third of the bases of each were to vanish due to underreporting, revenue would fall by an additional SKr 7.7 billion, for a total loss—from all three sources—of a little under 2 percent of general government revenues.

The illustrative calculations in the preceding paragraph are based on assumptions that will tend to overstate the revenue risk. In one important respect, however, they may understate it. In so far as interest income is deductible against Swedish tax at a marginal rate higher than that at which it is taxed abroad, there are potential gains from pure tax arbitrage. Borrowing SKr 100 in Sweden at an interest rate of 10 percent in order to lend, at the same rate, in a country that taxes interest at 5 percent—a transaction that generates no profit in the absence of taxes—generates a profit after taxes of SKr 2.5 (the excess of the deduction in Sweden, SKr 3, over the tax payable abroad, SKr 0.5). Thus the risk is not merely that interest income otherwise taxable in Sweden will escape tax, but that revenues in Sweden will be further undermined by residents borrowing, and taking tax deductions, to acquire interest income untaxed in Sweden. The likely extent of such transactions is hard to judge, being in principle limited only by imperfections in the capital market. Certainly the attractions of such arbitrage are limited by spreads between borrowing and lending rates, and by exchange rate risk; but the former will become less of a concern as the efficiency of the banking sector improves (as stressed by Andersson and Fall, 2000), while the latter would be reduced if Sweden were to adopt the euro. Alternatively, one could imagine multinational corporations or banks (of which Sweden has many) performing tax arbitrage operations in house, almost costlessly and without credit risk. There are, indeed, signs that taxpayers are adept at exploiting the potential value of interest deductions: net revenue from the taxation of interest income is already negative, with net taxable interest in 1998 of minus SKr 19 billion.

There is thus reason to suppose that pressures to reduce the rate of tax on capital income will intensify. As noted earlier, the current rate of 30 percent on interest and dividend income is not among the highest of the top marginal rates in the OECD—but neither is it among the lowest. For those with relatively small amounts of capital income, moreover, the flat rate of 30 percent under the Swedish dual income tax is likely to be higher than the rate they would pay in countries that apply a progressive tax to an aggregate of capital and labor income.

One difficulty that would arise in lowering the rate applied to capital income is that it would intensify the incentives that currently exist under the dual income tax to transform labor income (taxed at marginal rates of up to 55 percent) into capital income. Policing the borderline between the two types of income is especially difficult for small businesses, since employees can acquire equity stakes, for instance, and take part of their employment income as lightly taxed return on capital.82 Thus reducing the flat rate of capital income tax would put pressure on current levels of labor income taxation, amplifying the effect on total revenues.

These downward pressures on the flat tax on capital income may be mitigated by a recent agreement, in principle, to improve international cooperation with a view to strengthening personal taxes on interest income. Member states of the EU agreed in 2000 to move towards a mutual routine sharing of information, enabling them to bring under taxation their residents’ interest income arising elsewhere in the EU.83 Much important detail remains to be resolved, however—not least in terms of negotiations with key nonmembers, a prerequisite for action by the member states. At a technical level, the proposal to exchange information routinely is innovative, and its effectiveness remains to be tested. Doubtless the mere knowledge that information is being exchanged will have a salutary effect on tax compliance, at least in the early years of the scheme. The more fundamental difficulty remains, however, that the agreement will leave open opportunities for tax evasion through nonparticipating countries.

While there remain many imponderables in assessing the outlook for revenues from the taxation of savings, there is a clear downside risk. This risk is perhaps even higher than with the corporation tax, and may be of the order of a few percentage points of current tax revenues.


The increased ease of moving commodities across borders, both legally and illegally, makes high indirect taxes harder to sustain.84 Cross-border movement of commodities into and out of Sweden has become easier in recent years, particularly with the easing of fiscal controls at frontiers in the context of the EU’s single market program and the expansion of links with the countries of the former Soviet Union. This facilitates the arbitraging of indirect tax differentials across countries—both through relatively small-scale, legal, own-use purchases by individuals, and through organized smuggling—and so potentially exerts downward pressure on both tax rates and revenue. High excises on alcoholic drink and tobacco are likely to come under particular pressure. The incentive for “cross-border shopping”—using this term to cover a wide range of transactions, from legal purchases within traveler’s allowances to illegal smuggling and diversion frauds85—depends on the extent of tax differentials between countries. Irrespective of differentials relative to other countries, moreover, high indirect taxes in themselves run the risk of inducing evasion activities, including through the smuggling of goods that have not been taxed in any jurisdiction and illicit domestic production. As can be seen from the comparative indirect tax rates for the EU countries shown in Table 18, Sweden has the highest excises of any EU country on wine and spirits. They are far higher, in particular, than in Denmark or Germany, both easily reached from Sweden. The tax differentials this implies are amplified, moreover, by the high rate of VAT in Sweden—equaled only by that in Denmark—which is applied to the excise-inclusive price. Cigarette taxes are not out of line with those in neighboring EU countries, though the prospect of more open borders with nearby EU accession countries does pose a risk. The VAT rate itself is also sufficiently in excess of that charged elsewhere, notably in Germany, to risk generating tax-induced shopping on a broad range of items.

Table 18.Indirect Tax Rates in the EU, August 2002
VAT1Cigarettes2Unleaded petrol3Still wine3Beer4Distilled spirits5
United Kingdom17.580.4.742–.7912.500.194631.68
Source: EU Excise Duty Tables (July 2001).

Standard rate.

As percentage of price of most popular category.

Euros per liter.

Euros per liter per degree Plato of finished product. (The degree Plato is a measure of sugar content and hence alcohol potential of the unfermented liquor, or “wort” from which beer is made; 1 degree Plato corresponds roughly to 0.4 percent alcohol content by volume.)

Euros per liter of pure alcohol.

Euros per liter per degree of alcohol of finished product.

Source: EU Excise Duty Tables (July 2001).

Standard rate.

As percentage of price of most popular category.

Euros per liter.

Euros per liter per degree Plato of finished product. (The degree Plato is a measure of sugar content and hence alcohol potential of the unfermented liquor, or “wort” from which beer is made; 1 degree Plato corresponds roughly to 0.4 percent alcohol content by volume.)

Euros per liter of pure alcohol.

Euros per liter per degree of alcohol of finished product.

While cross-border shopping appears to be sizable in Sweden, its impact on budgetary revenues seems to be limited.86Table 19 reports estimates of the excise revenue lost from cross-border shopping. About one-third of the spirits consumed in 1996–97, it is estimated, were either smuggled or illegally distilled. For cigarettes, it is estimated that about 159 million sticks were smuggled, for a revenue loss of SKr 0.25 billion; the SKr 0.9 billion in the table comes from applying the same loss per stick to an estimate of 540 million sticks—a considerable increase—smuggled more recently. For alcoholic drinks, the forgone excise revenue is SKr 2.2 billion, with the associated VAT loss estimated by the ministry of finance to be SKr 0.94 billion. The implied total loss on excisable commodities is a little over SKr 4 billion, or around 0.34 percent of general government revenue. Even adding a loss of around SKr 0.75 billion in relation to new cars, the estimate for the excise revenue loss from cross-border shopping remains well below ½ of 1 percent of general government revenues.

Table 19.Estimated Excise Revenue Losses from Cross-Border Shopping(SKr billions)
Source: Ministry of Finance; and National Tax Board.

See text for derivation.

Source: Ministry of Finance; and National Tax Board.

See text for derivation.

While the downward pressures on excise tax rates implied by cross-border shopping are already being felt and acted upon by Swedish policymakers, there is little doubt that these pressures will increase. In June 2001, the government announced a reduction in the excise on wine by nearly 20 percent. The derogation under which Sweden is allowed to limit the quantities of tax-paid goods that travelers may import expires in January 2003. It may also be that the Internet will further facilitate cross-border movements, although business-to-consumer transactions (the only ones that properly give rise to a consumption tax liability) have remained relatively limited so far; and only about 3 percent of the VAT base relates to digitized products that pose the most novel tax problems associated with the Internet. Some protection against erosion is provided by the minimum indirect tax rates set by the EU, which in due course may also come to apply to Sweden’s Baltic neighbors. However, the potential future revenue at risk is significant. The yield from the excises in 1999 was about SKr 82 billion. Most of this comes from energy taxes, which are likely to be relatively robust against cross-border shopping. Nevertheless, even ignoring the associated reduction in VAT payments, a loss of one-eighth of this would reduce general government revenues by about 0.8 percent. Still larger sums would be at stake if the high standard rate of the VAT itself were to come under strain.


Labor mobility is potentially a concern—in terms of both its potential distortion by, and effect on, the welfare state—mainly at the two ends of the income distribution. The risk is that measures of redistribution may give rise to emigration by the better-off (with consequent loss of tax revenues and skills) and immigration at the bottom end (with consequent pressures on the welfare state in so far as migrants are net fiscal beneficiaries).

The prospect of outward movement of labor in response to the tax transfer system has been a concern for some years. Indeed, Pomp (1999, p. 87) argues that “The departure of Ingmar Bergman, Björn Borg, and Ingemar Stenmark has done more to focus Swedish attention on the enormous erosion of incentives than the writings of all the economists between Stockholm and Stanford.” How significant a threat this is to the current welfare state, however, is far from clear.

The first place to which one naturally looks for fiscal distortions to labor is the discrepancy in average effective tax rates on labor income between Sweden and likely countries for emigration. Table 20 shows the average effective tax rates that a worker receiving the average production wage (first column) or 167 percent of that wage (second column) would face in the countries of the EU. The first figure in each cell shows the rate taking account of income tax, employee’s social security contributions, and transfers. To take account of the reduction in real incomes brought about by indirect taxation, the figure in parentheses adjusts also for VAT at the standard rate of 25 percent. This will overstate the combined tax burden to the extent that part of consumption will be subject to VAT at a lower rate than the standard rate, and to the extent that some income is saved (although the latter effect averages to around zero over longer periods, because VAT will be paid on the future consumption financed by today’s savings). The conclusion that emerges from the comparisons in this table is moderately reassuring: though clearly high, relative to a number of member states, the combined tax burden in Sweden is not out of line with those in the other countries of continental northern Europe.

Table 20.Average Effective Income Tax Rates for a Single Earner, 1998
At Average Production WageAt 167 Percent of Average Production Wage
Austria28.6 (40.5)35.0 (45.8)
Belgium41.8 (51.9)48.7 (57.6)
Denmark43.4 (54.7)50.4 (60.3)
Finland35.4 (47.0)42.6 (53.0)
France27.3 (39.2)30.7 (42.1)
Germany42.1 (50.1)47.5 (54.7)
Greece18.3 (30.8)23.3 (35.0)
Ireland24.9 (37.9)35.9 (47.0)
Italy29.1 (40.9)33.8 (44.8)
Luxembourg24.6 (34.4)33.9 (42.5)
Netherlands34.4 (44.2)38.9 (48.0)
Portugal18.1 (30.0)24.5 (35.5)
Spain20.2 (31.2)12.8 (24.8)
Sweden34.4 (47.5)42.0 (53.6)
United Kingdom25.2 (36.3)27.0 (37.9)
Average29.9 (41.1)35.1 (45.5)
Sources: OECD (2000); and authors’ calculations.Note: Figure in parentheses is the VAT-inclusive average effective rate, calculated as (v + t)/(l + v), where v is the standard rate of VAT and t the effective rate preceding the parentheses.
Sources: OECD (2000); and authors’ calculations.Note: Figure in parentheses is the VAT-inclusive average effective rate, calculated as (v + t)/(l + v), where v is the standard rate of VAT and t the effective rate preceding the parentheses.

The migration decision is affected, however, by a range of measures not included in these calculations. Levels of gross pay are likely to be depressed, for instance, by the relatively high level of employers’ social security contributions in Sweden and, at higher levels of pay, by the extensive wage compression. Comparing net pay across countries within occupational groups, Andersson (1995) reports substantially lower net wages in Sweden. He also emphasizes, however, that account needs to be taken of the consumption benefits from public expenditure enjoyed in the various countries, on which score Sweden looks attractive. Moreover, the migration decision is more complex than such comparisons allow. Individuals may exploit tax differentials of different kinds at different times in their life, earning and saving in low income tax countries—perhaps repatriating earnings to their families in the home country—and then retiring to countries with low consumption and wealth taxes. On balance, while there are significant avoidance opportunities under the wealth tax, as noted earlier, Sweden would seem in a fiscal sense relatively unattractive to the wealthy.

Outward migration of Swedes has not been high enough to become a serious concern. Emigration does not currently appear high or increasing, even within the common Nordic labor market. In the 1980s, for example, an average of only 0.1 percent of Swedes emigrated, far below corresponding figures for Germany and Norway. In 1999, total emigration was about 39,000, compared with a total population of 8.9 million. While it appears relatively commonplace for highly skilled workers in Swedish multinationals to spend time working abroad, return migration historically seems to be high.

Sweden has been quite receptive to inward migration, with immigrants exceeding emigrants by around 14,000 in 1999—around three times the figure for the early 1980s. Immigration policy has been marked by a receptiveness to asylum seekers and refugees. In 1998, about 5.6 percent of the population was foreign born, a higher proportion than in any other northern EU country. In recent years, a high proportion of these—around 70 percent—have been asylum seekers, a group with a high welfare dependency. There appears to be no assessment of the net fiscal cost from this, although survey evidence continues to show a relative lack of political concern among Swedes (Brücker and others, 2002).

Looking forward, the key issue is the likely extent and impact of inward migration associated with EU enlargement. One estimate is that ultimately 2–4 percent of the population of the potential accession countries may wish to migrate to the current members (Brücker and others, 2000). Since people from these countries account for a higher proportion of the population in Sweden (3 percent) than in any other EU member except Germany—which suggests potentially strong family and community links—Sweden may be a target destination for a significant number of these migrants. Moreover, during its presidency of the EU in the first half of 2001, Sweden committed itself to a more liberal immigration policy toward these countries than did other EU members.

Assessing the extent of the likely inflow with any precision is extremely difficult. The relative generosity of the tax transfer system may increase the attractiveness of Sweden as a destination, but the state of the labor market is also likely to be important. Continued rigidities may make it hard to absorb inflows, which in turn will have feedback effects on migrants’ decisions that tend to reduce the inflows. The impact on public finances depends on the nature of the immigrants, and could even be beneficial. If, as seems likely, they are largely relatively young and relatively highly skilled, perhaps with a high propensity to return home after a period of good earnings, the impact may be to strengthen the public finances.

Spending Pressures

The prospect of strains on revenue would be less of a concern if there were also prospects of reduced spending pressures. Unfortunately, this is not the case.


Population aging set in earlier in Sweden than elsewhere, and firm action has been taken to deal with the pension implications. By the early 1990s, the old-age dependency ratio in Sweden was already at levels that other industrialized countries are projected to reach only in the coming years (Hagemann, 1995). This prompted a major reform of the pension system in 1999—described in Box 3—which included the introduction of an automatic stabilizing mechanism, placing it on a financially sustainable basis.

After 2010, however, significant further demographic pressures can be expected, including from nonpension age-related spending. Projections in the 2001 budget show a sharp increase in general government expenditure from 2010. Excluding interest payments, this is projected to be around 55 percent of GDP compared with the current 51 percent. This reflects rising pension payments and an increase in other age-related expenditures on health and social services for the expanding old-age cohorts. While the larger pension expenditures will be increasingly accommodated within the new pension arrangements, substantial fiscal pressure—perhaps in the order of 3 percentage points of GDP over the next 50 years—is likely to emerge on account of other age-related spending.

Local Government Spending and the Equalization System

Control of local government spending is key to controlling the overall level of public expenditure. Local government spending on health, education, social services, and other items, mentioned in Chapter 2, accounts for over 40 percent of general government expenditure. Although subject to a balanced budget rule, with expenditure ceilings applying only to central government, there is some risk that pressures on the level of spending at the central level may be deflected into an increase in local spending.

Current equalization arrangements limit the incentives that local authorities face to improve the quality of the services they provide or limit the tax rates they set. In an attempt to redistribute resources towards poorer localities, funds are reallocated horizontally between them, with each ultimately receiving an amount equal to the product of their populations and:

(Own tax base) x (Own tax rate) + (Average tax base - Own base) × (“Corrected” average tax rate),

where the averaging is across all local authorities, tax bases are computed in per capita terms, and the corrected average rate is 95 percent of the average, with further adjustments reflecting the division of responsibilities between the county council and municipalities in each county.87 This structure has two adverse consequences on the incentives faced by local authorities, best seen by noting that, for an authority charging the average tax rate:88

Box 3.Reform of the Swedish Pension System

At the start of 1999, Sweden implemented a radical reform of its old-age pension system in response to the expected sharp increase in the dependency ratio over the coming decades, placing it on a financially sustainable basis. The preexisting system was based on a national guaranteed minimum pension, a public defined-benefit pension financed on a pay-as-you-go (PAYG) basis, private pension insurance, and trade union or occupational pension schemes. The reform transferred responsibility for non-age-related pension payments (survivors’ and disability pensions) to the central government. In compensation, the National Pension Fund made substantial transfers to central government, contributing to a substantial reduction in public debt. Public funds associated with pensions remaining after the transfers constituted the buffer funds: four large funds competing on an equal footing from 2001, and a smaller one with the objective of investing in small and medium-sized Swedish enterprises not listed on the Stockholm Stock Exchange.

The new system applies in full to those born after 19541 and comprises two tiers: the main components are a public PAYG pension scheme (income pension) with associated buffer funds, and a fully funded defined-contribution scheme (premium pension). The bulk of the 18.5 percent of pensionable income contribution, 16 percentage points, finances the PAYG scheme. The remaining 2.5 percent is channeled by the Premium Pension Authority, a government agency, to privately managed pension funds offering fully funded pension rights, chosen by the income earner. All pension funds are strictly regulated and supervised. The activities of the public funds are also the subject of annual government evaluations performed each spring and published on June 1.

The new pension system has an automatic “balancing mechanism” that ensures that the system remains able to meet its obligations with fixed contribution rates and benefit calculation rules. The balancing mechanism stipulates that the system’s liability is indexed to the growth in average income so long as the present value of the system’s revenues and assets, including the buffer funds, exceeds its liabilities; if it does not, indexation is lowered until long-term financial balance is reestablished, at which time the system reverts to the original indexation rule. Under current projections, this mechanism is unlikely to be brought into play.2

The pension reform has significant implications for financial markets. Initially, the foreign exchange market may have been most affected as a stock adjustment in public pension funds triggered by a relaxation of their foreign exchange exposure rules ran its course. A noticeable medium-term impact is likely on the equity and bond markets, where the various pension funds will play an increasingly important role. The private pension funds are likely to go through a round of consolidation triggered by rising competitive pressures that could substantially reduce their numbers.

1 Pensions for people born before 1939 will be paid according to the old pension system, while a prorated mixture of the two systems will apply for those born between 1939 and 1954.2 For an account of the system by one of its architects, see Settergren (2001).
  • Short of attracting a net inflow of migrants—likely also to increase expenditure needs—there is little revenue to be gained by increasing the tax base through enhanced tax administration or improving the quality of public services and the effectiveness with which money is spent. This is because the direct revenue gain from an increase in the local tax base is offset by a reduction in the transfer received.

  • A small increase in its own tax rate will always increase the revenue it receives, since the usual limit to increasing revenue by raising tax rates that is implied by the contraction of the tax base does not operate: from the perspective of the local authority, any such contraction is offset by an increase in the transfer it receives.

While local governments are not simply “leviathans” concerned only with maximizing their own tax revenue, the inducement to inefficient and excessive expenditures, consequent upon such full equalization, is clear.

Political Economy

The Swedish welfare state has been built upon—and, as the outcome of the 2002 parliamentary election confirms, continues to enjoy—a broad consensus of political support, reflecting both a widespread egalitarian sentiment (also reflected in Sweden’s strong record of support for developing countries) and, doubtless, some degree of vested interests. The retrenchment of the 1990s also had broad social support: with a budget deficit of over 12 percent of GDP in 1993, the need for scaling back public expenditure became clear enough. In the present strong fiscal position, however, there will be pressure to reverse some of the past expenditure cuts. These found some reflection in the spring 2001 budget (in which, for instance, the ceiling on unemployment benefit receipts was increased). Such pressures may be compounded by a sense, among some commentators at least, that the reforms of the early 1990s compounded the recession that followed—inducing precautionary saving by the prospect of reduced social insurance—and that the gains from those reforms may not have been as spectacular as their more ardent advocates projected.

Increased pressure for redistribution might also be expected, and perhaps is already perceptible, from the rise in before-tax inequality over recent years. The Gini coefficient for the distribution of factor income—movement of which has commonly been glacial—has increased by around 15 percent over the past decade. Table 21 shows a significant increase in overall wage dispersion, especially between the upper and lower deciles. Many models would predict such an increase in before-tax inequality to lead to increased political support for redistribution. Majority voting over a linear income tax, for instance, leads to more progressivity in the tax, the greater the amount by which the median income falls below the mean.89

Table 21.Wage Dispersion
90/10 ratio150/10 ratio2
Source: Ministry of Finance.

Ratio of wage rate of 9th decile to that of 10th decile.

Ratio of wage rate of 5th decile to that of 10th decile.

Source: Ministry of Finance.

Ratio of wage rate of 9th decile to that of 10th decile.

Ratio of wage rate of 5th decile to that of 10th decile.

The politics of redistribution90 are complex, however, and there is some empirical evidence to suggest that higher before-tax inequality is associated with less redistribution. Persson (1995) suggests that this may be explained in terms of individuals’ preferences being defined not only over their own consumption but also on their consumption relative to that of others. Taxation then serves in part to correct the external damage that each individual confers on others by working more. And, the more equal initial incomes are, the more this consideration may dominate over standard efficiency and redistribution concerns. When before-tax incomes are identical, for instance, all voters may agree on a high marginal tax rate in order to mitigate the mutual damage that each would cause others by earning more, but when incomes are dissimilar, the element of redistribution between them implied by progressive taxation may eliminate the consensus for such a tax structure. Another potential explanation is that of Peltzman (1980), who argues that a negative association between inequality and the extent of redistribution might be explained by a diminished sense of solidarity between middle and lower income groups as inequality increases. These issues are clearly complex, and relatively little understood. In terms of practical politics, however, there appears as yet no reason to expect a substantial erosion of intrinsic support for the present extensive government intervention in Sweden.

Changing Labor Market Institutions

Sweden’s specialized labor market institutions have had a mixed record over the past decades. They have delivered stable periods with nearly full or fast-growing employment, as well as unstable ones characterized by rapidly rising unemployment. As noted in Chapter 4, Friberg and Uddén-Sonnegärd (2001) distinguish three periods since 1970:

  • The traditional centralized wage formation model, 1969–82. The key negotiating partners under the centralized framework were the Swedish Conferederation of Trade Unions (LO) and the Confederation of Swedish Employees (SAF), central organizations representing trade unions and employers, respectively. They sought to maintain full employment, but—relying on the safety valve of periodic large devaluations—ended up with a high wage-growth equilibrium characterized by annual nominal wage increases of over 10 percent.

  • Decentralized wage formation, 1983–90. During this period, the emphasis shifted back and forth between central and branch or individual trade-union-level negotiations, still retaining the LO-SAF partnership. As a result, the wage determination framework moved toward a more decentralized, patently suboptimal, midpoint where social partners failed to internalize the macroeconomic implications of higher wage increases. This led to a price-wage spiral, with real wages increasing by only 1 percent a year on average during this period.

  • Wage formation under stabilization policies, 1991–2000. This period commenced with a recession and soaring unemployment rates, convincing social partners of the need for restrained wage increases as part of a policy package to stabilize the economy. With a single hiccup in 1996–97, wage growth was halved to around 4 percent on average, as the Riksbank’s inflation-targeting framework gained credibility and inflation expectations subsided.

Friberg and Uddén-Sonnegard concluded that, despite the widely varying outcomes, the wage determination process was largely unchanged since 1970: once inflation expectations and demand for labor were included among explanatory variables for wage developments, results of Chow tests indicated no significant structural break.

The bargaining framework has improved since the early 1990s but remains vulnerable to exogenous shocks. Two key lessons from the theoretical literature are that the middle ground between centralized and decentralized wage bargaining should be avoided (Calmfors and Driffill, 1988), and that some cushion is needed to avoid excessive wage scale compression (Flanagan, 1999). The approach evolving during the most recent period builds on these insights. It combines sound macroeconomic policies leading to low inflation expectations, a sufficiently strong centralized component to impose macroeconomic wage discipline, and enough elbow room for follow-up negotiations to reflect local supply and demand conditions within the macroeconomic constraints. The introduction of an agreed set of rules for bargaining, and the creation in 2000 of the National Mediation Office (to settle unresolved procedural disagreements without interfering in the wage determination process), provide useful additional safety valves. Moreover, the replacement rate provided by the unemployment benefit has reversed its increasing trend from the early 1990s, improving job-search incentives (Forslund and Kolm, 2000). While the bargaining framework, enhanced by these changes, performed well in the high-growth period through mid-2001, it has not yet been tested by adverse macroeconomic conditions and—as with all centralized wage setting regimes—remains highly vulnerable to sudden shocks. Much like a large ship, the Swedish labor market needs time to turn around if such shocks materialize, with painful losses during the protracted adjustment process, as vividly demonstrated by the emergence of high unemployment in Sweden during 1993–98.

There may also be a need for the centralized bargaining framework to further adjust, even in the absence of shocks. With the working environment increasingly characterized by job rotation and multitasking rather than occupational specialization, the traditional centralized wage bargaining model becomes increasingly outdated.91 The emerging new work organization is driven both by globalization and a shift in workers’ preferences toward greater variation in work. It results in a flattening hierarchy of control and responsibility, more decentralized decision making, raises the demand for highly flexible labor with varied skills, and presupposes a finely nuanced incentive system. It is the last aspect that renders centralized wage bargaining highly inefficient in the new environment, since it continues to deliver uniform sectoral wages and a compressed wage scale. Such a wage structure cannot simultaneously support the high employment levels necessary for maintaining the welfare state and induce individual workers to perform the optimal mix of tasks that would allow firms to reap large benefits from the resulting complementarities.

As for the broader picture, various nonwage indicators also point to improving labor market performance during the past decade, but further progress hinges on enhancing incentives to raise effective labor supply. Since the crisis period, the number of hours worked has steadily increased, and, with public sector employment curbed, most of the employment gains have occurred in the nongovernment sector (Figures 23 and 24). As noted in Chapter 5, however, absences from work have steadily risen since the mid-1990s, with a particularly worrisome increasing trend in sickness absences. While this level is not unprecedented in a historical perspective, and may in part reflect easing unemployment levels, the increasing trend is not sustainable. Considerable disincentive effects on the supply of highly skilled labor and on human capital creation may also stem from the still highly compressed after-tax wage scale. With the logic of the bargaining framework (whose stability requires a minimal wage drift) precluding substantial step increases in before-tax wage dispersion, tax policy measures are the only available instruments for rapidly bringing about a decompression of the after-tax wage scale.

Figure 23.Annual Hours Worked per Employee

Source: OECD, OECD Employment Outlook 2000 (Paris).

1 Data from 1979 to 1990 are for western Germany.

Figure 24.Government Employment Index


Source: OECD Analytical Database.


The pressures that Sweden will face on the spending side in the years ahead are relatively clear. Those on the taxing side are harder to assess. It would be easy to exaggerate them: the constraints imposed by the international mobility of capital, goods, and labor are ones that Sweden has faced for some time. More generally, the surprising resilience of corporate tax revenues around the world indicates that the pressures on capital income tax revenues may not be as irresistible as has sometimes been thought. Nevertheless, the prospective forces at work all point in one direction: towards greater difficulty in raising tax revenue. Sweden, like others, is thus caught between upward pressures on spending and downward pressures on revenues. Estimating with any precision the severity of this tension is difficult, but might be on the order of a few percentage points of GDP—significant enough, in any event, to call for developing some strategy of response.

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