Funding effective public policy
There are six generic aspects to successful public policy:
The first is clearly identifying
the problem or need that requires dealing with.
The second is setting realistic objectives that will resolve the problem or fulfill the need, or at least ameliorate the problem and satiate the need as much as is practicable.
The third is good policy design i.e. developing policy solutions that are likely to deliver the desired outcomes and which can evolve over-time as circumstances change or if the original plans do not deliver what was expected.
The fourth is having effective organisations to implement the policy i.e. ones that are well-managed, suitably capable to implement the policy or policies, transparent and accountable and flexible in the face of experience about what works and what does not.
The fifth element is having sufficient resources in-place to deliver the desired policy outcomes and deal with contingencies.
The final factor is ensuring there is feedback and evaluation built-into the ‘system’, to learn lessons and continually improve over time.
The effectiveness of policy is particularly pertinent at the moment because of the current UK government’s emerging ambitions for administrative reform to improve the delivery capabilities of the state. Most recently summarised by Michael Gove in his Ditchley lecture.
The left, in order to be credible, must have a response to this aspect of the Conservative government’s agenda. It is particularly critical for any future democratic socialist government to have a highly capable state, because a democratic socialist government will be relying on the state to implement its radical programme. A programme which should have at the heart of it the transformation of the UK’s model of political economy, into a new British Social Model (BSM).
Reform of the state’s capabilities is for another time. This post is going to concentrate on the fifth element that is needed to deliver successful public policy – resourcing. In other words, maximising the effectiveness of what political economists and sociologists call the ‘extractive state’ or in the words of Joseph Schumpeter, the ‘tax state’.
If a democratic socialist government wants to develop a BSM, a crucial aspect of which will be spending more on health and care services, on education, on pensions, on protecting the environment, industrial policy, regional policy, housing and on security (policing, defence and bio-defence), then the state needs to be effective at extracting the resources in taxes required to fund that expenditure. This necessitates two conditions to be met:
An economy that generates a substantial productive surplus and consequently more tax revenues as a result of that growth.
The ability to raise substantially higher revenues than currently, whether long-run growth rates can be increased or not.
The rest of this post mainly focusses on the second of the two conditions outlined above, through a comparative analysis between the UK’s ‘tax state’ and that of ‘Denmark’. A country that raises much more tax revenue as a proportion of its GDP than the UK and has performed, economically, at least on-a-par with the UK over many decades and in some ways has done better than the UK.
How much UK government’s raise in taxes compared to other countries
According to the OECD, in 2018, the UK’s tax-to-GDP ratio was 33.5% (OECD, 2019). This was just below the OECD average of 34.3% (OECD, 2019). The UK’s tax-to-GDP ratio was slightly up on where it was in the year 2000. At the turn of the millennium it stood at 32.9% (OECD, 2019).
Individual income taxes are the category of taxes which raise the most revenue in the UK (27.2%), followed by VAT (20.7%). National Insurance Contributions are the third most lucrative source of money for the state (19.2%) (OECD, 2019).
The most successful ‘extractive’ states in the OECD have a tax-to-GDP ratio around 10% higher than the UK. One country that is consistently near the top of the tax-to-GDP ratio ‘league’ is Denmark. In 2018, the Danish tax-to-GDP ratio was 11% higher than in the UK - 44.5% of GDP (OECD, 2019). Further, Denmark has manged to tax at a relatively high, overall, level – sustaining taxation levels at approximately the mid-40% mark - for a long time (OECD, 2019).
In 2017, the UK government raised approximately £682 billion in taxes (OECD, 2019). In 2017, the tax-to-GDP ratio was at 33.3% of GDP (OECD, 2019). In a (more than) £2 trillion economy, such as the UK, this suggests that increasing the tax-to-GDP ratio to the levels that prevail in Denmark could see a UK democratic socialist government taking-in an additional £228 billion a year. Of course, there would be no guarantee of a revenue boost on such a scale. Economists will point out that, for example, likely behaviour changes as a result of higher taxes, could decrease the ‘rate-of-revenue-return’ on any increases in tax rates. Such economists would no doubt point to the considerable ‘tax leakage’ which occurs at the current, and much lower, tax-to-GDP ratio. What HMRC calls the ‘tax gap’ (HMRC, 2019). The ‘tax gap’ is described by HMRC in the following terms:
‘The tax gap is the difference between the amount of tax that should, in theory, be paid to HMRC, and what is actually paid…The tax gap provides a useful tool for understanding the relative size and nature of non-compliance…[and is the result of]…Some taxpayers make[ing] simple errors in calculating the tax that they owe, despite their best efforts, while others don’t take enough care when they submit their returns. Legal interpretation, evasion, avoidance and criminal attacks on the tax system also result in a tax gap’. (HMRC, 2019)
The 2017-18 ‘tax gap’ was estimated to be in the region of £35 billion (HMRC, 2019).
Despite the kinds of complications described above, that a higher tax burdens might create, the crude calculation suggesting an 11% tax-to-GDP ratio could raise more than £200 billion in extra revenues a year, indicates that considerable additional resources could be raised if the tax (and benefits) system in the UK could be calibrated in the right way, in order to maximise revenues while minimising any deterrence effect on the drivers of growth. Although, as will be demonstrated later in this post, the right kind of social conditions are an important underpinning to the successful Danish model and there are questions about whether the UK can replicate those and therefore, the extent to which the UK will fall short of what a country like Denmark can do, in terms of revenue raising.
Sustaining a high tax-to-GDP ratio
Why Denmark has been able to maintain taxation at over 40% of GDP
The Nordic countries in general, and Denmark in particular, offers some lessons as to how a higher tax burden can be sustained over time. According to a paper by economist Henrik Jacobson Kleven, there are three ‘policy-based reasons’ why the Scandinavian countries, and Denmark in particular, have been able to sustain a high tax burden:
The tax system is designed and administered in order to maximise the availability of information about tax liabilities and utilise third-parties as much as possible to collect and report information.
Taxes are broad-based and relatively simple, ensuring behavioural distortions are minimised.
A substantial proportion of the taxes raised are used to subsidise goods which are complements to working e.g. care services, education and training, public transport, etc.
The combination of these factors have helped reduce, in Denmark, what economists call the ‘elasticities of taxable income’ i.e. the scale of the behaviour response of those impacted by tax changes. The size of the ‘elasticity’ helps determine the increase or loss in revenues that is likely to occur due to a tax. Typically, if taxes increase the response is expected to be a negative one e.g. individuals either ‘step-up’ their tax avoidance or evasion practices or reduce their work effort or alter their risk-taking and investment plans, or some combination of these actions. It should be further noted that while at the population level the ‘elasticity’ of the response in Denmark has been ‘modest’ (Kleven and Schultz, 2009) for the reasons listed above and explored in more detail below, perhaps expectedly, it does vary across different dimensions. For example, Kleven and Schultz estimated that ‘elasticities’ for capital income are greater than those for labour income, that the ‘elasticity’ among the self-employed his higher than for those that are employed and finally, ‘elasticity’ is greater among those in higher income brackets. (Kleven and Schults, 2009). Perhaps 2 to 3 times larger among those in the top income quintile than those in the bottom income quintile (Kleven and Schultz, 2009).
The importance of information
Kleven argues that the overall ‘tax gap’ in Denmark is as low as 2.2% (Kleven, 2014). The Danish ‘tax gap’ is about a third of the size of the UK’s estimated ‘tax gap’. An important reason for this small ‘gap’ is that:
‘…the Scandinavian tax systems have very wide coverage of third-party information reporting and more generally, well-developed information trails that ensure a low level of tax evasion’. (Kleven, 2014)
In Denmark for example:
‘…tax enforcement is very effective and overall tax compliance is high due to the widespread use of double-reporting by third parties such as employers and financial institutions’. (Kleven et al, 2011)
The largest scope for ‘leakage’ is among those who self-report their income i.e. the self-employed. However, Kleven, argues that in Denmark self-reporters are relatively compliant, resulting in, proportionately, a higher tax-take from such groups compared to that of other countries such as the United States (Kleven, 2014). Nevertheless, self-reporting remains among the main reasons for the on-going rates of ‘tax leakage’ in Denmark, with an estimated ‘evasion rate’ of around 50% (Kleven, 2014).
Broad-based and simple
The second reason that Denmark is able to sustain a much higher (than the OECD average) tax-to-GDP ratio is the broad-based and comparatively simple nature of the Danish tax system. As Kleven argues:
‘…broad tax bases…further encourage low levels of tax avoidance and contribute to modest elasticities of taxable income with respect to the marginal tax rate’. (Kleven, 2014)
Behind the technical phraseology, Kleven is pointing out that the comprehensive tax systems in-place in the Nordic countries in general and Denmark specifically, i.e. ones with few exemptions, allowances and other distortions, mean that the scope for (the comparatively) high tax rates in these countries to deter productive economic behaviour or incentivise avoidance, are limited. Consequently:
‘…taxable income elasticities in Denmark are considerably smaller than…[many]…found for other countries…The relatively small taxable income elasticities…allow for higher levels of taxation without incurring larger losses in economic efficiency’. (Kleven and Schultz, 2014)
The macroeconomic evidence for Kleven’s argument is evident in Denmark’s comparative growth and unemployment data, at least as it compares to that of the UK. The comparative macroeconomic performance of the UK and Denmark is explored, briefly, later in this blog post.
Supporting labour supply through the welfare system
The third leg of the policy-stool that Kleven suggests helps ensure the Scandinavian countries in general and Denmark in particular, can sustain a higher tax-to-GDP ratio is some of the way the revenues are spent. Kleven describes how governments in Scandinavia, spend:
‘…relatively large amounts on the public provision and subsidization of goods that are complementary to working, including childcare, elderly care, and transportation. Such policies represent subsidies to the costs of market work, which encourage labor supply and make taxes less distortionary…Furthermore…[they]…spend heavily on education, which is complementary to long-run labor supply and potentially offsets some of the distortionary effects of taxation’. (Kleven, 2014)
The provision of a wide range of services, on a universal or near universal basis, act as a ‘subsidy’ to participation in the labour market, according to Kleven. As such they are less distortive of the incentives to supply labour into the labour market (Kleven, 2014). Consequently, Denmark and other Scandinavian countries have high levels of labour market participation. The result of the latter is the generation of more tax revenues to pay for the provision of public services and a visible return by most people on the taxes they are paying.
However, it should be noted that Kleven fails to explore, to any great degree, the role of ‘active labour market’ policies in countries like Denmark, which have been an important part of the Danish model of political economy for a long time. As welfare state scholar Gosta Esping-Anderson points out, the costliness of the ‘social democratic welfare regime’ in countries like Denmark incentivise the prioritisation of high-levels of employment (Esping-Anderson, 1990). The significant amount spent by the government in Denmark, for example, illustrates the importance of ‘active labour market’ policies. The OECD estimate that the Danish state spends just under 2% of GDP on such measures (OECD, 2017). Any comprehensive analysis of how Denmark has manged to be successful in keeping unemployment relatively low and employment levels high over long periods, while sustaining a high tax-to-GDP ratio, would need to take account of such measures.
The harder to replicate, elements
While the policies that help Denmark maintain a high tax-to-GDP ratio can, to a large extent, be copied by other countries, there are harder to replicate aspects, which are also likely to contribute to the ‘extractive’ success of the Danish state i.e. non-policy factors which help reduce the ‘negative elasticity’ response to higher taxes. Many of these other factors are cultural and historical and are captured in the term ‘social capital’. Social capital is a convenient summary phrase for:
‘…the links, shared values and understandings in society that enable individuals and groups to trust each other and…work together’. (OECD, 2007)
Kleven presents a range of evidence suggestive of a strong link between the level