The Nordic Model - Embracing globalization and sharing risks

sion of welfare services. This is an assumption about technology (our version of
the “Baumol hypothesis”), that we discussed above. The effects of more growth
on the state of public finances can now be explained in simple terms with the
help of figure 5.1.
First, higher growth means more output and incomes and thereby it leads to a
bigger tax base and higher tax revenues (box A in figure 5.1). This is the effect that
people have in mind when they claim that we should solve the public finance
problem through more rapid economic growth.
Second, higher private sector productivity will raise real wages not only in the
private sector but in the whole economy, including in the public sector (as a consequence
of market forces and/or wage coordination by unions). The rise in the
public sector wage bill increases public expenditure and absorbs part of the increase
in tax revenues (box B in figure 5.1).
Third, public pensions and other transfers will fall relative to wages unless they
are protected through indexation (to wages) or increased by discretionary decisions.
Political pressure will normally prevent transfers from falling permanently
behind general income developments. Assuming this distributional constraint to
hold, public spending on transfers will absorb the rest of the increased tax revenues
(box C in figure 5.1). Invoking the “Baumol hypothesis” (or the “Baumol disease”)
and the distributional constraint prevents more growth from improving
public finances.
Fourth, higher incomes are likely to increase the demand for services, including
the demand for publicly provided welfare services. The income elasticity of demand
is normally positive and for some of these services, such as health services,
it is likely to be quite high. Growing incomes will therefore be associated
with growing demand for welfare services and pressure on the government to increase
their supply as well as to improve their quality. Again, more public spending
is called for (box D in figure 5.1), though by now there remain no additional
tax resources to draw upon. The likely overall result is therefore that more growth
in itself leads to a deterioration rather than an improvement in public finances. It
may help public finances only if public sector wages and/or transfers are allowed
to fall behind general income developments.
A fifth consideration (not shown in the figure) is that higher incomes may increase
the demand for leisure and reduce the amount of work supplied at a given
(net) wage rate. The supply of labour will diminish since the income elasticity of
demand for leisure is positive (and presumably sizeable), and the subsequent decline
in employment will reduce the tax base.
To repeat, the preceding is not an argument against growth in itself. Growth is
indeed important for material well-being, and it is important that productivity
should continue to increase if Finland is to remain a high income country.
The message of the box is rather that growth is not a solution to the financial
problems that the welfare state is facing. Or to put it differently, policies boosting
growth will not have a double dividend by both improving material well-being
and ensuring sound public finances. More difficult policy choices have to be
made to ensure the financial viability of the welfare state.
Welfare services: rising costs and increasing demand · 91