The Nordic Model - Embracing globalization and sharing risks

The level of taxation is already high at the outset. Taxation
is not only a question of whether the money should go to private
or public pockets. Taxes affect incentives: economic agents must
in most situations be expected to react to the reward for work
that they receive after taxes and the prices they pay, including
the tax components of these prices. This is the reason why some
taxes – say environmental taxes – can be used to steer decisions
in a direction which is considered favourable to the society. But
it is also the reason why many economic decisions are likely to be
adversely affected or distorted by taxes. In particular, the direct and
indirect taxes levied on labour income will reduce labour supply;
individual workers are induced to choose more leisure relative to
consumption (and work), though it might well in the interest of
society at large that people should work more.
The most relevant metric for understanding how taxes affect
the labour market is the so-called tax wedge. The tax wedge is the
difference that taxes make between what labour costs to employers,
and what employees get in return for their work. To see this,
consider a setting where an employer and employee have agreed
on a given wage. The total cost to the employer is the wage plus
eventual social security contributions (paid by the employer). The
reward to the employee is the wage less eventual social security
contributions (paid by the employee), direct taxes and indirect
taxes. Both direct and indirect taxes have to be taken into account
since they determine how much consumption the employee can
get for the work effort – and consumption in its many forms (today
or in the future) is the main motive to work. Hence, the total tax
wedge is made up of social security contributions, direct income
taxes and indirect income taxes. Figure 5.3 shows the tax wedge for
different countries computed for a worker with average income.
For Finland the tax wedge is nearly 60 per cent (57.5 per cent),
which is at the higher end in the OECD. To see why the tax wedge
is a barrier to employment, consider a worker willing to work for a
reward in terms of consumption equal to 100 units. The value of
the production to an employer has to be at least 160 units, because
it must cover both the compensation to the worker and the tax
wedge. Consider an activity that yields an output of only 140 units,
which is well above the compensation demanded by the worker.
Raising taxes is not
the straightforward
solution – because tax
rates are already high
and their economic
costs considerable
Large tax wedges reduce
the scope and
incentives for work
and other economic
activities
94 · The Nordic Model