The Nordic Model - Embracing globalization and sharing risks

One may ask why this problem arises. If we all understand that
taxes are needed to finance the welfare state we support, why is
there a problem? The reason is that individual tax payments have
no direct effect on the services the tax payer can access. This is
precisely one of the defining characteristics of the Nordic model,
namely that entitlements are unrelated to tax payment. Another
way of expressing this is that the effect of one individual contributing
a little more or less in taxes is negligible as it is shared with 5
million other inhabitants. However, when the whole population
contributes less it adds up and has significant implications for
total finances.
The effect of taxes on distortions therefore implies that it is
not costless to levy taxes. The cost of raising one euro of public
revenue is effectively larger than one euro. This is so since the cost
includes both the direct effect of the euro going to the public sector,
and the cost in terms of the economic activity squeezed out due to
the tax. If a tax of one euro reduces incomes by, say, 20 cent, then
the true cost of raising one euro to the public sector is euro 1.20;
namely, the one euro paid directly and the indirect income loss
of 20 cent. Available estimates are highly uncertain but suggest
that the (marginal) cost of public funds for Finland and the other
Nordic countries may indeed be much higher than the direct costs
because of the increase in efficiency losses. 5
A problematic aspect of taxation is that it makes the price
of leisure lower to individuals than it is to society. An individual
considering the option of enjoying more leisure (shorter working
hours, more vacation, earlier retirement) will lose the net income
after all taxes, or the consumption that the net wage would buy.
To society the cost of leisure is the total income lost, including
the tax revenue of the public sector. Hence, the tax wedge causes
a difference between the cost of leisure to the individual and to
society; leisure is less costly to the individual deciding on his or
her leisure than it is to the society at large.
The above may seem to leave a puzzle for understanding the
Nordic countries: if taxes are potentially so harmful, how come
overall labour force participation is high, and how can these
countries be among the richest countries in the world? There are
many explanations for this (and yet the issue may not be fully
understood).
There is a “common
pool” problem in that
the individual does
not factor in the consequences
of his/her
decision for the society
at large
The costs to the economy
of collecting 1
euro in taxes is significantly
larger than
1 euro
Taxes on labour makes
leisure unduly attractive
relative to work
How can the Nordic
economies do reasonably
well at these tax
rates?
96 · The Nordic Model