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Can Sweden’s welfare state rise to the challenges of the twenty-first century?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
August 2003
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IMF Survey: What was your motivation for studying Sweden’s welfare state at this juncture?

Thakur: IMF surveillance in advanced European economies, as elsewhere, has increasingly extended beyond its traditional macroeconomic focus. During the Swedish consultation, we set out to look at the broader picture of Sweden’s welfare state and to assess its achievements and prospects. Sweden’s experience has been extensively studied as a model of the social democratic welfare state, and so, to draw on as broad a spectrum of views as possible, we widened our discussions beyond the official and semiofficial circles to include a range of observers–for example, academics at the Stockholm School of Economics and Uppsala University, and various research institutions.

You could say that our study, which has evolved over a period of almost two years, is, in a sense, the IMF’s attempt to understand what is so special about the Swedish model, why many have regarded it as successful, what its costs are, and what challenges it is likely to face in the future. In our view, the two key forces that the Swedish model will need to confront if it is to remain viable are globalization, which potentially undermines the welfare state’s fiscal basis, and the demographic transition.

IMF Survey: There has been considerable debate about the benefit of a welfare state like Sweden’s, with its critics saying it hampers growth and its advocates saying it ensures high living standards for all Swedish citizens. Hasn’t the welfare state begun to have a negative effect on economic growth?

Cerra: Indeed, Swedish scholar Assar Lindbeck observed that Sweden slipped from having the third highest per capita income among OECD countries in 1970 to ranking fourteenth in 1991. But a careful study of the trends in relative incomes shows that Sweden managed to maintain its per capita income at a roughly constant margin above the OECD average until its banking crisis in the early 1990s. The recession that began in 1991 led to an abrupt and permanent decline in output and per capita income.

In short, Sweden lost its high ranking very suddenly at the onset of the banking crisis and has not been able to regain it. Looking at other measures–such as GNP rather than GDP, per capita income of the working-age population rather than the total population, or ones based on different exchange rates for international comparisons–leads to the same conclusion. Thus, it can be argued that the slippage in Sweden’s living standards measured by per capita income was not a gradual sclerosis necessarily caused by the welfare state but rather a sharp onetime drop in income triggered by avoidable macroeconomic policy mistakes that was not recouped later. But Sweden ranks high on many other measures of living standards, such as educational attainment, health care, and environmental quality.

The two key forces that the Swedish will need to confront if it is to remain viable are globalization, which potentially undermines the welfare state’s fiscal basis, and the demographic transition.—Subhash Thakur

Despite recent slippage in its ranking, Sweden continues to enjoy high per capita income

(1995 purchasing power parity)

Data: OECD; IMF, World Economic Outlook, and IMF staff calculations.

The literature on how the welfare state affects growth is also relevant. A lot of academic studies suggest that a number of different taxes distort labor supply decisions, the incentive to save, and so forth. The extent of that depends on the type of tax, how distorting it is, and whether the revenue is put to productive use, such as for education or programs that enable the labor market to adjust to changing circumstances, or whether it is used to finance unproductive public expenditure.

IMF Survey: Sweden was one of the stars of the hightech sector before the bursting of that bubble. Assuming that high growth in this sector helped offset some of the economic difficulties caused by welfare policies, what is the prognosis for growth in Sweden?

Cerra: The explosive demand projections for the high-tech sector must now be revised down with the bursting of the bubble. Yet Sweden’s long-term prospects in this sector are still promising, especially if labor market incentives are improved, particularly for highly skilled workers. Sweden has a highly educated workforce and productive labor relationships. Its openness to international trade, significant investment in research and development, political stability, and high quality of institutions and transparency in economic policy, as well as its links to both continental Europe and the Anglo-Saxon countries, enhance its competitive position.

IMF Survey: Has the quality of the government intervention in Sweden helped offset some of the downsides of a welfare system?

HorvAth: It certainly has. The quality of government intervention has been very high in several respects. The public sector has been transparent. There is also a strong regulatory framework in Sweden, which helped create an environment conducive to private sector activity despite the large role of the public sector, a necessary component of any developed welfare state. Sweden’s very strong social safety net has encouraged risk taking; it has been argued that this was one of the reasons the information technology sector thrived in Sweden.

Thakur: Transparent and effective governance in the public sector has been a key element in the Swedish story because such governance has helped sustain the social consensus for the high level of taxation and public spending. Without it, the viability of the welfare state would have come under question.

IMF Survey: What, specifically, has been the impact of Sweden’s labor market interventions?

HorvAth: First, centralized wage bargaining was a pivotal element of the welfare state. It helped maintain social peace and delivered very high rates of participation and employment. These, in turn, ensured the high tax revenues needed to sustain a welfare state. But there are significant drawbacks to the centralized wage bargaining setup, including a compressed wage scale, which leads to relative overpayment of low-skilled labor and relative underpayment of high-skilled labor. This can create disincentives because the reward for accumulating human capital is lower than in other countries. It could also imply some net human capital loss through net migration.

Various measures have been taken to offset some of the problems of centralized wage bargaining. For example, a significant portion of wage determination was shifted from the central level down to the factory level, leading to increased wage flexibility and some wage decompression. There was also a rise in part-time and temporary employment, helping to maintain very high participation rates. For example, the participation rates of women and people over 55 are higher in Sweden than in almost any other country.

Keen: On the tax-benefit side, it’s true that the combined effect of taxes and transfers is to produce, for some groups, quite high effective marginal tax rates on labor income. But the same is true in many other European countries and is to some degree inescapable if one wants to ensure high basic living standards for all. We do, though, express some concern in the book about the generosity of unemployment and, perhaps even more, sickness benefits.

IMF Survey: Sweden’s tax regime has been successful in attracting foreign investment. Can it sustain this?

Keen: For many years, Sweden’s tax treatment of companies has made it pretty attractive to investors. Historically, it did this by combining quite high corporate tax rates with a fairly narrow tax base. Since a major tax reform in 1991, it has changed strategies and now has a fairly broad base but relatively low rates. The issue for the future is what happens to corporate tax revenues. If other countries lower their tax rates and make their tax regimes more attractive, Sweden will come under pressure to respond, thereby diluting its revenues. Further pressure on corporate taxation can certainly be expected. When Sweden adopted the 28 percent corporate tax rate in 1991, it seemed remarkably low, but now it seems on the high side compared with, say, Ireland, where the rate is 12½ percent.

IMF Survey: But Sweden’s tax regime has not favored saving. Is there any discussion of changing the tax structure to improve the saving rate?

Keen: The tax treatment of capital income has certainly been a recurring issue in Sweden. In fact, in the 1991 tax reform, Sweden moved away from taxing capital income and wage income at the same rate—a radically new approach. Essentially, it decided it had failed to tax capital income effectively—revenues from capital income taxes were actually negative because people claimed more deductions for interest payments than they declared as taxable income.

So Sweden moved to a moderate, low, and uniform flat tax on capital income of various kinds. Sweden has not adopted special savings incentive schemes, like the IRAs or the 401(k)s in the United States, to encourage household savings. Rather, it has tried to have a simple, moderate tax on capital income. There may be scope for reducing effective tax rates on savings, but we think a lot can be said for this strategy.

HorvAth: I’d like to add that, overall, national savings have significantly improved partly because of fiscal consolidation that moved the budget from a large deficit position to a sizable surplus.

IMF Survey: In the absence of policy interventions, how serious would poverty and income inequality be in Sweden? Harking back to the quality of government intervention—the amounts spent on education in particular—doesn’t this reduce the need over time for transfers to equalize income distribution?

Keen: Those are tough questions. It’s essentially impossible to say what poverty and inequality would be in any industrial country without government intervention. Typically, to assess how intervention affects inequality and poverty, we compare people’s incomes before and after taxes and transfers. Of course, that pretax income reflects people’s perceptions of how much they’ll receive in transfers from the government. If there were no income support, we would typically expect pretax incomes of the poor to be higher than they actually are, because the onus would be on people to look after themselves.

Whether the need for activist distributional policy declines over time depends in part on the dynamics of inequality over people’s lifetimes. We are all endowed with different skills and have different luck; some of us have good ideas, some bad ideas; some of us are healthy and some not. By the end of our lifetimes, some inequality would emerge even if we all started off equal, and this inequality can transfer itself to the next generation through bequests of various kinds. Some people would say that’s fine. But Sweden has a stronger egalitarian consensus than that.

HorvAth: A lot of different aspects have to work together for a large welfare state to be sustainable. Other countries have tried a welfare state without having a critical mass of supporting institutions in place. Hungary’s attempt to create a welfare state, for example, was considered premature because it tried the transfers and large spending without having the revenue base.

Thakur: The Swedish experience is interesting in the context of the debate around the world, particularly in developing countries, on whether rapid growth is compatible with a reduction of inequality. We all know that some of the economies in east Asia have grown rapidly and also reduced poverty and inequality. That’s certainly true of Sweden. If we look at a time span of more than a century, Sweden moved from being one of the poorest countries in Europe to one of the richest. At the same time, the degree of inequality was dramatically reduced, and that has something to do with the points made earlier about the quality of public intervention and how public spending has been used to assist people at the bottom of the income distribution.

IMF Survey: However one interprets its past performance under the welfare state, Sweden will face challenges in the years ahead. What do you think are the most significant of these, and how do you think they will affect public support for the welfare state?

Cerra: The change in the composition of the population and the workforce may present the most significant challenges. For example, the aging of the population will entail fiscal costs not only for public pensions. There will be an increasing strain on the health care system, and we’ve already seen an increased use of sick leave, which is generously compensated in Sweden. The local government workforces are particularly susceptible to these problems, even in the near term, because they tend to be older. In addition, many of the health care services are provided by local government, and there will be increasing pressure for tax increases at this level to fund an expansion of services so as to increase both the number of health care service providers and the wages to attract people to this sector.

Immigration associated with European integration and the expansion of the European Union may help reduce some of these pressures—for example, if they can help increase the number of young workers. But immigration, if poorly managed, could also undermine the social consensus behind social insurance programs.

Thakur: Globalization is as important a force as demographic transition for the prospects of a large welfare state. Although it has been much debated whether globalization is a new force or has been around for a long time, the degree of integration around the world has clearly been rising rapidly. The older notions of solidarity that have been very important to the success of the Swedish model are under stress from the forces of global integration.

Globalization also tends to reduce governments’ autonomy to put in place market-correcting measures to preserve their own model of the social contract. That’s where the interaction of demographics and globalization creates powerful pressures, which are most obvious on the fiscal side. Our central message is that Sweden will need to streamline its welfare state to preserve its key elements and sustain its success.

IMF Survey: What lessons can you draw for other industrial countries from Sweden’s experience?

HorvAth: The lessons can be divided into three groups: design, sustainability, and the way a developed welfare state reacts to shocks. On design, there has not been a successful welfare state where incomes are low. So high per capita incomes appear to be a prerequisite.

There also needs to be a critical mass of institutions in place that reinforce each other and sustain the welfare state. We’ve talked about the labor market institutions, such as wage bargaining, but there is also a need for a transparent and efficient tax and transfer system that maintains incentives and achieves some of the main objectives of a welfare state, which are lower income inequality and giving everyone equal opportunities in life. A strong safety net is essential. There’s also a critical need for a sound policy framework. For example, Sweden has a well-implemented inflation targeting regime and a fiscal framework that ensures fiscal prudence. Finally, there is a need for a strong and broad social consensus in support of a welfare state because building all the institutions necessary to sustain one takes several political cycles.

As for reactions to shocks, the large public sector makes the system more rigid, and centralized wage bargaining makes the labor market more rigid. It is thus important to prepare for exogenous shocks, and it’s important not to compound the shocks with policy mistakes. If the adjustment is not fast enough, there might be permanent losses in income. That has been the Swedish experience.

Thakur: The Swedish experience has attracted policymakers in several developing countries. In this context, an important lesson to keep in mind is that Sweden has always viewed itself as a small open economy—open to trade, investment, and competition from abroad. It is no accident that Swedish economists such as Eli Heckscher and Bertil Ohlin were pioneers in the study of international trade. That’s why globalization, although an intensifying force, is not a new phenomenon for Sweden.

IMF Survey: You take your book title from a remark by Swedish Prime Minister Göran Persson. He compares Sweden’s welfare state to a bumblebee that should not, in principle, be able to fly but does. Can the Swedish bumblebee continue flying?

Thakur: Sweden’s welfare state has sustained itself for a long time. Our book attempts to explain the forces that have shaped it to see whether the bumblebee will need to adapt a bit.

Horváth: If it manages to adapt to changing circumstances, there is no reason it cannot continue to fly.

Copies of Sweden’s Welfare State: Can the Bumblebee Keep Flying? by Subhash Thakur, Michael Keen, BÁldzs HorvÁth, and Valerie Cerra, are available for $23.50 each from IMF Publication Services. For information about ordering, please see page 227.

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