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Costs and benefits of 'Scotlinavia'

Published: 10 June 2015
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Talk of Scotland adopting a Scandinavian economic model usually comes with no mention of the bill but, suggests recent research, the impact of higher taxes is more complicated than it might at first appear. 
 
The Scottish Government holds up the Scandinavian economic model as one this country might emulate.
 
The focus is typically on the good news of more and better public services, with little comment on higher levels of taxation to pay for them.
 
Under the fiscal reforms introduced in the Scotland Act (2012), together with the more extensive changes in the current Scotland Bill, a Scottish government could increase the average rate of income taxation to Scandinavian levels and implement substantial increases in public spending accordingly.
 
There are two opposing effects. First, while disposable incomes and private consumption fall as tax rises, the impact on overall demand is more than offset by the rise in less import-intensive government expenditure, which tends to stimulate the economy. However, a second effect operates on the supply side of the economy and tends to depress economic activity. The conventional view in the UK is that workers prize real take-home pay over public goods, so the imposition of the higher tax leads to higher wages and lower competitiveness.
 
In a model of the Scottish economy developed with colleagues at Strathclyde University, these adverse effects overwhelm the beneficial demand-side impact because the Scottish economy is highly dependent on external trade and is particularly sensitive to changes in competitiveness. The overall net result is a contraction in the Scottish economy, with net outmigration and a fall in investment.
 
However, the conventional view of wage bargaining, taxation and public spending that underlies these results might exaggerate the scale of the bad news, and hide possible sources of good news linked to a more Scandinavian approach.
 
First, the conventional view assumes that Scottish wage rates are determined solely in Scotland. However, many wage systems operate at the UK level, so the adverse impacts on the Scottish economy of the hike in income taxes may initially be mitigated, although a radically different income tax rate from the rest of the UK may make these UK-wide systems unsustainable.
 
Secondly, the conventional view only considers the direct effects of the increase in government expenditures on the demand side of the economy. However, the public might be expected to value the increases in public services that this would imply, and this could reduce wage demands. Scandinavian wage-bargaining systems typically involve institutional agreements among unions, firms and governments. Public services - the so-called "social wage" - as well as real take-home pay are part of that process.
 
What would happen if we had such systems? What if a fall in workers' take-home pay was offset by the rise in public services? Workers might agree not to bargain for higher wages, resulting in no adverse supply-side effects and the positive net demand-side effects would lead to expanded economic activity our model suggests could increase Scottish GDP by around 2.5 per cent and employment by nearly four per cent (and attract net in-migration). However, this implies average take home pay in Scotland falling by 12 per cent, though government spending would rise by 20 per cent.
 
There is also evidence that the extent to which increased public spending offsets increased taxation is affected by how public revenues are spent. Spending on education and health tends to be more persuasive in inhibiting wage claims than increases in, for example, defence expenditure.
 
Thirdly, significant elements of public expenditure impact directly, and positively, on the supply side of the economy, most obviously infrastructural spending. Our modelling suggests that this boost to productivity can sometimes outweigh the adverse effects of higher wage costs. The impact of infrastructure spending can be rather less immediate than that of an income tax hike but some forms of government spending classified as current expenditures have the characteristics of investment, in human capital. Much of education and health spending is of this form, yielding significant private and social returns.
 
From 2016 onwards the Scottish Government will have increased scope to set Scottish income tax rates. If Scotland wishes to emulate Scandinavia, it will shortly possess the fiscal powers to do so. The debate over the wisdom of such a move, and the basis for making informed choices about the kind of future we wish to create, should start now. Our model suggests there are risks and that reducing the negative supply-side effects requires institutional frameworks to consider a mix of taxation and public spending. If there really are advantages to a more Scandinavian approach, we have sufficient powers to begin this process.
 
Professor McGregor is director of Strathclyde International Public Policy Institute.
 
Tobias Emonts-Holley, Dr Patrizio Lecca and Professor Kim Swales also contributed to this article under the auspices of the Centre on Constitutional Change.

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