Sweden Proves Khaldun-Laffer Right

In Europe there is a strong general trend in which high-tax nations stagnate economically, while economic growth is shifting towards member states with lower taxation levels, talent supply and business friendly regulations. To break the stagnation, Sweden has implemented numerous tax cuts and abolishment of several excise taxes, and needs to continue abolishing or reforming growth-inducing taxes. The policy lessons are relevant internationally, particularly since Sweden has proved that Ibn Khaldun and Arthur Laffer were very right in explaining that once taxes reach a certain level, lowering taxes might even increase revenues.

Already 700 years ago, the Tunisian economist and social scientist Ibn Khaldun laid the foundations for the understanding that states often, in connection with expansion towards higher tax levels, created displacement of work, investment and talent. An expanding public sector at some point through excessive taxation crowds out economic activity in the private sector, shrinking the tax base. Arthur Laffer then developed the theory further, in the famous napkin sketch during a dinner. The result is the Laffer-Khaldun curve which shows the link between tax level and tax revenue.

In 2010, economists Mathias Trabandt and Harald Uhlig, in a study published by the European Central Bank, calculated where European countries were on this curve. It turned out that Sweden, Denmark and several other high-tax countries in Europe have such high tax wedges that the taxes on the margins hardly or not at all contribute to net income. This particularly applies to capital taxes but also taxes on work.

In Sweden there was an extensive public debate on “the protection tax” (“värnskatten” in Swedish), a supposedly temporary five percent extra top marginal tax for high income earners. This tax was introduced in 1995 and abolished in 2020. Before that, there had been a debate in Sweden where the advocates that reduced taxes could be partially or completely self-financing were accused of being frivolous, but the evidence was strong, and the debate shifted towards an acceptance of the self-financing effect. The Ministry of Finance calculated that the abolition of the defense tax would probably be roughly self-financing. The evaluation that the Confederation of Swedish Enterprise recently published reaches the conclusion that the degree of self-financing in practice was between 206 and 237 percent.

This is pretty interesting news for advocates of tax policy around the world. The top five percent marginal tax on high income takers that was abolished in Sweden crowded out work to such a degree, that its abolishment led to doubling of the tax revenue. The top income tax reduction that proved to stimulate the economy so tremendously was introduced during the reign of Stefan Löfven, a social democrat prime minister.

Recently the current center right government led by liberal conservative Ulf Kristersson launched an ambitious fall budget with reduced taxes on work and abolition of the plastic bag excise tax and the flight excise tax. However, the challenges of accelerating growth are extensive.

It is important to understand why governments in Sweden, on the right as well as the left, are reducing taxation, cutting top income earners marginal rates, and going as far as abolishing two environmental taxes which have been shown to not be the optimal policy instruments. The core reason is the need to break from stagnation.

Between 2010 and 2022, Sweden had a real increase in the standard of living per inhabitant of only 5 percent, less than half of the level for the entire EU. Even during 2023 and so far in 2024, Sweden has lagged behind in terms of growth. While countries like Sweden with a high tax burden and regulatory burden are stagnating, economic activity is shifting towards countries with lower taxes and more business-friendly policies.

Sources: Eurostat, In 2013 dollars inflation calculator and own calculations.

Business-friendly Ireland has more than doubled its wealth per inhabitant over the same period and overtaken Sweden in wealth. The Netherlands is another Western European country that has overtaken Sweden in prosperity during the same period, it can be described as having a more business friendly version of the Swedish model, with lower taxes and more focus on insurance solutions for universal welfare coverage. Sweden's stagnation is noticeable at the national level and even more noticeable when the analysis is done regionally. Since 20210, the real standard of living has actually decreased in Jämtland, Halland, Södermanland, Västmanland and Kalmar counties, while it has not increased at all in Gotland county. It is clear that change is needed.

Sources: Eurostat, In 2013 dollars inflation calculator and own calculations. For 2022, it is estimated
that all counties have had the same real prosperity development as the national average.

A number of different policy changes are needed to stimulate growth: lower taxes, lower regulatory burden, strengthened security, strengthened infrastructure and strengthened energy supply. A particularly important issue concerns excise taxes and their application. Excise taxes increase the price of goods, create administrative costs and uncertainties for business operations. Sometimes they are needed, but often they are not optimally designed means of control. Some current examples:

• The flight tax was abolished in the autumn amendment budget 2024 as it created distortions, costs for households and companies at the same time as more effective environmental control instruments were already in place through the EU.
• The plastic bag tax was introduced in 2020 and three years later the decision was made to abolish it. The tax was not effective, was an over-implementation of the EU's packaging directive, and was not the most effective policy instrument.
• A public inquiry from 2017, before the corona pandemic, showed that there was uncertainty as to whether disinfectants were covered by the excise duty on disinfectants or not. Then followed the corona pandemic, when there was an extensive need for disinfectants and shortages of this among staff in care and social care as well as individual households. In retrospect, the Tax Agency has chased many of the companies that assisted with hand sanitizer during the pandemic, because they did not administer an excise tax that was unclear from the beginning.

The electronics tax displaces economic activity from Sweden without being an optimally designed policy instrument. For example, it is not a gain but a loss for the environment that a TV is imported from another European country because it is cheaper, rather than bought with lower shipping from Sweden. Chewing tobacco in a bag is, unlike snuff in a bag, a product that can be produced for consumption in Sweden and also be exported. While snuff is not legal in many other countries, chewing tobacco in bags are. However, the Swedish Tax Agency's excise department interprets the product differently, which might stop production and exports. This inhibits a potentially successful future Swedish export industry from growing.

Even when excise taxes are needed, it is important to implement them in a way that does not inhibit business activity. Sweden, as an integrated part of a common European market, needs to have flexible processes, otherwise economic activity will be crowded out.

A recurring theme in Sweden is that business owners are generally satisfied with the Tax Agency's service, but those who end up in legal processes do not feel that they are sufficiently legally secure in their relationship with the Tax Agency. The organization Rättvis Skatteprocess, which aims to create fair tax trial processes, has analyzed 1,600 decisions in the administrative courts between the years 2018 and 2022 and found that fewer than in fewer than one in five cases are granted full compensation for court costs, even when the individual has won approval. This is unusual, since the Swedish legal system typically has the party losing paying the court costs. In 26 percent of the cases, the individual receives full or partial approval in the matter, but is not granted any compensation at all. This illustrates how legal cases involving the tax agency are distinct from typical legal disputes, resulting in that many companies do not dare to pursue legal issues against the Swedish Tax Agency.

Finally, the Swedish Tax Agency's role as an authority needs to again become focused. The new working form, in-depth dialogue, is meant to make the authority more business-friendly by providing tax advice to companies. It however leads to gray areas and question marks about the Swedish Tax Agency's function as a regulatory authority.

It is not only the economy that benefits from tax reforms, but also the government. The governments that are re-elected tend to be precisely those that increase the level of economic freedom, shows a comparison of the governments that have existed in developed economies since the mid-1990s. Interestingly, the effect is just as large for governments on the left as on the right. Both in Sweden and internationally, it has often been the same governments that implemented tax cuts and other reforms to increase economic freedom that were also later re-elected.

Sweden is likely to continue introducing tax reforms, in order to break the stagnation and become more competitive. The public is rewarding reform willingness and fiscal conservatism, and there is a need to again strengthen the working and responsibility ethics. Perhaps the most important Swedish policy lesson is that Ibn Khaldun and Arthur Laffer have been right all along about the importance to limit the tax burden.

Nima Sanandaji, Director, European Centre for Entrepreneurship and Policy Reform (ECEPR)

Photo: Ximonic, via Wikimedia under CC 4.0 License. Charts: courtesy Nima Sanandaji.