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Scandinavia’s Third Way Policies Killed Entrepreneurship and Growth

A COMMON NOTION IS THAT IN SWEDEN, and to some extent other Nordic nations, have embarked on a unique economic route: the Third Way. Third Way politics refers to an alternative to free markets on the one hand and Communism on the other. Indeed, policies did steer sharply to the left during the late 1960s in Sweden. Not only did the overall tax burden rise, but the new system also discriminated heavily against individuals who owned businesses. As politics radicalized, the social democratic system began challenging the core of the free-market model: entrepreneurship.

Taxes Targeting Business Owners

Swedish economist Magnus Henrekson has concluded that the effective marginal tax rate (marginal tax plus the effect of inflation) that was levied on Swedish businesses at times reached more than 100 percent of their profits. The table below shows the effective marginal tax rate for different combinations of owners and sources of finance. As can be seen, debt financing consistently received a much more favorable tax treatment compared with equity finance. In addition, the taxation of households was unusually steep due to high general marginal tax rates, high levels of inflation, and the combined effect of wealth and income taxation. Family-owned companies in particular were affected by a wealth tax on their net worth. It was not possible to deduct the wealth tax at the company level. Therefore, funds required to pay the wealth tax were first subject to the mandatory payroll tax as well as the personal income tax.

Effective Marginal Tax Rates in Sweden in 1980

Owner Debt New Share
Issues
Retained
Earnings
Households
(private owners)
58% 137 52
Tax-Exempt Institutions -83% -12 11
Insurance Companies -55% 38 29

In 1980 a person who owned a business could pay an effective marginal tax rate of 137 percent on the returns on the capital raised by new share issues. This means that the individual would actually lose money by making a profit once the effect of both taxes and the inflation of the original investment were taken into account. If the business had been financed by debt, the venture became profitable, albeit still facing a high tax rate. Tax-exempt institutions and insurance companies could face negative effective taxation, due mainly to the effect of high rates of inflation.

Capitalism without Capitalists

Henrekson draws the conclusion that the tax policies were “developed according to the vision of a market economy without individual capitalists and entrepreneurs.” Not surprisingly, the sharp left turn in economic policy markedly affected entrepreneurship. Sten Axelsson, another Swedish economist, has shown that the period between the end of the 19th century and the beginning of World War I was a golden age for the founding of successful entrepreneurial firms in Sweden. After 1970, however, the establishment of new firms dropped significantly.

In 2004, 38 of the 100 businesses with the highest revenues in Sweden were entrepreneurial—in other words started as privately owned businesses within the country. Of these firms, 21 were founded before 1913. Additionally, 15 were founded between 1914 and 1970. Only two had been formed after 1970. If the 100 largest firms are instead ranked according to how many people they employed, none of the largest entrepreneurial firms were founded after 1970.

If the 100 largest Swedish firms are instead ranked according to how many people they employed, none of the largest entrepreneurial firms were founded after 1970.

How can this dramatic fall in entrepreneurship be explained? Why did Sweden become so heavily dependent on firms that were formed generations ago? One reason might be that it takes time for firms to grow large; another, that large firms played a more vital part in the economy in previous times. However, these factors alone cannot explain the massive reduction in the number of new entrepreneurial firms in Sweden. Clearly, one important factor is the changes in economic policy towards the famous Third Way between socialism and free markets.

Reliance on a few large companies, often founded more than a century ago, is also common in the other Nordic nations. As an example, Nokia contributed fully a quarter of Finnish growth from 1998 to 2007; this single company, founded in 1865, generated nearly a fifth of the country’s exports.

Social democratic politicians and labor union representatives have long favored an economic system that relies on a few large companies. These employers are seen as stable and it is easy for both the government and the labor unions to negotiate with them. However, systems that favor old economic structures but do not encourage entrepreneurship become less able to adapt. Nokia’s recent failures have affected Finland’s economic well-being significantly. This in turn has spurred a debate about how nascent entrepreneurs can be encouraged.

In Norway, comprehensive state involvement in the economy supported by public oil wealth still today distorts economic dynamism. The Norwegian government owns 37 percent of the total equity of firms listed on the stock market. In addition it also controls some non-listed major firms such as Statkraft. If listed, the power-generation firm would be the third-largest company on the stock market.

The Organisation for Economic Cooperation and Development pointed out in 2013 that effective taxes on interest-bearing accounts and shares can reach 113 percent for private owners in Norway who pay wealth tax, a group including successful entrepreneurs. Private owners who do not pay wealth tax and have invested in owner-occupied housing on the other hand face zero taxation. This situation is, according to the OECD, “likely to result in significant distortions to saving and investment behavior.”

Unlike Norway, Sweden has in recent years abolished punitive taxes on entrepreneurs. Taxes on profits no longer reach 100 percent at the margin. Taxes on wealth and inheritance have in fact been abolished. Historically, however, Sweden has been the Nordic nation where Third Way policies have been most far-reaching. The hostile attitude towards private owners was in line with the idea of creating capitalism without capitalists.

Employee Funds and Other Forms of Socialized Ownership

These policies culminated in the introduction of “employee funds” at the beginning of the 1980s. The idea was to confiscate parts of companies’ profits and use them to buy shares, which in turn would be part of the funds controlled by labor unions. In effect, the system was designed to transfer the ownership of private companies to the unions gradually—a soft evolution towards socialism. Although the system was abolished before it could turn Sweden into a socialist economy, it did manage to drive the founders of IKEA, Tetra Pak, H&M, and other highly successful firms away from the country.

Third Way policies are often upheld as the normal state of Swedish policies. In reality, one can better understand these policies as a social experiment that has with time been abandoned because of poor growth results.

Third Way policies are often upheld as the normal state of Swedish policies. In reality, one can better understand these policies as a social experiment that has with time been abandoned because of poor growth results. Interestingly, even the leading social democrats at the time seem to have been aware of the damage that Third Way policies could do.

The most striking example relates to the introduction of the employee funds. Kjell-Olof Feldt, one of Sweden’s leading social democrats and at the time the finance minister, had to debate the benefits of the funds in parliament. But the minister was uneasy. During the debate, he was scribbling on a piece of paper. A Swedish reporter took a photograph of a poem that the minister wrote down. Remarkably, it turned out that the finance minister was anything but enthusiastic about the funds. In fact, he believed them to have had a significant negative impact on Sweden. Feldt went as far as describing them using profanity.

Kjell-Olof Feldt had good reasons to be critical of the radical ideas championed and introduced by his own party. In October 1983, a few months before Feldt scribbled his famous poem, what is likely to have been the largest political demonstration in the country’s history was arranged. Upwards of 100,000 people marched against the employee funds. Although the social democratic leadership seems to have been aware that the funds were a bad idea, they had invested too much political prestige in the idea to back away from it.

The funds were introduced in 1984, and later abolished following the election of a center-right government in 1991. Not only was the confiscation of profits for the funds stopped, the money previously gathered in the funds was transferred into pensions savings and research foundations. Sweden chose to return to the path of market economics over that of socialism.

Poor Scandinavian Economic Performance

OECD Countries Ranked by GDP Per Capita

1970 1980 1990 2000 2010
1. Switzerland Switzerland Luxembourg Luxembourg Luxembourg
2. Luxembourg Luxembourg Switzerland Norway Norway
3. United States United States United States United States Switzerland
4. Sweden Iceland Iceland Switzerland United States
5. Australia Canada Canada Netherlands Australia
6. Canada Sweden Sweden Ireland Netherlands
7. Denmark Austria Austria Austria Denmark
8. New Zealand Australia Australia Iceland Austria
9. Netherlands Belgium Japan Denmark Ireland
10. Belgium Denmark Denmark Canada Sweden
11. Germany Netherlands Belgium Sweden Canada
12. Austria Germany Germany Australia Belgium
13. Iceland Norway Norway Belgium Germany
14. France France Finland United Kingdom Finland
15. United Kingdom Italy Italy Japan Iceland
16. Italy Finland Netherlands Germany United Kingdom
17. Finland Japan France Italy France
18. Norway New Zealand United Kingdom Finland Japan
19. Japan United Kingdom New Zealand France Italy
20. Greece Greece Spain Israel Spain
Source: OECD Statistical abstract and author’s own calculations.

The employee funds were the tip of an iceberg of destructive policies introduced during the Third Way period. Changes in regulation, taxation, and increased state involvement had reduced the growth potential of the previously dynamic Swedish economy. As late as 1975 Sweden was ranked as the fourth richest nation in the world according to the OECD. As shown in the table above, the policy shift that occurred dramatically slowed down the growth rate. Sweden dropped to 13th place in the mid-1990s. In 2010, following a period of recovery from the country’s crisis and the free-market reforms that followed, Sweden had risen to 10th place.

As late as 1975 Sweden was ranked as the fourth richest nation in the world. The policy shift that occurred dramatically slowed down the growth rate. Sweden dropped to 13th place in the mid-1990s.

Norway has, thanks to enormous oil wealth, climbed in the rankings. Finland almost dropped out of the top 20 ranking during the mid 1990s, until recovering to 14th place in 2010. This recovery coincided with long-term reforms towards more economic freedom. Denmark fell from seventh place to tenth place between 1970 and 1980. Three decades later, Denmark had regained its previous ranking, after an impressive array of market-oriented reforms. Of significant sized economies, only Japan, which has experienced decades of lost growth and has huge demographic problems, has come anywhere near to dropping so many places as Sweden. It is interesting that the Left rarely discusses this calamitous Swedish growth performance from 1970 to 2000, when promoting Swedish-style Third Way policies.

Even Bo Ringholm, social democratic finance minister in Sweden, has acknowledged Sweden’s lack of growth. In 2002 he explained:

If Sweden had had the same growth rates as the OECD average since 1970, our total resources would have been so much greater that it would be the equivalent of 20,000 SEK [$2,700] more per household per month.

It should also be noted that by 2010, by which time Sweden’s relative decline had been arrested, government spending in Sweden had fallen to levels not very different from those in other major European economies (including the United Kingdom).

During recent decades, Nordic nations have implemented major market liberalizations to compensate for the growth-inhibiting effects of taxes and labor market policies. Indeed, Denmark has even moved towards a flexible labor market. One reason for this change is that the countries have learned their lessons from the failures of socialism. Today few, even among the hard Left, openly point to the Nordic Third Way policies as a positive experience. In the 2015 edition of the Economic Freedom of the World Index, Denmark was ranked as the 11th freest economy in the world, one place above the United States and two above the United Kingdom. Finland has the 19th freest economy, followed by Sweden’s at 23rd and Norway’s at 27th.

Denmark stands out as having an unusually high tax share of GDP as well as uniquely market-friendly regulations. But opening up markets does not fully compensate for the effect of high taxation. Such policies affect the living standard of the average Dane. An analysis by Danish think tank CEPOS shows that increased taxes have crowded-out direct household spending. Therefore the private spending of the average Danish citizen dropped from being the sixth highest in the world in 1970 to being the 14th highest in 2011. Sweden experienced a fall from eighth to 16th place during the same period. Even after the normalization of Nordic policies, the effects of high taxes and burdensome regulations on entrepreneurship are evident.

One measure of high-impact entrepreneurship is the number of entrepreneurs who have earned a billion-dollar fortune by creating or expanding a business. Together with Tino Sanandaji, I have worked on constructing this measure by looking at the individuals who have appeared in Forbes magazine’s list of the world’s richest people. We find that, in Scandinavian countries, the rate of high-impact entrepreneurship per capita is almost one-third that of countries with an Anglo-Saxon legal system. Political barriers have reduced the rate of successful firm creation in otherwise knowledge-intensive and innovative countries.


Mr. Sanandaji is a research fellow at the Centre for Policy Studies in London. This article is excerpted from his book, Scandinavian Unexceptionalism: Culture, Markets, and the Failure of Third-Way Socialism, © 2015 by the Institute of Economic Affairs. His book Debunking Utopia will be published this summer.