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From Economic Analysis to Inclusive Growth

WASHINGTON, DC – Most economies are seeking a recipe for inclusive economic growth, whereby high rates of investment, rapid innovation, and strong GDP gains are pursued alongside measures to reduce income inequality. Conservatives insist that growth requires low taxes and incentives such as flexible labor markets to encourage entrepreneurship. But reducing inequality requires higher levels of government spending and taxation (except when government is pursuing deficit spending to stimulate a depressed economy).

The Scandinavian economic model is often invoked to bridge this gap. The Danish “flexicurity” system, in particular, has historically delivered solid economic performance alongside low inequality. Leading economists such as Philippe Aghion have published excellent analyses of how this model could balance growth, equality, and overall satisfaction of citizens elsewhere in the world.

These economists argue that labor markets with few restrictions on hiring and firing, low taxes on entrepreneurship, and generous incentives for innovation are compatible with a relatively equal income distribution, high social spending by government, and equalizing social policies such as universal free education.

This model has sustained an ongoing debate in Europe, one that is now relevant in the United States, because Donald Trump’s new administration has promised to help globalization’s “losers” while improving innovation and growth. But in the US, it is far more difficult, politically, to argue for generous public spending on education, health care, and financial security for retirees, because doing so always raises the specter of high taxes.

An inclusive growth model would seem to have to square the policy circle. It would have to increase substantially public spending, particularly on education, unemployment benefits and training, and health.

It is useful to look at the numbers from the oft-cited Danish and Swedish examples. Generally speaking, these countries have excellent economic indicators. Although GDP growth is not higher than in the US, most people share a high standard of living, and surveys show that Scandinavians (particularly Danes) are some of the happiest people in the world. But, as the following chart shows, these countries also have some of the highest government spending- and taxation-to-GDP ratios in the OECD.

spending to taxation ratios

Hypothetically, if the US adopted Denmark’s universal free education policy, but kept its tax-to-GDP ratio unchanged, its fiscal deficit would exceed 6% of GDP. The US has run deficits that high only during World War II and the Great Recession of 2008-2009, when a huge stimulus package was implemented to spur recovery. So, just providing universal free education in the US would run the country’s deficit up to the highest level ever recorded in normal times.

In the context of this comparison, it would seem that the circle cannot be squared without a major macroeconomic shift. Scandinavian countries are smaller and can more efficiently collect revenues and administer public services. But even if the US approached this efficiency – a difficult feat in such a large and diverse country – social solidarity still would demand high effective taxes, as it does in Denmark and Sweden.

Another crucial component of the Scandinavian model is labor-market flexibility. On the OECD “Employment Protection Legislation” index, the US scores a 1.2 on a 0-5 scale, where zero indicates full flexibility. Meanwhile, France and Germany come in at 2.8, Italy at 2.9, and Denmark and Sweden at 2.3 and 2.5, respectively. This shows that, though Scandinavian labor markets are more flexible than elsewhere in continental Europe, the US labor market is far more flexible – and provides less security – than any of them.

Such broad static accounting suggests that we should proceed cautiously in applying lessons from the Scandinavian model to large countries like the US. Then again, to assess a model’s long-term impact on citizens’ welfare, we would need a more dynamic analysis over the course of at least a decade. Only then could we gauge how strongly investment and innovation would respond to incentives, how much free universal education would cost in the medium term, or how demographic structures would affect different social policies.

Economic analysis alone cannot settle the political debate between right and left. What it can do is help to narrow and focus that debate. The key is for participants on both sides to be more explicit about the values and objectives they believe that society should pursue, and to quantify their assumptions about how dynamic performance will respond to particular incentives. Only then can a democracy choose effectively between potential paths.

Good economic analysis can enable “constructive populists” to debate the “post-fact, fanciful populists” who seem to be on the rise, with a realistic alternative discourse – one that is transparent and based on credible expectations of economic policies and outcomes. In other words, economic analysis can facilitate good choices; it cannot make them.