This post is the first of a series in which PhD fellows at DBP present their research with a view to current political and economic issues.
By Niels Fuglsang, PhD fellow, DBP
When the Danish government in August 2017 proposed a tax reform that will reduce taxes on income, cars, telephones etc. for 23 billion Danish kroner (3,09 billion Euros) towards 2025, the minister of taxation was confronted with a question from a journalist about whether the reform would increase the economic inequality in Denmark.
The minister said: “This is a reform that increases the inequality, but we do that with open eyes… We have to increase inequality a little bit in order to create growth”. The minister backed his argument with calculations from economic models showing that the tax reform would increase the Danish GDP by 6,5 billion Danish kroner (873 million Euros) as people in jobs would work more while people without jobs would do more to get a job because of the economic incentives.
The reform is one in a series of reforms during the last decades which aim at increasing the income gap between those who have a job and those who don’t by either cutting income taxes or reducing social insurances and social benefits. In the period from 1993-2016 the high income tax level has thus been reduced by 12 percent (to about 56 percent) while the low income tax level has been reduced by 10 percent (to about 40 percent). Since 2008 the number of Danes who are eligible to pay high income tax has furthermore been reduced from one million people to half a million people. And since 1993 unemployment insurance has been reduced from eight and a half to two years. The reforms have all been backed by the economic models predicting that the economic incentives will result in more growth and higher employment.
Economic modelling has proven a powerful tool for driving this strategy. This has to do with the two-sided nature of economic models. On the one side they have a deeply political substance. On the other side they have an apolitical appearance.
Economic models are political because they never contain the whole world, but only part of it. The Danish economic models for example have since the 1990s included relationships showing how economic incentives increase the structural employment and growth. The methods for calculating this have become still more sophisticated with time. On the other hand, explicit concepts of inequality do not play any role in the models according to which Denmark could increase economic inequality to Brazilian levels without any economic consequences. Prominent economists like Joseph Stiglitz and organizations like IMF or OECD however argue that inequality can have negative consequences for the economy because it increases social problems and hinders socially marginalized people from contributing to society. It therefore matters which part of the world is included in the model and which part is excluded. It gives a political direction to the model and influences which economic reforms will be given high and low grades.
Economic models appear apolitical because they are too complex for most policy makers and journalists to understand. They see the models as a black box that you can feed with input (a political policy proposal) and which then provides an output (an economic evaluation of the proposal). What happens inside the mathematical equations is most often taken for granted and not questioned. Political negotiations rarely concern the assumptions of the model but rather start on the basis of the analysis produced via the economic model. In this way the ideas in the model are separated from the political process and constitute the commonly agreed truth about the economy on the basis of which the parties will negotiate. When occasionally the Ministry of Finance is confronted with critique, they respond by depoliticizing the models stating that these are “based on facts”, that they use the “conventional economic principles” as this is the most “responsible” policy, and warn against “letting political ideology control the economic models”.
When the Danish models were first put into use in the 1970s they were clearly inspired by Keynesian economics in their understanding that aggregate demand drove production and employment. Neoclassical economic theory however made its way into the models in the later part of the 1980s, and the models today constitute a Keynesian-neoclassical synthesis. From the 1980’s the models included an understanding of a general equilibrium which was determined by the supply side of the economy. The models thus predicted that if the supply of labor was increased this would with time turn into employment. In the 1990s and especially in the 2000s relationships on incentives were added, claiming that lower unemployment insurance and lower income taxes increase the supply of labor and thus in the long run support employment and growth. During the last decade the models have been adjusted so that, in the black box, the supply of labor turns into employment faster than before. Reforms of tax levels as well as social insurance will thus work faster than they did in the earlier versions of the models.
As neoclassical theory has taken a still more prominent role in the models, it becomes increasingly easy for political parties who propose reforms with tax cuts to get good evaluations from the economic models. At the same time it has become more difficult for political parties who want to spend more public money on education or social programs to get good evaluations, as it is usually necessary to raise taxes in order to pay for this policy. In the 1990s the leader of the right wing opposition Anders Fogh Rasmussen (prime minister 2001-2009) publicly criticized the models because they did not sufficiently take into account the value of “deregulating the markets and increasing the incentives to work” and thus were not in line with “common sense”. Today the left side of the Danish parliament criticizes the models for being “neoliberal” and favoring tax cuts over social and environmental investments.
The problem for democracy is that while the models show a political rather than an objective truth, politicians are often left without influence on what should be taken into account in the equations of the models. These decisions are depoliticized and left to a narrow circle of “neutral” economic experts. The history of the use of economic models in Denmark however shows that if political parties want to set a powerful agenda for the economic policy whether that is tax cuts, social investments, sustainable development or something else, they have to develop models that take into account the value of the policies they propose. Otherwise they are fighting an uphill battle against a black box which will categorize them as irresponsible and derail their agenda.
In my PhD project that I am currently undertaking at the Department of Business and Politics, CBS, I examine the political nature of economic models. Which ideas drive them and how do they influence politics and policy? In the coming years I will try to open up the black box and hopefully shed some light at its political substance.