Rising inequalities challenge Finland's social model.
Rising GDP has been accompanied by increasing inequality
Apart from GDP, income equality is an important aspect of well-being. While GDP has continued to rise, income distribution has worsened in almost all OECD countries over the past decades. This has been influenced by the quick pace of globalisation, rapid technical progress, and changes in social structures, which have raised the relative returns to skilled labour and reduced those to unskilled workers. The rapid transition has made it difficult for welfare systems to bridge the growing income gaps. In Finland, this took place against a deep recession in the 1990s, which led to a sharp rise in unemployment and reduction in participation rates, as many left the labour force to live on social assistance or pensions. There was also considerable structural change, with the traditional forestry and paper industries losing competitiveness and giving way to buoyant new industries with a dramatic expansion in openness. At the same time, this transformation increased regional concentration of economic activity, which contributed to growing income disparities across the country. For example, over half of the increase in GDP between 1995 and 2005 was generated by only one of the twenty regions in Finland (Uusimaa, the Helsinki region with 11% of the population). (1)
While the Nordic countries have among the most even distributions of income in the OECD, they have seen some of the most rapid deterioration in income dispersion in recent years (Figure 4.1). (2) The importance of income equality in countries' social welfare functions differs, but is particularly important in the Nordic countries, including in Finland. Acceptability of change and related reforms are also more difficult if large sections of society are perceived to be worse off. Reconciling closer integration with the global economy and managing the changes that it entails, while maintaining a fair distribution of resources and opportunity is an important challenge going forward (Anderson et al., 2008).
This chapter looks at the challenges of maintaining income equality in the face of widening earned income differentials and growing disparities in regional outcomes across Finland. It looks at various measures of inequality, including income distribution, poverty rates and regional income and employment differences, and what factors may have contributed to increasing inequality. Apart from global trends, such factors include the impact of domestic policies, including education, labour market, reforms in the welfare system, and distortions in the tax system. Income and labour market disparities have become particularly stark between regions in Finland given the concentration of economic activity in the South. The chapter concludes by discussing policy issues stemming from balancing income transfers and work incentives. The role of municipalities as providers of many social services and education is particularly important, especially in the light of growing fiscal and demographic pressures.
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Income inequality has widened in Finland in recent years
Income inequality declined steadily until the early 1990s in Finland aided by an increasingly generous welfare transfer system. To assess the sources of inequality the Gini coefficient can be decomposed into i) factor income (before-tax labour, entrepreneurial and property (capital) income); ii) gross income, which includes the impact of social security and other transfers; and finally iii) disposable income, which incorporates the effects of taxation (Box 4.1). Both gross and disposable income inequality trended downwards until early 1990s, while factor income inequality remained largely stationary (Figure 4.2, left panel). This points to the important role of social transfers in distributing income (including tax progressivity and transfers, Mahler and Jesuit, 2009; Brandolini and Smeeding, 2007). The compression of the wage distribution due to incomes policies also played a role during this period (Uusitalo, 1989). By the mid-1980s income inequality in Finland was among the lowest in the OECD (Figure 4.2; Atkinson et al., 1995; Forster and Mira d'Ercole, 2005; OECD, 2009a). (3)
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Income distribution started to worsen after the 1990's recession. The sharp rise in unemployment due to the recession increased factor income inequality. The impact of joblessness on disposable income inequality was muted by the transfer system, as indicated by the more gradual worsening in disposable income inequality. But social transfers were not enough to maintain the degree of equality as unemployment spells lengthened, unemployment insurance expired and retrenched workers moved on to more modest unemployment benefits, and disability and other pensions. The worsening also reflected considerable cuts in the welfare system motivated by the need for fiscal consolidation, and to reduce unemployment rates that had peaked at over 18% (Van Gerven, 2008). For example, prior to the recession, employment was guaranteed for those out of work for longer than 12 months. The government also fully subsidised such employment for the first 6 months, which reset unemployment benefits to another 23 months, resulting in churning. The guarantee of subsidised employment was abolished in 1992 and the renewal of earnings-related unemployment insurance by participating in subsidised work was restricted in 1997. The increase in factor income inequality after the recession, despite improving labour market conditions, also reflects the quick recovery of asset values as compared with employment rates that never quite fully recovered from the 1990s recession (Figure 4.2, left panel). Another factor is the increase in high paying jobs in the newly emerging industrial sectors.
Box 4.1. Components of disposable income Factor income = Wages and salaries + Entrepreneurial income + Income from property i) Wages and salaries (including fringe benefits and incentive stock options). ii) Entrepreneurial income iii) Income from property = Interest income + Dividends + Rental income + Imputed net rents of owner-occupied dwellings + Realised capital gains + Pensions and compensations based on private insurances. Gross income = Factor income + Current transfers received iv) Current transfers received = Occupational pensions + National pensions + Other social security benefits + Social assistance allowances + Other current transfers received Disposable income = Gross income - Current transfers paid v) Current transfers paid = State income tax + Municipal income tax + Other current transfers paid
Factors driving rising income inequality
The distribution of disposable income has become more uneven in most OECD countries over the past two to three decades (Figure 4.1). There are a number of common factors that have contributed to this phenomenon (OECD, 2009a). Trends in population and social structures are impacting on measures of income inequality in many OECD countries. Household units are becoming more atomised. Rather than the traditional model of two parents and children under the one roof, the trend has been towards fewer children and more solo living, particularly among the low income older and younger age cohorts. The result is that income surveys, which are done on the basis of household income units, measure greater numbers in the low income deciles. Moreover, increased fragmentation into smaller household units means reduced economies of scale and cooperation in domestic production, and lost economies of scale in consumption (Ringen, 2007). That said, only a small proportion of the change in Finland's disposable income Gini coefficient over the past two decades can be attributed to altered age and household structures (OECD, 2009a).
The inclusion of growing numbers of employed students in the income survey can inflate numbers in the low income deciles and may account for some of the increase in aggregate inequality in Finland over recent years. The proportion of tertiary students who work has increased to 26% in 2007 from 14% in 2000. While it is difficult to be sure what types of jobs these students are engaged in, it is likely that they are employed part time in the services sector in relatively low wage jobs.
Changes in the population structure can also impact on developments in income inequality over time as poverty tends to be more prevalent among the old and young age cohorts, and single parent households. Although Finland is ageing earlier and more rapidly than most other OECD countries, these factors have been shown to account for only a small proportion of the increase in Finland's aggregate Gini co-efficient between 199S and 2005 (OECD, 2009a). Nevertheless, removing both the top and the bottom income deciles, income equality within the remaining 80% of households has continued to show a mild upward trend since the mid-1990s (Figure 4.2, right panel) pointing to some "hollowing out of the middle class" (OECD, 2009a).
Considerable research has been undertaken exploring the degree to which giobalisation (trade, foreign investment and migration), skill based technological change and labour market institutions play a role in explaining the trend of increased income inequality in OECD countries. Globalisation and technical change are likely to play an important role in Finland where openness has increased dramatically over the past two decades and the structure of the economy has been transformed, while labour market institutions have remained relatively rigid. This literature is commonly motivated by the trend decline in labour shares witnessed in many countries over the past three to four decades. However, there does not appear to be any cross-country correlation between changes in aggregate income shares and changes in household disposable income distribution (Harjes, 2007). As shown in Chapter 3, wages in Finland are more compressed than in any other OECD country.
Trends in patterns of employment have also impacted on income distribution. The growing incidence of non-standard employment (part-time, contract and casual work) has contributed to the widening of the distribution in factor income. This is also reflected in the increased concentration of capital and self-employment income in many OECD countries. The trend towards increased labour market participation and higher employment rates (female participation being an important factor), and the lessening of the gender wage gap, have both offset the increased dispersion in labour income over time.
Finally, the amount of public resources spent on income redistribution is a very important determinant of disposable income equality across the OECD. This is especially true in the Nordic countries where social benefits are both progressive and generous, and income tax rates are high. While this redistributive mix seems prudent, given research that suggests that social benefits appear to be the most efficient means of affecting disposable income distribution, it can come at the cost of blunting labour market incentives. Moreover, high tax rates on top income earners can motivate tax avoidance, blunt work incentives and make it difficult to keep and attract skilled labour.
The sharp rise in incomes of the highest earners has been an important factor in rising income inequality
Much of the rise in inequality over the past decade is due to a disproportionate increase in disposable income accruing to top income earners in Finland. If the top income decile is removed from the Gini coefficient, the rise in inequality is muted considerably from around the mid-1990s onwards (Figure 4.2, right panel). Over this period, income accruing to the top quintile in Finland increased by 4.6% per annum on average compared to 1.6% for the bottom quintile and 2.S% for the middle three quintiles. This is by far the largest increase in top quintile income relative to the mean of any country in the OECD over this period and contrasts with earlier periods when income in the top quintile actually declined relative to the mean (OECD, 2009a). Furthermore, income accruing to the top 1% increased more than six times faster than total income between 1990 and 2002 (Riihela et al., 2009). The increase in the mean income of the top 1% is also considerably larger than the median, suggesting that much of the increase is concentrated in just a small upper proportion of the 1% of top income earners (Figure 4.3). For a small country like Finland, this means a very small number of people.
Rising realised capital gains and dividends contributed heavily to the large increase in the measured income of top income earners. Through the 1990s, equity prices climbed dramatically in Finland on the back of the emergence of the ICT sector, and this is reflected in a considerable climb in the share of total disposable income in the top decile derived from capital gains. Dividends also increased rapidly through this period, in part due to the increased profitability of Finnish firms through this period. However, total dividends increased vastly more than profits: between 1994 and 2005 real profits increased by around one half while over the same period real dividends to households increased by almost a factor of ten (Statistics Finland, National Accounts). Part of the surge in dividends to top earners can be traced to a major tax reforms during the same period. Following the example of other Nordic countries, Finland introduced a dual income tax (DIT) system in 1993. This aimed at removing the unfavourable tax treatment of capital income by combining a progressive labour income tax with a flat tax rate on capital income. Its rate was initially set to the lowest marginal tax rate on labour income (initially 25% but later increased to 29%) and thus well below the top marginal tax rate on labour income (see Box 4.2). The reforms also included the full imputation of dividends. (4) Apart from improving the tax treatment of legitimate capital income, this opened an opportunity for high income earners to reclassify labour income as capital income to take advantage of the lower tax rate.
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Box 4.2. The Dual Income Tax system The Dual Income Tax (DIT) model is attractive on a number of efficiency grounds. Taxing capital income results in double taxation; once when the income that is used to purchase the capital is earned, and again when income is earned on that capital. This is analogous to taxing future consumption at a higher rate than present consumption. A policy consequence of this is that capital income should be taxed at a lower rate than labour income (indeed, the tax on capital income could arguably be zero). Moreover, if inheritance taxes address the equity concerns of capital transferred across generations, then a preferential treatment of assets saved for retirement is an argument in favour of lower capital income taxation. Finally, capital may be more internationally mobile than labour, and may have become even more so in recent decades, and therefore easier to evade taxation, so governments might treat it preferably. Indeed, in some continental European countries the dual tax system has been proposed as a means of addressing tax competition from the transition economies (GCEE, 2006). On the basis of these principles, in the late 1980s and early 1990s the Nordic countries each implemented a system of taxation that differentiates between labour income and capital income. The latter comprised income derived from interest, dividends, capital gains from financial assets, imputed rent on housing, accrued returns on pension savings and profits from personal enterprises. This base therefore includes some forms of capital income that had been completely untaxed under the previous system. Capital income is then taxed at a rate close to the lowest marginal rate on labour income, and corporate taxation is also harmonised to this rate with imputation allowing close integration of the capital and corporate tax systems. Simplified compliance is an argument in favour of this system with the DIT model making the demarcation between capital income and labour income, in principle, better defined. This means that administrative costs should also be lower. However, this is not to say there are no problems, and a number of them have started to challenge policy. Not least of these has been the division of entrepreneurial income into its labour and capital-derived components (which are indistinct from profits) and, given the preferential tax treatment of capital income, personal business owners have an incentive to categorise as much profit as capital income as possible. This possibility seems to have motivated individuals to incorporate into business structures. Each Nordic country has taken a different approach to this problem (Kanniainen et al., 2007). One solution is to impute average returns to business capital (the so-called presumptive rate of return) but this is unlikely to reflect the true returns and could reduce entrepreneurial incentives. Multiple imputation rates would complicate administration. Moreover, this whole approach invites political lobbying, as Christiansen (2004) documented happening in Norway.
Capital income accruing to top income earners has increased substantially following the reforms. With the highest effective marginal tax on labour income rate at roughly 61% (taking into account indirect taxes but not employers' social security contributions; Pirttila and Selin, 2006), the motivation to minimise tax was strong. Capital income of the top 1% of income earners increased from 28% to 54% of their total disposable income between 1994 and 2006 (Riihela, 2009). While some of the increase might be attributable to a trend toward greater equity-based remuneration of senior executives, particularly in the high-tech sectors (where the "superstar phenomenon" is prevalent), much of this is due to income shifting. As a result, immediately following these changes progressivity was reversed for those earning above EUR 60 000 per annum (Riihela, 2009).
The increase in measured dividend and realised capital gains after the 1993 tax reforms may in part be due to statistical coverage issues. In the pre-1993 tax system it was easy to wholly avoid taxation of profits by realising them as untaxed capital gains, in which case they were not recorded in the revenue statistics. In fact, it was possible to take out profits without paying the corporate income tax, as coverage of this tax base was patchy. With the reform, taxation of capital gains was tightened, as was the tax base of the corporate income tax by e.g. removing the possibility to distribute profits not subject to corporate income tax. As a result, revenue from the corporate income tax increased dramatically. Distribution of profits in the form of (statistically recorded) dividend income also became more prevalent, which partly explains the impact of the 1993 reform on the recorded household income distribution.
Recent reforms to the DIT system increased the taxation of dividends. The imputation system was abolished and a partial classical model of dividend taxation was introduced. After the reform, 70% of the dividends received from listed companies are taxed as capital income. Dividends from non-listed companies under the 9% return margin (i.e. return in relation to the company's net assets) are tax free up to the EUR 90 000 threshold and 70% of the exceeding amount is taxed as capital income. If the dividend income exceeds the 9% return margin, 70% of the exceeding amount is taxed at the progressive labour income tax rate. To diminish income shifting a special rule on the taxation of so-called work related dividends was added to the Income Tax Act. According to the rule, dividends from nonlisted companies are taxed as earned income if the dividends are based on the agreement concerning the work effort of the receiver.
Incidence of poverty has increased with joblessness
Although poverty in Finland remains low in the OECD context, it has substantially worsened in recent years by most measures (Riihela, 2009; OECD, 2009a). This is the case for all household types except those with two income earners, which have seen a very marginal decline in poverty rates (using the 50% of median income definition) between the mid-1990s and the mid-2000s (OECD, 2009a). (5) Apart from social transfers and wage levels, poverty rates tend to be related to employment status (OECD, 2009a). The number of households in poverty in Finland was 34% when no one was working but declines to 10% with one worker and to just 1% with two workers. Joblessness has undoubtedly been a very important factor in explaining poverty rates in Finland, in view of the high unemployment rates in the 1990s and since it has taken a decade to halve them. Many of the unemployed also exited the labour force to live on social assistance or pensions, and even by 2008 participation rates had not recovered to the levels prior to the 1990s recession. This underscores the need for policy makers to focus their attention on getting people engaged in the labour force and into work as the most effective means of combating poverty.
Regional labour outcome disparities are also on the rise
Another dimension of well being and equality is the regional distribution of labour market outcomes, which also shows a worsening trend in Finland. As with income inequality at the aggregate level, Finland ranks comparatively well within the OECD in terms of disparities in per capita GDP across regions. The Gini coefficient of per capita GDP across Finnish regions is well below the OEGD average and has been relatively stable between 1995 and 2005 (Figure 4.4, left panel). Moreover, the degree of dispersion in disposable income across regions has also been broadly static since the mid-1990s (Figure 4.5). (6) However, intercountry studies of inequalities can mask important differences across regions of individual countries arising from local conditions and geography, or the differential impact of globalisation and structural change on individual regions. For example, socio-economic outcomes vary increasingly in Finland across the three hundred plus municipalities. Moreover, inter-regional disparities are a significant factor in the growing aggregate-level income and social inequalities in Finland outlined above.
Labour market outcomes are an important aspect of inequality, as well as being a determinant of income dispersion. Unemployment is uneven across regions of Finland (Figure 4.6), and has contributed to increasing regional factor income inequality in recent years. The increasing variance in labour market outcomes across the regions is reflected in greater factor income dispersion (Figure 4.5). However social transfers seemed to have been effective in offsetting its impact on disposable income differences between regions (Figure 4.5).
The rise in the dispersion of regional unemployment rates in Finland was amongst the highest in the OECD between 1999 and 2006 (Figure 4.4, right panel). This leaves Finland above the OECD average by 2006 (OECD, 2009b). Paradoxically, this deterioration occurred during a period of steady declines in the aggregate unemployment rates.
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Following the deep recession of the early 1990s, the aggregate and the extremes of the range of unemployment rates across regions started to decline in 1993 (Figure 4.7, left panel). However, the dispersion of regional unemployment rates did not decline relative to the falling average and, as a result, the coefficient of variation trended strongly upwards over this period (as does the Gini coefficient). Not only did the variance of the regions with respect to joblessness increase over this period, but so did the variance of participation rates and dependency ratios (Figure 4.7, right panel).
This disparity in labour market performance across regions is even more pronounced when looking at males. The gender disparities in labour market outcomes reflect significant structural shifts in activity within the regions since the early 1990s. For instance, between 1992 and 2007 total employment increased by 13%, but employment in forestry and related manufacturing declined by 17%, and employment in agriculture declined by a massive 46%. These two industries are traditionally associated with more peripheral regions and dominated by low-skilled male workers. In contrast, women tend to be employed in the rapidly growing municipal services sector (eight out of ten municipal employees are female).
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Addressing disparities is complex calling for action on many fronts
Designing policies that address disposable income or regional inequality often involves balancing offsetting priorities and effects (for instance in terms of equity and efficiency) within tight budget constraints, especially in the current context of fiscal consolidation requirements. The complexity and causes of disparities call for a multifaceted approach including social, labour market, education, and tax and other fiscal reforms. These must be weighed against the intertemporal distributional concerns that the sustainability problem illustrates, which are particularly pertinent in the case of Finland. As the population ages and the regions struggle to adapt to ongoing structural change, the finances of both central and regional governments will come under increasing strain and their ability to continue to fund redistribution via income and other in-kind transfers will erode.
Finland has a long history of regional development programmes aimed at promoting equality and sustainability. In recent years this approach has gained a renewed impetus. In 2007 the government articulated its regional policy objectives in its Regional Development Act. These are: i) to strengthen national and international competitiveness of the regions; ii) to strengthen regional vitality and reduce regional disparities; and iii) to solve special regional challenges. Moreover, in August 2007 the functions of a number of ministries were combined into the new Ministry for the Economy and Employment which also took over the responsibilities of the Department for Development of Regions and Public Administration from the Ministry of the Interior, while the Regional and Local Administration Unit from the Ministry of the Interior was transferred to the Ministry of Finance. In January 2010 the government launched a Cohesion and Competiveness (CoCo) Programme which aims to build on individual regions' competitive advantages and strengths, thereby enhancing regional attractiveness to business and new residents. While these types of programmes might have cushioned the impact of structural change in the regions over the past two decades, disparities have nevertheless worsened, and given current fiscal pressures, room for extra spending on these measures is extremely limited.
At the same time, some further increase in income inequality may be inevitable. Increasing skill premiums may entail larger differences in wages. Constraints on public finances will limit amounts available for social transfers. These trends will put emphasis on policies that improve labour mobility and target transfers more efficiently.
Better targeting of social transfers
As in other Nordic countries, the role played by the public sector in Finland is central in tempering the uneven distribution in factor income. Finland and the other Nordic countries spend considerably more on both direct social benefits and other in-kind transfers such as public education and public health. Social benefit spending is boosted by the availability of long duration income-related unemployment benefits (500 days in the case of Finland; see Chapter 3). Relative transfers to smooth private (factor) income to achieve an equitable distribution of disposable income in Finland are among the highest in the OECD (Mahler and Jesuit, 2009). For instance, the gap between the Gini coefficients for private factor income and disposable income was 0.21 in 2004, compared to 0.19 in Sweden (in 2000) and Denmark (in 2004). (7) Over three quarters of redistribution in Finland is made through the transfer system (Mahler and Jesuit, 2009), which is in line with the other Nordics, but lower than in France and Switzerland. Comparing social benefits spending as a share of GDP against the consequent improvement in the Gini coefficient from moving from personal to disposable income shows the important role that unemployment benefits and pensions played in Finland in reducing income inequality following the 1990s recession (Figure 4.8). While increases in social transfers will be limited by the worsened fiscal outlook, even better targeting of the current system can have some impact in reducing inequalities.
To reduce income shifting among high earners, the DIT tax system should be reformed
Some of the dispersion in incomes can be reduced and equity increased by reducing potential for tax shifting in the DIT tax system. This would also help share the tax burden. A linearly progressive rate of capital taxation with rebates for low income earners could be one option. The provision for non-taxed shareholder dividends up to EUR 90 000 for closely held corporations is also a loophole that should be abolished. Moreover, the rate at which dividends that exceed that level are taxed is lenient and should be re-examined. These issues are likely being examined by a government working group currently formulating tax reform proposals.
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Reinforcing labour market and education policies can reduce inequalities
The link between the income of parents and children is commendably weak in Finland and this in large part can be attributed to the strength of the pre-tertiary education system (OECD, 2010). Comprehensive schooling reforms were instrumental in lowering the correlation between father's income and that of his son (Pekkarinen et al., 2009) and have also assisted in achieving low inter-school variation in test scores (OECD, 2006). This success has also been assisted by concerted efforts within schools to provide targeted remedial measures for those students who fall behind. This may be facilitated by among the highest teacher-to-student ratios in the OECD, particularly at the lower secondary level (OECD, 2009c). The low aggregate correlation between parent and child educational outcomes have resulted in high levels of intergenerational income mobility by OECD standards, with Finland ranking on a par with Norway and better than Sweden, Germany and France (D'Addio, 2007).
Nevertheless, intergenerational educational immobility remains an important issue in Finland particularly at the tertiary level, as highlighted by Statistics Finland census data on educational attainment across generations. For instance, in 2007 a 30-49 year old female is six times more likely to have obtained a higher tertiary qualification if her mother has a higher tertiary qualification as opposed to a basic level of education. The son-to-father higher tertiary attainment probability is even higher at close to seven times if the father also has a tertiary qualification compared to a basic level of education. Moreover, recent OECD research finds that in Finland, like in the United Kingdom and a number of southern European countries, the son of a father with a tertiary education enjoys a 20% wage premium compared to a son whose father does not have a tertiary qualification (OECD, 2010). This corresponds with the finding of high private internal returns to tertiary education in Finland relative to other OECD countries (OECD, 2006) and contrasts with the very small income penalty for a son whose father has attained less than an upper secondary school education. Indeed, the low-educated parent penalty is so small in Finland that, even with the high tertiary-educated parent premium, the aggregate intergenerational elasticity is low by comparison to most other OECD countries (Causa and Johansson, 2009).
Inactivity and welfare dependency are strongly transmitted across generations, particularly for women. This seems to be especially so in Finland which is second only to the United Kingdom among European OECD countries in the degree to which welfare dependency is transmitted from mother to daughter (OECD, 2009a). Employment continues to be important in either lifting both individuals and families out of poverty or in reducing income disparities (OECD, 2009a). Poverty reduction by other means typically implies blunted work incentives. While certain measures aimed at increasing participation and employment might be detrimental for income equality (at least in the short term), particularly those that focus on financial incentives, other measures such as active labour market programmes and stricter gate keeping may have a considerably milder effect on equality (OECD, 2009a). Chapter 3 makes a number of recommendations regarding how the performance of regional employment offices might be improved.
Reducing skill mismatches and promoting regional mobility would also help improve regional equalities, particularly in factor income and labour market outcomes. As outlined in Chapter 3, more needs to be done to ensure that those without jobs are efficiently matched with existing vacancies. This also means that greater effort needs to be made to provide the appropriate skills to those workers who have become retrenched due to structural change and find that their existing skills are no longer suitable in the new industrial structure. In addition to more resources for this task, the right incentives also need to be put in place so that the unemployed more readily take up retraining opportunities, lift job search intensity and step up enforcement of relocation requirements. (8) The recent extension of the commute radius to 80km is a move in the right direction, but greater incentives and assistance could be provided for more distant moves where housing costs are frequently the greatest impediment.
The recommendation (Chapter 3) that wage outcomes be more closely related to productivity outcomes within firms has been resisted in some quarters on the basis that this may lead to a rapid divergence in wage outcomes and a consequent deterioration in equality. While this is true to some extent, there are several factors particular to Finland and the other Nordic countries that would mitigate this. We have already noted the important role that the transfer system plays in equalising disposable incomes in Finland. Moreover, educational outcomes in Finland are especially homogeneous, especially within generational cohorts, meaning that the distribution of productive abilities should be relatively even (Andersen et al., 2007). Furthermore, in the long run, homogeneous wage outcomes across all sectors of the economy, without regard to relative productivity differences, are not sustainable, particularly in an economy that is becoming more and not less internationally open and more skill-intensive in production.
Regional inequalities can be reduced by improving municipal management
Smaller municipalities tend to have disproportionately large populations of lower income groups due to demographics disparities. (9,10) For instance, the 20-30 year old cohort is particularly absent from smaller municipalities. This might in part be because significant proportions attend tertiary institutions which are typically only found in the larger municipalities. (11) Nevertheless, the imbalance in the age distribution in small municipalities remains when looking at the shares of prime-age and older cohorts (Figure 4.9). (12) As the population ages in coming years, dependency ratios are likely to climb even higher and strain municipal finances, especially in the smaller municipalities (see Chapter 2). (13)
A case for reducing the numbers of municipalities in Finland, along the lines of what has been done in Denmark, was also made in Chapter 2 of this Survey. Municipalities are an important feature of the Finnish system of government, particularly as Finland has among the largest proportion of population living in rural areas in the OECD at around 53% in 2005. But Finland also has one of the fastest rates of urbanisation in the OECD, with the decline in the rural population of 2.2 percentage points in the decade to 2005 being second only to Iceland (OECD, 2009b). This, combined with the growing regional inequalities and imbalances outlined above, suggests that the existing municipal framework is likely to come under increasing pressure going forward, particularly as structural change continues and demographic trends take hold.
The previous Survey recommended that more should be done to encourage the consolidation of municipalities, with a view to improving the efficiency of service delivery. The growing regional disparities highlighted in this chapter provide further motivation for greater efforts in promoting mergers, particularly aimed at achieving minimum sustainable population-sized units (perhaps 20 000 as in the case of the Danish reforms). These would help to achieve economies of scale and address concerns about the competence of municipal administration, as talent would be less diluted than is currently the case. Mergers of this sort would put local governments in a better position to tackle the rising inequalities that have been highlighted in this chapter by being able to pool resources and to put local governments as a whole on a more sustainable fiscal footing (Chapter 2). However, administrative mergers themselves are unlikely to be sufficient and need to be coupled with strong incentives for the enlarged entities to reap the benefits of the economies of scale and other efficiency improving measures. This would help to reduce costs and improve the quality of service provision, thereby improving the fiscal position of municipalities, as well as being in a better position to address inequalities.
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Box 4.3. Summary of recommendations concerning rising inequality Distortions in the tax system are encouraging income shifting * The opportunities offered by the dual tax system for high income earners to reclassify labour income as capital income challenge the sustainability of the existing dual tax system. Fundamental reforms of the system may be required as the continual patching up of loopholes is untenable in the long run. A linearly progressive rate of capital taxation with rebates for low income earners should be considered to address concerns about progressivity. * Shareholder dividends up to EUR 90 000 are not taxed for closely held corporations. This disproportionately high limit should be reduced e.g. to correspond more directly to actual returns to capital. Moreover, the rate at which dividends exceeding that level are taxed is lenient and should be re-examined. * Lowering income tax rates on high income earners would reduce incentives to shift income, improve work incentives and help to keep and attract skilled labour. Labour market rigidities are hampering matching and exacerbating regional disparities * The lack of interregional mobility remains an impediment to the efficient functioning of the national labour market and has contributed to growing interregional inequality. Existing schemes to promote mobility should be re-examined. Furthermore, enforcement of the requirement for unemployment benefit recipients to relocate should be stepped up. * Wage compression should be deemphasised as a strategy for promoting income equality, as it does not assist in promoting sustainable job creation, particularly in an environment of globalisation and rapid technical change. * Policies to promote labour market participation and employment should be pursued as these have been found to be the best strategy for tackling poverty. Moreover, higher levels of participation and employment increase the tax base and make transfer-based redistribution more affordable. Municipalities will struggle to address rising inequalities unless efficiency is improved and financing addressed * Improvements in the efficiency of service delivery by the municipalities are being hindered by the large number of small entities. A more ambitious programme of rationalisation--including wholesale mergers along the lines of what has happened in Denmark should be considered (see Chapter 2).
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Glossary ALMPs Active labour market policies ATO Australian tax office BIS Basic income support CAPB Cyclically-adjusted primary balance DIT Dual income tax ECB European Central Bank EPL Employment protection legislation EMU European Monetary Union ETK Finnish Centre for Pensions FIN-FSA Finnish Financial Supervisory Authority GDP Gross domestic product HECS Australia's higher education contribution scheme HELP Higher education loan programme ICT Information and communication technology KELA Social insurance institution LAFOS Labour force service centres LMS Labour market support MEE Ministry of Employment and the Economy PES Public Employment Service R&D Research and development SATA Social Security Reform Committee SGP Stability and Growth Pact VAT Value added tax
(1.) Sweden has also seen a similar pattern although it is considerably less pronounced than in Finland. The Stockholm region contributed around 40% of total real GDP growth between 1995 and 2005 while it comprised 21% of the total population of Sweden.
(2.) Denmark stands out as the one Nordic country to record only a marginal deterioration in disposable income inequality over the past two decades (Figure 4.1). This might be partially attributable to the "flexicurity" system that was introduced in the mid-1990s, which combines high unemployment benefit replacement rates with strict employment activation requirements. This has assisted in keeping Denmark's unemployment rate well below the Nordic average for much of the period since the mid 1990s.
(3.) According to OECD (2008), Finland ranked second after Sweden as having the most equal in income distribution among OECD countries in the mid-1980s, but by the mid-2000s. Finland had dropped to 7th.
(4.) According to the National Accounts, between 1993 and 2005 dividend income increased by a factor of almost ten (Statistics Finland).
(5.) The worsening can be partly due to the denominator, which is usually a fraction of median disposable income, outpacing increments in social benefits. However, neither nominal GDP nor nominal disposable income grew exceptionally fast in Finland by OECD standards over the decade to 2005 despite strong real GDP per capita growth. This is a reflection of the very modest inflation and nominal wage increases recorded through most of this period.
(6.) Riihela (2009) shows that Gini coefficients over time within the 4 NUTS2 regions in Finland show a similar "U" shaped profile to the aggregate coefficient. The author also shows that average incomes across the regions tended to converge until the mid-1980s but have since remained static relative to one another.
(7.) Fiscal Redistribution Dataset. Assembled by David K. Jesuit and Vincent A. Mahler, www.lisproject.org/publications/fiscalredistdata/fiscred.htm.
(8.) Prior to the 1963 Act on Employment, reduced-wage public works employment was the only form of unemployment assistance and a policy of "total" inter-regional mobility was in force. After 1963 full wages were paid for subsidised employment and priority was given to finding employment in municipalities in which the unemployed resided. Also if the unemployed person was not able to be placed in a job, an unemployment benefit was paid by the government.
(9.) The relationship between municipality population size and unemployment rates is in fact an inverted "U". In 2006 the very smallest municipalities (ranging between 120 and 2 999 residents of which there are 89) had an average unemployment rate half a percentage point below the average of all municipalities. Conversely mid-sized municipalities (ranging between 3 000 and 9 999 residents of which there are 158) had an average unemployment rate of half a percentage points above the average while in larger municipalities the unemployment rate was also half a percentage point below the average. This is likely to be related to the larger share of the labour-intensive service sector in total value added in the smaller municipalities. The service sector share in the very smallest municipalities (120 to 999 residents) was almost six percentage points higher than the average while in mid-sized municipalities it was almost two percentage points lower. (Data from the Association of Finnish Local and Regional Authorities: www.kunnat.net).
(10.) Many of the very smallest municipalities are majority Swedish speaking. Around 10% of all Finnish municipalities are majority Swedish speaking but almost 60% of municipalities with a resident population of less than 1 000 are majority Swedish speaking. Finland has a disproportionate number of small municipalities, with the smallest half of all 348 municipalities (ranging from 120 to 14 000 inhabitants) only making up 10% of the country's total population. The average population of the 348 municipalities is just over 15 000 but the median is around 5 700.
(11.) The movements in the shares of other age cohorts across the municipalities hold even when adjusting for these differentials in the 20-30 year old cohort shares.
(12.) Those municipalities with small populations tend to have fewer prime-age residents and a greater proportion of retirees. Nationally in 2008, around 38% of the population was 55 years or older. However, for municipalities with less than 3 000 inhabitants (around one quarter of all municipalities) over 48% of the population was in that age cohort. Conversely, nationally 19% of the population is aged between 30 and 44 while for the small municipalities the figure is 15%. This point is further illustrated by the demographic dependency ratio (those aged below 20 and above 65 as a ratio of those aged between 21 and 64). In 2008 the national ratio was 0.66 but for municipalities with less than 3000 inhabitants the ratio was around 0.82.
(13.) Sweden has 290 counties with populations ranging from 2 500 to 810 000 and an average of 32 000 and median of 15 300. After the reforms of 2007, Denmark has 98 municipalities with populations ranging from 2 000 to 227 000 with an average of 56 000 and median of 43 000.