The Finnish Great Depression of the 1990s: reconciling theory and evidence

Output and the financial factors

Details of the corporate tax reform

The idea behind the Finnish growth strategy prior to the 1990s crisis was that large and expanding firms were good for growth, and accordingly a high rate of physical investments was administratively maintained with tax subsidies and accommodative monetary policy in the decades after World War II. The investment rate was the highest among OECD countries between the years 1960 and 1990 and as a consequence the country’s production capacity was very large at the onset of the crisis, while the marginal product of capital was low. The resulting inefficiency problem escalated during the depression, the growth model collapsed, and the country faced a long-lasting restructuring of production (see Pohjola 1996; Heikkinen and Kuusterä 2001). This paper illustrates with the general equilibrium model how it affected the economy under crisis conditions.

The statutory corporate income tax rate was very high before the reform (on average 50 percent in 1987), but generous allowances like inventory and investment reserves and accelerated fiscal depreciation considerably reduced the corporate taxes collected (Valkonen 1999). The variety of tax allowances, and the high statutory tax rate, were once part of a deliberate strategy of stimulating firms to plow back profits into their businesses in the Nordic countries. The idea was that large and expanding firms were good for growth. During the 1980s, there was a shift in emphasis. In Finland the motivations for the corporate and capital income tax reform were both external and internal (Valkonen 1999). Domestically, the most compelling reasons were the need to improve the efficiency of the allocation of capital and to promote neutrality in taxation of industrial branches, types of capital, sources of financing and investing sectors (Junka et al. 1995). The corporate tax reform was also designed to adapting the Finnish financial and capital markets to the deregulation of the international capital movements (Junka et al. 1995). Opportunities for tax arbitrage had emerged as a result of the deregulation of credit markets. International pressures were generated by the deepening economic integration to other parts of Western Europe and the wave of tax reforms carried out there, which intensified tax competition. On the other hand, it is hard to argue that the reform was directly motivated by the Soviet collapse. Its timing as well as the fact that it was structural (it did not markedly affect the total tax rates as shown by Gorodnichenko, Mendoza, and Tesar 2012) does not support this hypothesis. The main reforms of the tax system were carried out during the years 1987–1993, i.e. there was no “big bang” but instead a gradual implementation. The elements of the reform were the broadening of tax bases and the lowering of tax rates from 1987 onwards, the adoption of an avoir fiscal system in corporate income taxation (1990), the introduction of source taxation of interest income (1991), the separation of taxation of earned income and capital income and a major corporate income tax reform (1993) (Valkonen 1999). Previously, Kuusi (2015) have collected more details of the crisis, such as comparisons between the industry-level changes in the effective tax rates, and the investment rates. They support the idea that a major transition indeed occurred during the Finnish Great Depression.

Why did the reform have a large impact in Finland, but not in Sweden? The reason lies in the fact that there were major differences between the Swedish and the Finnish tax systems prior to the reform. Airaksinen and Hagfors (1987) finds that the Finnish system generated a significant tax subsidy to investments especially due to the treatment of interest expenditures in the taxation. In Finland the interest income derived from bank deposits and government bonds was tax exempt prior to the year 1991. Debt finance of the corporations was thus strongly favoured as corporate interest expenses were tax deductable. As a result, in the regulated financial markets the tax wedge became negative for investments financed by debt. Since such treatment of interest income and expenditures was non-existent in the Swedish system, the tax wedge in Sweden could have been over 7 percentage point higher in 1986 based on the calculations by Airaksinen and Hagfors (1987). Another paper that confirms the favourable tax treatment of the investment in Finland is Holland (1984). On the other hand, it should be acknowledged that many European countries resorted to similar policies after World War II. In most other countries the period of rapid catch-up ended with the oil crisis of the 1970s. In Sweden, for example, the 1970s was a time of major structural changes. After the investment boom in the early 1970s, the volume of investments in Sweden dropped substantially and the investment rate never returned to the old levels. Landesmann (1992) describes the period being diffcult for the Swedish economy. Problems in the private sector forced the government to rescue ailing firms and support the restructuring of Swedish industry. However, by the early 1980s the restructuring proved to be successful and the Swedish economy gained a position as an exporter in high technology areas.

Utility maximization of the unconstrained consumer

This appendix lays out the standard utility maximization problem for the unconstrained consumer. Let us write the Lagrangian.

where time index t of all endogenous variables is omitted, while (′) denotes the next period, t + 1. D denotes domestic riskless bond, and DP return on bond, so that DP′=(1+rtn)D. There are financial frictions equivalent to property taxes (τ_k and τ_d) on both types of capital. The property taxes are returned in lump-sum transfer, T, to households. T also includes the cost of the tax credit that is levied on the household.

Let us write down the FOCs for consumption

investment:

future assets:

and labor (in model specification, where the representative household optimizes the supply of labor):

Lagrange multipliers are then solved from (c) and (i_j)’s:

Next, the FOC is solved for D:

The dynamic optimality conditions are found by combining (aj′)'s with (c)’s for j = d, k:

Let us denote τj1−τj (≈τ_j) by f_j.

Furthermore, the optimality conditions are expressed in terms of relative prices and using the definition of the real interest rate, (1+rtn)pypy′=1+rt, they become

Following Gorodnichenko, Mendoza, and Tesar (2012), exogenous real interest rate shocks are used that match the monetary policy shocks in a simple cash-in-advance set-up. The real interest rate follows an exogenous path during the crisis years 1991–1996. After 1997 the real interest rate becomes an endogenous variable, and it ensures that the economy reaches a full employment equilibrium with balanced trade. This paper abstracts from further analysis of money and a technical assumption rtn=0 is made so that 1+rt=pypy′.

Further characterization of the model

This appendix illustrates further the structure of the model. Furthermore, let us write down the whole model, while prices are expressed as relative to the price of the domestic good (p_y,t = 1). The main non-standard feature of the model is the use of a dummy variable ξ_t that governs the exogeneity of the real interest rate. When ξ_t = 1, the real interest rate is fully exogenous and when ξ_t = 0, the real interest rate is endogenous and it ensures a full employment equilibrium x_t = 1:

On the supply side the following six equations govern production and prices of production factors:

The next set of equations governs the domestic price, the share of domestic goods, and exports. In the first years of the crisis the volume of exports is considered exogenous. A balanced trade condition is enforced at later periods of the simulation:

where ex_t denotes the value of exports and the volume of exports in terms of domestic good is measured as extpy,t. ξ_t is the same, exogenous dummy variable that governs the exogeneity of the wages and the real interest rate. extexo is the exogenous export demand. The second term on the left-hand side collects components of the balanced trade condition (the value of imports). When ξ_t = 1, exports are fully exogenous and when ξ_t = 0, the balanced trade condition holds.

Solving the initial price level requires an additional equation that governs the size of the foreign market in the steady state. A constant (cons) is used to calibrate the model to match relative prices to the data. The terms-of-trade variable p_w,t is exogenous and it governs the domestic share of the foreign good, as is calibrated to match changes in the domestic

The pricing kernel consists of the Euler equation and the two zero arbitrage conditions arising from the household utility maximization

Consumption is further governed by the following static conditions and relative prices:

Finally, the model is closed by imposing the aggregate resource constraint: