By Alistair Scrutton and Teis Jensen
COPENHAGEN (Reuters) - Danish Prime Minister Helle Thorning-Schmidt alienated her center-left voters when she started cutting one of Europe's most generous welfare systems shortly after she was elected.
Two years later there are signs the reforms by "Gucci Helle" - as the elegantly-dressed leader is known to critics - are paying dividends and her popularity has rebounded.
Denmark, along with similar ones other Nordic countries of Sweden, Finland and Norway, has long cherished a welfare system that includes living allowances for students and generous parental leaves, part of decades-long social policies focused on egalitarianism.
But the high cost, which will rise as populations age, specter of debt crisis in several southern European countries where governments overspent, and the need to lower taxes to make economies competitive has brought pressure for change.
Sweden was the first to direct the debate about the welfare state away from preserving it as it is to making it more affordable.
Thorning-Schmidt's government, which was elected on promises to tax millionaires but has reduced corporate taxes, raised the pension age and implemented a cut in unemployment benefits, has now taken a political risk by forcing the debate in Denmark.
"I think we have found the right formula, not to be popular ... but to do the right thing," Thorning-Schmidt, 46, told Reuters in her office in Christiansborg Palace in Copenhagen. "Reforms are necessary and we will not stop."
Her coalition government had plummeted in polls since her 2011 election with many supporters turning to the anti-immigrant Danish People's Party and the leftist Red-Green Alliance.
She has faced protests, rare in Denmark. More than 800,000 children were locked out of schools for four weeks this year by teacher protests after the government pushed for longer hours. Students carried out large demonstrations against grants cuts.
But just in the last month her ratings have started to improve, helped by an expenses scandal involving the opposition leader as well as signs of economic recovery and rises in consumer confidence.
"The current government, whether you like it or not, has shown courage," said Niels Thygesen, economics professor at Copenhagen University. "The idea - that reform is needed - is much more widespread."
The debt crisis in the euro zone forced many other European countries to cut spending to get their finances back on track.
This stirred the debate among mainstream center-left parties torn between pursuing traditional tax-and-spend policies as France's Socialist leaders initially sought to do, and trimming pensions and welfare benefits in ways that alienated voters, as in Germany, Spain and Greece.
While the four major Nordic countries, all with triple AAA credit ratings, were less affected by the troubles in the neighboring euro zone, they are having the same debate.
Sweden is mulling more cuts to pensions and sickness benefits. Finland has come under pressure to raise pension ages.
Even Norway has concerns it is becoming uncompetitive as oil wealth and welfare means many can afford not to work and that competitiveness is suffering from rising wages. Norwegians have even added a new word to their vocabulary - "to nave", or to get benefits from NAV, the labor and welfare agency.
In Denmark, two scandals involving welfare payouts have also helped to change opinions of a system that is largely responsible for a tax burden of around 48 percent of GDP, the highest in Europe.
One involved "Poor Carina", a single mother of two picked for a television program meant to expose hardship. But that backfired when it turned out she received around $2,700 a month - more than many full-time workers.
Later in the year, a man labeled "Lazy Robert" further fuelled the national debate when he told his story of being on welfare since 2001 with no plans to take a lower-paid job.
Marginal taxes on high earners reach nearly 56 percent on income of around $76,000. Businesses complain that taxes are too high, making it hard for them to stay competitive.
Asger Aamund is chairman of Bavarian Nordic, a biotech company producing cancer drugs and vaccines that helps underpin Denmark's reputation for innovation. He said high taxes were driving away skilled labor.
"We have all our development in Munich, where we have 100 scientists," Aamund said. "And we have almost 100 scientists in California doing our cancer vaccines."
Some economists say that Denmark's current welfare system is unsustainable and risks become unaffordable in 2020, a date that is often mentioned in the media.
"Everyone is looking toward to 2020," said Anders Krab-Johansen, managing editor of Borsen newspaper. "The date is all over the place. After that we have less oil and more old people. Things have started to get unsustainable already."
Thorning-Schmidt, a surprise choice as leader of a party that has always defended the welfare system, made clear within days of her election that her leftist election promises would not be met.
"They ran away from everything," said Aamund. "I have never seen anything like that, so fast. This was very brutal."
Perhaps the most far reaching reform - first proposed by the previous center right government but enacted by Thorning-Schmidt - was reducing early retirement. More than any other policy, this may have put Denmark back on a path of fiscal sustainability.
The government also allowed unemployment benefits to be cut from four to two years, and put restrictions on municipal spending to control the budget better. Welfare cuts helped pave the way for cuts in corporate taxes from 25 to 23 percent.
It was a switch that voters cried "broken promises". When cutting corporate taxes, duties on soft drink also fell, sparking outrage given welfare was being trimmed.
There were signs Thorning-Schmidt - born in a modest Copenhagen suburb - would bring change to her party when she was elected in 2005, beating more elderly statesmen. Elected to the European parliament in 1999, she gained a reputation as a pragmatist rather than ideologue.
Conservative Party chairman Lars Barfoed recalls the surprise hearing her as an MEP arguing for raising pension ages.
"That was her entrance in Danish politics," he said. "Her ideological stand? I don't have the faintest idea."
Thorning-Schmidt has struggled to win over voters, often appearing stuffy in public and with the image of an upper-class socialite. After the teachers strike, polls showed her party at its lowest in a century. Trying to give a speech on May 1, she was heckled by protesters.
She defended sending her eldest daughter to private school and battled with media prying into the tax affairs of her husband - Stephen Kinnock, son of former British Labor Party head Neil Kinnock.
"She has refused to change her style. Some social democrats have said you cannot dress up like that, looking so elegant with a handbag and high heels," said Thygesen. "She has always refused to scale down."
Much remains to be done. Denmark's place in the World Economic Forum's global competitiveness rankings fell to 15th this year from 8th in 2011-12. The WEF highlighted taxes, regulations, financing and restrictive labor regulations.
Further reform - including more changes to unemployment benefits - may be stymied as 2015 elections approach. Some say she could move to the left if the nuances of coalition politics allowed.
But the economy is on her side. The OECD says unemployment may fall from 7.0 percent to 6.5 percent by 2015, election year. After a 2012 recession, growth will pick up this year and next.
That, and an expenses scandal that hurt her main opponent, helped her in local elections this month when her Social Democratic Party did better than expected, winning the most votes of any party.
This could give her the impetus for further welfare reforms.
"Reform is on the agenda," said Krab-Johansen. "The issue is whether you can sustain it."
(Added reporting by Paul Taylor in Paris; Editing by Anna Willard)
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