Monday, 10 May 2010

Who will pay the inevitable tax increases?

Nat O'Connor: As part of our analysis of the Finance Act 2010 we looked at the national finances. An Saoi has pointed out that tax revenue is more or less on target. But even if those targets are met, the size of the deficit makes tax reform essential.

The primary role of the Finance Act is to make sure that the State's tax revenue is stable, sustainable and sufficient to fulfil its functions. But our analysis shows serious deficiencies in this area.

The following two diagrams illustrate the Department of Finance's headline figures on revenue and expenditure. Source for 2001-2008 data: Department of Finance (2009) Budget and Economic Statistics 2009. Source for 2009-2010 data: Department of Finance (2009) Pre-Budget Outlook November 2009. Figures for 2009 are provisional and figures for 2010 are projections.

Figure 1: Central Government Revenue and Expenditure (2001-2010), in Millions of Euro, net figures

Figure 1 includes all revenue and expenditure (including sources of revenue in addition to tax, such as selling State assets, loans to the State, etc).

Figure 2: Tax Revenue and Current Expenditure (2001-2010), in Millions of Euro, net figures

Figure 2 limits the figures to tax revenue and year-on-year ('current') expenditure only. This is to remove 'one-off' effects, such as from capital spending.

Simply looking at the illustrations shows the extent of the fiscal crisis. Both figures show the sharp drop in tax revenue (by a third, €14.2 billion) between 2007 and 2009. Some of the tax decline is due to the overall global economic recession. Optimistically, maybe half. The rest of the decline is due to the collapse domestically, especially in the construction and housing sectors. This is tax revenue that is not likely to ever return to mid-2000s levels.

Figure 2 also shows that the Department of Finance's 2010 projection for tax revenue is for less than 2009, whereas expenditure is increasing. In other words, the current deficit is getting larger, not smaller.

Figure 1 shows the reverse only because of large one-off cuts in capital expenditure, plus the effect of non-tax sources of revenue. In the absence of additional capital spending items to cut, any serious attempt to close the current deficit at the next Budget must involve more deep cuts in current spending and/or significant increases in tax.

Tax revenue for 2010 is projected to be €30.8 billion, whereas current expenditure is projected to be €47.5 billion. That's a gap of €16.7 billion.

Let's assume that global economic recovery will close half the gap in tax revenue over time (which is a big assumption). On this basis, using the Department of Finance's projections for 2010, the gap that remains to be bridged by spending cuts and/or tax increases is at least €8.3 billion.

(Note) This is a simplification of the overall situation. I am assuming that it is necessary to balance tax revenue with current expenditure because the major cuts on capital spending between 2009 and 2010 cannot be repeated and are not a permanent way of bridging this gap. I am also assuming that non-tax sources of revenue (currently including the Pension Levy) are not a stable replacement for tax revenue, although they provided over €800 million in 2009 and are projected to provide €2.3 billion in 2010. There is always disagreement about measuring the deficit, and of course State-led economic stimulus could also help decrease the gap by boosting economic activity. Yet, I think it is worth focusing on the basic mismatch between tax revenue and current spending because the gap is so large. And it seems certain that the Government must deal with the €8.3 billion question soon.

Unlike the last budget, which involved cutting one-off capital spending and making a pre-payment to the National Pensions Reserve Fund (NPRF), a continuation of the cuts strategy will require much more to be taken from front-line services. If the Croke Park deal holds, with its commitment for no more pay cuts, it is hard to see where billions in cuts can happen. Hence, I come to the conclusion that some significant tax increases are inevitable to help bridge the gap.

Tax increases at this time may further depress the economy, especially if they are based on income tax or consumption taxes. So there is a need to look at broadening the tax base to include different forms of tax, including taxes on wealth, in order to minimise the dampening of consumer spending. For example, ex-Taoiseach Bertie Ahern's regret at abolishing property tax may just be one example of the discussion on new taxes yet to come.

From an equality perspective, there is a clear need to examine how much tax everyone currently pays, relative to their income and their needs, and to seek the establishment of a much more progressive tax system, where those who benefit more from the economy also pay proportionately more tax. At the same time, we need to establish a target, such as the 45 per cent of GDP suggested by John Fitz Gerald of the ESRI, because we are not talking about temporary tax increases to weather out the crisis, but a long-term restructuring of the tax system to make it more sustainable and sufficient for the level of public spending that we settle on.

There is a real risk that new taxes (and service charges) will fall disproportionately on low and middle income households, while those on high incomes continue to benefit disproportionately from tax expenditure. While any move to consolidate Western European levels of tax and spending will require virtually everyone to pay more tax, there is nevertheless a need for more public discussion now on the future shape of our tax system, including how much taxation should be paid by different groups in society.


Seamus Coffey said...

This is a useful piece and one that carefully highlights the scale of the problems in the exchequer accounts.

The Public Sector Pension Levy does not form part of non-tax revenue. The Department of Finance prediction that non-tax revenue will increase from €834 million in 2009 to €2,355 million in 2010 is down to two factors.

The first is an expected increase of the Central Bank surplus from €290 million to €640 million. The second is the anticipated receipt of €1,000 million as payment for the Deposit Guarantee Scheme. These alone account for the increase in non-tax revenue. We have yet to see if these targets will be met.

In the Exchequer Accounts the Public Sector Pension Levy is netted against the current expenditure of each department rather than counted as a revenue. The increase in current expenditure that will occur this year would be even larger if this levy had not been netted out. Cuts in wages are being offset by increases elsewhere.

Finally, I also accept that tax increases and a broadening of the tax base are inevitable. However, if we examine how much tax everyone pays as the post suggests we see that we have a highly progressive tax system. We can argue about the rates but the system is progressive.

The most recent income distribution data from the Revenue Commissioners comes from their 2008 Statistical Report. The figures cover 2006, but more recent data should soon be available.

For 2006 the Revenue Commissioners report that 80.3% of the 2.26 million income tax returns they handled paid 9.35% of the income tax collected. The 19.7% of earners with incomes more the €50,000 paid 90.65% of the tax.

The effective income tax rate on all earners below €50,000 was 6.94%. For those earning less than €30,000 the effective income tax rate was 3.13%. The effective tax rate was 2.00% for the lowest 50% of tax cases by income. Low and middle earners do not pay income taxes in Ireland. If transfers such as child benefit and mortgage interest relief are accounted for many earners in Ireland are actually net beneficiaries from the State rather than contributors.

The effects of indirect taxes are obviously more difficult to determine and do fall disproportionately on lower income categories increasing contribution rates.

It is obvious that our tax system needs an overhaul, and if we are to maintain current expenditure levels more tax revenue has to be raised. However, I think we have to be careful that we correctly identify our starting position.

Rory O'Farrell said...

@ Seamus

"The effective tax rate was 2.00% for the lowest 50% of tax cases by income."

I wonder how much it costs to administer the large number of people paying relatively small amounts. I'm sure at the lower tail of the income distribution the government probably loses money from collecting such taxes.

Seamus Coffey said...

Hi Rory,

In 2006 the total administration cost of the Revenue Commissioners was €420.14 million. The amount of income tax collected from the lowest 50% of tax cases was €276.53 million. Even if collecting income was all the revenue did the amount collected would be greater than the administration costs, but not by much

(0.5 x 420.14) = 210.07 < 276.53

As the Revenue are involved in much more than just collecting income tax we can take it that the gap is much much wider.

Lower down the income distribution this may not hold. For example, in 2006, the average amount of income tax paid by tax returns earning €20,000 or less was €82.68 - for the year!

Overhead, administration and salary costs wouldn't be long cancelling the tax collected but I would guess that the efficiency of the Revenue Commissioners still has us coming out ahead here. It is a lot of work for little return.

Michael Burke said...


this is very useful and there just 2 points I want to highlight.

The first is fig. 2. This should be widely broadcast, because it nails a big lie. It clearly demonstrates that the cause of the deficit is the collapse in tax revenues, not rising government spending, which intially remains on trend and the falls back due to governmetn cuts. In fact, over the long run and prior to the the Irish Depression taxes grew in line with GNP and slower than GDP, while spending growth was far more slow.

The second is that there is a lot of research to support a policy of a stimulative fiscal redistribution - including recent research based on 7 leading econometric models (Fed,IMF, ECB, etc.) The authors' conclusion was that government investment was the most stimulative measure and that "only targeted transfers [to the poor] comes close."

The reason transfers to the poor are stimulative is that the multiplier effect is directly related to the propensity to consume- and the poor are obliged to consumer a greater proportion of their incomes. They also tend to consume more domestically, not being able to buy either helicopters made abroad nor gin palaces in Marbella.

The forms of that transfer are varied, and could include both indirect as well as direct taxes.

Tomaltach said...

Michael Burke,

I'm not sure I buy your big lie theory. On the face of it, yes, the problem was that tax revenue rather suddenly collapsed. But surely that fact alone hides more than it reveals. First, why did tax revenue plummet so precipitously? The answer is that the steep revenue growth preceding the fall was on the back of an unsustainable bubble. It was artificial. In other words, though the revenue graph before the fall was growing wildly, it had swerved off a long-term sustainable path. The trouble was that spending was curving skywards with it: we jumped from 35 billion to 50 billion in about three years or so. A leap of over 42%. It doesn't take an expert on growth economics to figure that such a skyward lurch was unlikely to be met quickly by the productive capacity of the economy. Even if it was desireable to evolve to a higer level of spending (in terms of GNP) than we began with in 2003, it would always have been wiser to expand the spending programs at a more moderate pace. Fast increases in spending lead to waste since the management and delivery mechanisms are not capable of administering them efficiently. In short, money gets chucked at problems instead of figuring out long term efficient solutions.

The sudden drop in taxes is half, but only half, of the story. The other half is on the spending side. It is surprising to me how so many left wing commentators have allowed their ideological blinkers to obscure this reality. Knowing that the Ahern administration was incompetent, and knowing our spending was increasing more rapidly than could be absorbed sustainably, the left still denies that any of the huge monies allocated over the period of the bloat were badly spent and therefore merit correction. The implicit mantra is, ignore the quality of the spending, lock in the programs, and despite our very precarious indebtedness, keep throwing other peoples money into the same old structures.

Michael Taft said...

Tomaltach – it is not helpful to the debate to first make up what other people say and then draw implications (‘implied mantra’) from what they didn’t say in the first place. I am not aware of anyone – left, right or centre- who ‘denies that any of the huge monies allocated over the period of the bloat were badly spent’. If you are aware could you please let me know – I’m curious. It is also not helpful because it obscures the valid points you make re: management and delivery mechanisms. There was wasteful spending (SSIAs and decentralisation, to name two of many, many examples of unthought out, unplanned spending policies).

As to general government expenditure increases, it is noteworthy that current expenditure (as measured by Eurostat’s ‘Government finance statistics’) in 2000 was 28 percent of GDP. In 2007 – the last year of growth – current spending rose to 31.3 percent; a rather small rise that still left Ireland with the lowest level of current spending in the EU-15 whether measured in GDP and GNP. It should also be remembered that during this period we had substantial population growth – 14 percent; compared to the EU-15’s 2.5 percent growth rate. So much of this small increase was spent keeping pace with demographics.

What is more interesting is that in 1996, current spending made up 36.7 percent of GDP – well above both 2000 and 2007 levels. In that year, GDP grew by over 8 percent, 50,000 jobs were created (the equivalent of 70,000 jobs today), and the Government ran a balanced budget. All this to say that higher spending levels are not inconsistent with a growing, fiscally balanced economy.

This has less to do with ‘blinkers’ and more to do with asking the right questions. For instance, the Government over the three years 2009-2011 will have cut over €11 billion in public spending, or nearly 7 percent in today's GDP terms. Yet, according to the recent EU Commission’s Spring forecast, the deficit will over that same period fall by less than 1 percent of GDP, leaving us well above the current Government’s projection. As a deficit-reduction strategy is it not right to ask – why isn’t it working?

Tomaltach said...

"...All this to say that higher spending levels are not inconsistent with a growing, fiscally balanced economy.. I agree.

But I find it interesting that your examples of wasteful spending are short, once-off programs. I was rather more thinking of current spending allocations that are a fixed part of our annual spending. One example is benchmarking. I found it extra-ordinary that just before Christmas in talks with the government Union bosses offered to modernise how our public service operates and bring it into the 21st century. They said that openly. And I thought, wait a minute, we have already paid for that transition. But of course, we are stilling waiting on it to happen.

But benchmarking was only one political manoeuvre that has contrubuted to our fiscal nightmare. There were others of course, such as the insanity of effectively removing 40 to 50% of workers from the tax net.

Comparison with 1996 is useful. But hidden in the 1996 figures are far higher payements for Central Fund Services, mainly this meant the national debt repayments, which over the following decade shrank significantly. In other words, in terms of real spending on services, the shrinkage you mention doesn't exist.

The increase in population is also a red herring. An increase in population will result in, ceteris paribus, no increase in the percentage of GDP being allocated.

Michael Burke said...


it almost looks like we are agreed that plummeting taxation revenues are the cause of the deficit. Almost, but not quite, since you go on to argue that the revenues were artificially inflated by the boom, and therefore that spending growth should have been lower. I understand that this is widely-held view, but it no more correct for that.

The opposite is the case. The 'Celtic Tiger' bubble was actually a period of slower growth in the economy, even if its denouement in the Irish Depression is excluded. Real GDP grew by a little over 20 per cent in the years 2003-2007 (before the recession began) a compound rate of 4.7 per cent, whereas it rose by a little over 67 per cent in the six preceding years, a compound rate of 9 per cent.

Tax revenue growth was similarly weaker, up 47 per cent in 2003/07 versus a rise of 77.3 per cent in the six prior years. The annual compound rates of tax growth are a little over 10 per cent over both periods. (The higher rate of growth in tax revenues than GDP is accounted for the by the elasticity of tax revenues, and this despite a string of tax cuts).

It is neither desirable nor possible to return to Celtic Tiger bubble. But tax revenues are not a mirage; they are a function of economic activity and the tax regime. Boosting the former and reforming the latter is the only way to reduce the deficit; the opposite of current policy, which is failing.

Nat O`Connor said...

The Public Sector Pension Levy does not form part of non-tax revenue. ... In the Exchequer Accounts the Public Sector Pension Levy is netted against the current expenditure of each department rather than counted as a revenue.

Thanks for that clarification. Although note that a small part of the pension levy is also listed as a source of non-tax revenue in the Exchequer Statements (e.g. April’s figures – see Note 2)

However, if we examine how much tax everyone pays as the post suggests we see that we have a highly progressive tax system. We can argue about the rates but the system is progressive.

Michael Taft has rather comprehensively replied to this on his post.

His analysis suggests that our system is not “highly progressive”, but has limited progressivity.

However, to take on board your point more fully, I do think that we need to more precisely define what we mean by ‘progressivity’ in the tax system. That is more than I can do fully this minute, but I think it should include the following elements.

There should be more analysis of what minimum income is required for an acceptable minimum standard of living. The calculation of this should include non-cash subsidies like differential rent in social housing, the value of medical cards, etc. This should be the basis for personal tax credits that removes people from the tax net and it probably requires more sophistication than the current cut-off points.

Within the calculation of a minimum income, there is a need to compare the disposable incomes and purchasing power of different income groups.

As an example of this, let’s take the most progressive tax figures from Michael Taft’s example – bearing in mind all the caveats around the calculation of these figures. The 2nd income decile pays 23 per cent tax (Household A) versus the 9th decile, which pays 38.5 per cent (Household B). Looking at the latest EU SILC figures for gross income (2008) on Table 1.1 (pp. 24-25) and rounding the numbers for ease of calculation, let’s say Household A has an income of €20,000 and Household B has an income of €100,000. A will pay €4,600 in tax, whereas B will pay €38,500. B clearly pays both more tax in actual terms and proportionately more. Yet, putting this in another way, A is left with a net income of €15,400, whereas B has €61,500 after tax. Household A might not have enough of an income to cover the necessities of life, particularly with dependents. Household B will have a sizable surplus after meeting all needs; they will be able to pay a mortgage on a house in a nice area, etc.

The argument is not about denying B the rewards of work. But, how much surplus income is it reasonable for B have, if A is not meeting a modestly defined set of needs. And I do mean modest.

I don’t claim to have proved this point here, due to the lack of more precise data about incomes, tax paid and the exact cost of meeting a modest set of needs. But this approach is the kernel of the argument to seek to decrease B’s net income in order to bring A’s net income ‘over the line’ in terms of meeting basic costs. I don’t think this requires massive tax hikes – especially if more tax is gained from corporations, by cutting tax expenditure on corporation tax – but it does require more sophistication in how we calculate tax bands and rates relative to living costs, in order to have a more progressive tax system.

Aidan R said...

A very useful piece of analysis. Economic historians (and commentators) will scratch their heads in years to come, wondering why the government immediately opted to cut public sector pay as an 'adjustment' strategy, rather than go for the fairer (common sense) option of a collective increase in taxation. It is blindingly obvious that our public finance problem is directly associated with a collapse in an unsustainable revenue base (whatever about the nuanced differences re: time scale and expenditure). How, and why this has not become part of the main stream discourse (on the public finance crisis) is hard to fathom.