Friday, 10 September 2010

Seven Principles for Progressive Income Tax

Nat O'Connor: On an earlier post about indirect tax, I was asked to sketch out some principles about income tax.

Specifically, the questions were "how much income tax should everybody pay, and what proportion should that income tax be of the total tax intake? ... (a) at what point on the income scale should a person start paying tax, and at what rate and (b) at what point on the scale should the maximum rate kick in and at what rate ... So what do you propose in relation to entry level tax rates, and top tax rates?"

This is not meant to be a complete policy on income tax, as I'd need a lot more data (and time!) for that. But I am going to answer these questions in four parts. Firstly, I am going to set out some general principles for taxation. Secondly, I respond to the issue of people on high and low incomes not paying enough (or any) income tax. Thirdly, I am going to give some illustration of the effect of changing tax credits and bands. And then, finally, I am going to consider the question of how much tax someone should pay.

Part 1
Seven principles for taxation are that it should be stable, sustainable, adequate, progressive, efficient, transparent and responsive to economic, social and environmental externalities.

Stable – A stable tax system should be based on sources of revenue that do not fluctuate excessively as part of economic cycles. For example, this will require taxes on wealth, as well as income and consumption. Taxes on wealth (such as property tax) tend to be more stable during a recession. Property tax is common in many countries and is used to fund local government.

Sustainable – A sustainable tax is drawn from a source that will not become exhausted. Similarly, a sustainable tax system is not undermined by excessive tax expenditure.

Adequate –A country’s tax system must provide sufficient revenue to pay for the level of public services that people want, as well as other state liabilities, such as servicing the national debt.

Progressive – A progressive tax system is one where those who gain more from the economy (in terms of wealth and income) make a proportionately larger contribution. This should be the net effect across the whole tax system, not just income tax. Public services are one way of making the net benefit from the economy more progressive for people on lower incomes.

Efficient – Economically efficient tax is one which minimises economic distortion. The tax system should seek to encourage economic activity.

Transparent – All taxes, and to whom they apply, should be clear. In addition, all exemptions, tax relief, etc. should be transparent.

Responsive – The tax system also has role to play in influencing behaviour, by being responsive to market failure/externalities. Taxes can be used as policy tools to achieve economic, social and environmental goals. For example, carbon taxes discourage carbon-heavy activity such as burning of fossil fuels.

Note, sometimes these principles may be in tension. For example, responsiveness to externalities can conflict with progressivity, and hence something like carbon tax may need to be balanced with other measures, so that regressive effects do not occur which cost low income households disproportionately more of their income.

Part 2
In relation to income tax, the comment was made that "As things stand we have a very skewed tax take. The lower 50% of citizens pay no income tax, at the other end of the scale, neither do 4,000 individuals earning €100,000 +."

Sarah Carey claims that the facts about high earners not paying any tax are misunderstood, if not exaggerated. In particular, she refers to Section 23 of the Finance Act 2010, which increases the minimum rate of tax ('effective tax') from 20 per cent to 30 per cent that certain high earners must pay if they qualify for and use certain tax relief measures.

However, she misses the point that this only applies to "certain reliefs". Upon checking the relevant section (485C) in the latest Tax Consolidation Act guidance notes on Revenue's website, page 60, unrestricted reliefs (e.g. business expenses, other unnamed unrestricted reliefs) are always taken into account before restricted reliefs. Hence, there is some scope for someone to shrink their taxable income before the 30 per cent effective tax rate applies.

On the question of low paid people not paying income tax, the principle of progressivity requires the whole tax system to be progressive. So, there is not necessarily any problem with people on low incomes not paying income tax, if this compensates for the higher proportions of their incomes they pay in indirect taxation (like VAT), as I argue in the previous post. Also, as the worked examples below show, a single PAYE worker on €20,000 pays a small amount of income tax; so I don't think it can be true that 50 per cent of citizens pay no income tax, unless you are counting pensioners and people on social welfare. Certainly, most workers pay income tax; only those near the minimum wage do not.

However, the principle of adequacy requires that, if people want European levels of public services, then these have to be paid for. So, in order for the tax system to be adequate, everyone may need to pay more – although, in line with the principle of progressivity, those who benefit more from the economy should pay proportionately more.

Part 3
For reference, the current rates are 20 per cent on all income up to €36,400, and 41 per cent as the marginal rate. A single person gets €1,830 in personal tax credits. PAYE workers get an additional €1,830 (Citizens Information). For example, single PAYE workers on €20,000, €40,000, €60,000 and €80,000 would pay income tax as follows:

Obviously, this simplified example excludes income levy, PRSI, etc, as well as other possible tax credits or reliefs.

The Minister for Finance has announced Budget Day will be Tuesday 7 December. With all the talk of 'broadening the tax base', I guess that he will consider lowering tax credits and band thresholds, but not rates, in order to increase income tax on lower paid workers.

For example, if the single credit and PAYE credit were reduced to €1,500 each, our PAYE workers would now pay as follows:

Note, that this has the effect of tripling the proportion of the lowest income (€20,000) that is paid in income tax, while having proportionately less effect for those with higher incomes.

If the Minister instead chose to lower the marginal rate of 41 per cent to those earning over €33,000, a similar result would occur for those earning €40,000 or more, without increasingly the tax yield from those earning €20,000, as follows:

Obviously, this measure would generate less extra revenue overall. To maximise revenue, without raising rates, the Minister could combine both measures:

Now, all this is speculation, as I don't know what the Minister is going to propose. But I think it is worth pointing out the effects of changing credits and bands, as these kind of changes are often less obvious to people than rate changes, while they can have just as significant an effect.

Also, these examples give some facts and figures for illustration of the original question: how much income tax should people pay?

Part 4
I don't think increasing income tax is the best policy for Budget 2011, except maybe for those earning €100,000 plus. Instead, I'd prefer to see some kind of progressive system of property tax, as that would bring wealth into the equation as well as earned income. Since there are relatively few taxes on wealth in Ireland, that would be more progressive than simply increasing income tax.

In principle, in the medium term, as direct income tax (with higher marginal rates for higher earners) is more progressive than (flat rate) indirect tax, I'd prefer to see more tax on income and less VAT in the overall balance. Although, actually, I think any future increase on direct tax should be to address the low level of social insurance paid by employers and employees.

The last Budget unilaterly cut the amount of time people receive unemployment benefits for, as well as the amount paid, which shows how vulnerable the social insurance system is to political decisions. I'd prefer social insurance increases to income tax increases, alongside a more robust legal structure that gives people stronger guarantees about what level of benefit they receive when unemployed. In this context, I'd be quite happy to see much higher levels of unemployment benefit, which should be subject to income tax. But, as above, Budget 2011 is dealing with a jobs crisis, so it is not the time to increase social insurance, as to do so would increase labour costs and discourage job creation.

Income tax could be made more progressive. For example, Ireland is unusual in only having two bands (20 per cent and 41 per cent). There would be scope to have a third band, say 48 per cent, for incomes over €100,000. I would consider splitting up the existing bands too to have more bands with less difference between them. If the Government was to increase the standard rate of income tax, I think it would be important to increase personal credits, so that people on lower incomes are not made worse off.

Overall, I can't say what level income tax should be without access to a lot more data, namely costs for efficiently implementing West European standards of public services in Ireland, alongside data on the distribution of wealth and incomes. Such data would make it possible to calculate how much those services are going to cost (along with the banks and servicing the national debt). But we would be looking at moving towards Government tax revenue and expenditure at 45 per cent of GDP (which is still only average in Europe). The debt and banks may actually raise this much higher in the medium-term.

To conclude, I reiterate that everyone in Ireland pays tax – including indirect tax (VAT, excise, etc) – so I'll continue to dispute that only income tax counts when discussing 'broadening the taxbase'. As well as indirect taxes, new taxes on wealth (such as property tax) could have a significant role to play.

Ultimately, the taxation discussion should begin with what kind of public services people in Ireland really want. And when we can calculate the likely cost of these services, we can present people with a realistic tax model for how we can afford to pay for them.

It's at that point that democratic politics should provide people with real choice, depending on their preferences and how well or badly they'd do under each model. The conservative parties might continue to peddle low taxes, while they really mean returning public service spending to 35 per cent of GDP or less once the recession is over and the bank debt paid off. Progressive parties should be able to present a model of moving towards European norms at 45 per cent of GDP.


Antoin O Lachtnain said...

Do you really think that business expenses should be taxed?

Property tax is not a wealth tax. It's a resource tax, the same as a carbon tax or a bin charge. It is true that the NPPR charge has a lot of characteristics of a wealth tax, but that is not a typical property tax internationally (as far as I know).

You are forgetting about resources here. You have to use the tax system to incentivise end-users to save resources.

Progressive taxation is not just about wealth transfer. It is also about increasing incomes so that people can bear the cost of their resource use directly and can adjust their usage in response, instead of having the cost absorbed into a tax.

Why start with what level of services people would like as you propose? Why not start by asking how much tax they want to pay?

Nat O`Connor said...


I don't think legitimate business expenses should be taxed. But I think there is a need to look at what qualifies as a legitimate expense, and how they are accounted for and audited. The legislation I was referring to shows that the 30 per cent effective tax rate only applies after some other tax reliefs (including legitimate expenses) are deducted from gross income.

Different legal instruments seem to be used in the composition of the tax system, so some reliefs are considered (e.g. by the Commission on Taxation) to be part of the basic tax system, whereas others are considered to be tax expenditure. Hence, some tax reliefs exist which are the legal measures used to lower one's pre-tax income to account for one's legitimate expenses. I think the distinction made by the Commission on Taxation, subsequently used by the Department of Finance, oversimplifies what tax reliefs are really part of the tax system and which are not. I suspect other countries have a much tighter rein over the amount of relief available for different categories of expenses. Some OECD and World Bank papers concur; at least to the extent of acknowledging that there is no easy division between 'structural' elements of the tax system and tax expenditure.

In answer to your second point, I am perhaps equating wealth with assets, and I'd count someone's assets to be part of their resources, along with any income streams they have. I'm not sure what you mean by distinguishing 'wealth' from 'resources'.

I get the idea that carbon-based fuels are finite resources on the planet, and tax can help curb people's use of those and promote better resource management. But residential property is not quite the same. Unless you think the term 'wealth' is not useful, and we should focus on more exact terms like assets, resources, etc.

Finally, I'd start with the level of services people would like because I'm sitting on that end of the see-saw and the Minister for Finance is on the other side. In other words, I feel the public debate is biased towards a low tax mantra and there hasn't been enough debate on what benefits higher taxation (and higher public spending) could have.

The Minister said "the burden of taxation in this country is high enough". That's a clever rhetorical device that intimates tax is already high, when in fact the Irish state has consistently much lower tax revenue than the EU average (as a percentage of GDP). It also reinforces a biased notion of tax as a burden, rather than a democratic act that can also be economically advantageous for many people (on a cost-benefit basis).

Ultimately, I agree that we need to present people with a full menu of choices about taxation and public expenditure, with clear price labels beside each item of expenditure. Let people choose from there.

Antoin O Lachtnain said...

What I mean by resources is things like carbon fuels (and the capacity of the environment to absorb CO2).
Property (by which I mean the land rather than the buildings) is a strictly limited resource, which they aren't making anymore. Land stockpiling is definitely an issue, and surely that is the point of the tax? To force people to get an income from the property to cover the tax, or else to sell it to someone who can make profitable use of it.

Again and again we go back to comparisons to EU GDP ratio averages, as if these are somehow norms. Even if you accept that EU countries provide a perfect model for taxation (which I do not), Ireland is just not a typical EU country. It has a younger population and no defence spending, for instance. The GDP is undoubtedly skewed too by the multinational presence here.

Antoin O Lachtnain said...

Which tax reliefs are you talking about other than legitimate business expenses? Are talking about capital allowances?

Nat O`Connor said...

Not capital allowances. But for example, it seems that some tax relief for private pensions can be used to reduce your taxable income rather than being claimed against income tax.

The Commission on Taxation 2009 report lists a lot of measures on pages 316 to 323. Much is standard (e.g. to avoid double taxation) but some of it merits scrutiny, and even some standard reliefs should possibly have caps or limits.

Nat O`Connor said...

Ireland may have more young people and less defence spending, but it has possibly the world’s most expense bank rescue combined with a housing collapse legacy which risk cancelling out those advantages.

I agree Ireland is not a typical EU country, but actually none of them are. Europe contains wide variety in terms of state versus private sector roles in the economy, natural resources (or lack of same), demographic trends, level of defence spending, etc.

But there are commonalities. We are all part of the EU/EEA single market, so we all have to compete in that arena. There are also ‘norms’ that the EU represents: broadly a more social version of capitalism what is found in the USA, where raw competition is ameliorated by public services and a stronger welfare system. For example, as an EU citizen I am entitled to a free European Health Insurance Card, which entitles me to free or subsidized health care wherever I travel in the EU. The provision of healthcare is a European ‘norm’. I argue that there are similar norms in relation to other areas of social policy, such as education, housing, pensions and social welfare.

None of this comes cheap, and many countries across the EU are struggling to work out how they can continue to provide high quality pubic services with aging populations, and less and less workers in proportion to the number of people not working.

Some EU countries do not have particularly good public services, despite higher levels of taxation than Ireland. High tax is not a panacea. But Ireland’s tax take is really very low in comparison – even if you use GNP figures for Ireland and GDP for all other countries, to cancel out any distortion in the figures represented by multi-national activity.

I am concerned that there has been a long-term disinvestment across the vast majority of public services in Ireland. For example, it will take years to upskill public servants to manage and analyse their data properly. Similarly, investment in education is slow and requires a long-term perspective. Enda Kenny may be getting stick for suggesting it will take 10 years to fix the economy, but it could take 20 years to fully transform the outcomes that our education system generates, because many people spend 20 years in education (e.g. from pre-school aged 4 to leaving college at 24). And until we reform education, the ‘smart economy’ is going to be only a bit-part of our economy, because we still have levels of literacy and numeracy problems.

So, I agree that we are going to have to discus more than EU tax-and-spending norms. We need to look at how much other countries spend and what outcomes they get for their investments; as well as much more detail on how they organise services; for example, hours in school, pupil-teacher ratios, subjects taught, etc. And Eurostat and other EU agencies provide a great service in allowing us to make these comparisons (as does the OECD, offering more diversity in the mix).

Hence, I will continue to talk about EU and OECD norms! But I agree that Ireland does not have to adopt the average level (although I think it is worth thinking about). That’s a democratic choice. And even if we did go for the average, there would be a lot of detail required about what we prioritise within that level of public spending.

Antoin O Lachtnain said...


Why would it take years to upskill civil servants? If the civil servants we have can't do the job, why don't we fire them and get some more? The civil service is not supposed to be an occupational therapy centre.

There is no point in educating a new generation of public servants if you are going to leave incapable people holding the reins. If you do, then the time until you get a change will be 40 years, not 20.

I went through pages 316-323. I don't see what you could get rid of there, quite honestly.( I notice that there is no CAT on a gift to oneself, though, so I plan on buying myself something nice while I still can.)

In relation to pensions, I think you are referring to the allowance on administration fees relating to setting up or changing a pension scheme. I cannot see anything in changing this.

If you use GNP, then Ireland comes in in the middle quartiles. Not high, but not particularly low either.

Why use percent of GDP or GNP anyway? What about per capita? I see that per capita, we pay more tax than our Spanish counterparts. Why should I pay more than a Spanish person for fewer services? If I were paying the same number of euros in Spain, I would benefit from better health care, better transport and the peace of mind that only a standing army can give.


Anonymous said...

Obviously, this simplified example excludes income levy


The most significant change to the income tax code in recent years, with a significant positive impact on progressivity which you're supposed to be discussing, and you just ignore it completely?

Surely its not beyond the wit of man to include the income levy in the calculation?

costs for efficiently implementing West European standards of public services in Ireland, alongside data on the distribution of wealth and incomes

Are you serious?

Do you really think you can estimate how much extra spending would be required to have a health system up to French standards?

Or putting the question another way, can you estimate the improvement in the Irish health service due to the massive increases in funding over the celtic tiger period?

Did it (a) improve marginally, (b) stay pretty much as bad as ever, or (c) get substantially worse?

As we saw from the last public spending binge, large increases in funding tend to have to negligible impact on service levels. Most of the extra money is swallowed up in salary increases for incumbants, recruitment of non-productive headcount (work-life balance officers, anyone?), accretion of extra layers of bureaucracy and pointless quangos, unjustifiable "cost neutral" improvements in conditions (early retirement, reduced hours on the same pay, mar dhea flexi-time and so on) and of course wasteful spending to enusre the budget won't be cut next year.

Do you really think you can somehow model the service improvement curve as funding is increased, without restoring to spurious arguments like ... you see, the previous funding increase of 50% was only making up for historic under-investment, if only they'd continued to shovel money into the pit and increased the funding by another 10%, the service improvements would at last begin to flow. Yeah, right.