Tuesday, 19 October 2010

Fine Gael's 3:1 Ratio

Nat O'Connor: Fine Gael has given some useful clarity on their fiscal policy position with the declaration that they would seek €1 billion in tax increases for every €3 billion in cuts (Irish Examiner). Across the period of the four-year plan, this suggests that they would seek to close the deficit while making Ireland an even lower tax economy than it was before the boom; which can only mean the wholesale removal or reduction of public services, and significant cuts to public pay and/or numbers.

The implications of the 3:1 ratio can be spelled out in more detail once we establish just how much needs to be cut in the four-year plan.

The Opposition finance spokespersons were given access to data by the Department of Finance today. Is it just political theatre, or did the spokepersons really not know that the adjustment needs to be more than €7.5 billion over the four-year plan?

Consider, we have known for some time that the deficit is c.€19 billion (not including the banks), although it now seems that it might come closer to €20 billion. In July, the IMF's most recent report on Ireland suggests that the structural deficit is eight and a half per cent of GDP (i.e. the bit that won't go away when the economy recovers, welfare payment decrease, tax increases, etc.); which is €13.6 billion (8.5% of 2010's estimated GDP of c.€160 billion). So, it should have been obvious to them for some time that the four-year plan will have to make adjustments of c. €12-14 billion to meet the target of 3 per cent of GDP by 2014.

Note, I'm assuming that the economy will not have moved to the height of another economic cycle, so we would need to clear the entire structural deficit by 2014, assuming that at least €5 billion of a cyclical deficit remains, which will diminish with further economic growth. (€5 billion in today's money is the 3 per cent of GDP requirement under the Eurozone SGP). Arguably, the target for cutting the structural deficit could be slightly less, if the economy recovers faster and helps closes the gap. Hence, my use of the range €12-14 billion.

If we seek a €12 billion adjustment, Fine Gael's 3:1 ratio equates to €3 billion in taxation and €9 billion in cuts; €14 billion would imply €3.5 billion in tax and €10.5 billion in cuts.

A more moderate approach would be a 1:1 ratio, with an equal balance of tax and spending reductions; for €6-7 billion of each.

Patrick Honahan, before he became Governor of the Central Bank, suggested that Ireland's tax take could increase by 3 per cent of GDP (i.e. €4.8 billion) (e.g. quoted here). And that level of tax increase is just to return us to the same type of low tax economy we had before the boom. Nonetheless, if €4.8 billion was taken as an ideal level of tax increases, that would imply €7.2 billion to €9.2 billion in cuts. That is a ratio of 2:3 or almost 1:2 (depending on whether we adjust by €12 or €14 billion). Hence, Fine Gael, with only €3 or €3.5 billion in taxes, would not even reach the €4.8 billion that Patrick Honahan suggests is a credible target.

And once we have established what levels of tax and spending cuts each party wants in the four-year plan, the next question is timing; that is, should we frontload the adjustment? Or keep a more even pace? Or should be push out the deadline for fiscal adjustment by a few years? Leo Varadker of Fine Gael is on record calling for more adjustment sooner. TASC argues for a slower pace (€3 billion adjustment in 2010) to avoid damaging the economy too much in one year.

Of course, we will have to deal with more than the structural part of the deficit if we don't foster recovery in the economy!

TASC's budget proposals argue that we need to foster economic growth through targetted investment to build up human capital and intellectual capital (education, training, R&D) as well as physical infrastructure (broadband, schools, renewable energy). Speaking at the Kenmare economics conference, Leo Varadker emphasised his disagreement with the TASC proposals and signaled Fine Gael's intention to focus all investment on infrastructure (including broadband and renewable energy, but also forestry and other areas).

It would be nice if every political party could state what ratio they would choose between tax and cuts, as it would be a useful rule-of-thumb for the broad implications of their fiscal policy. Likewise, we'd need to see their timescale and what they would do to foster economic recovery.

More importantly, from TASC's perspective, it will be essential to see how each party's four-year plan would change the distribution of income and level of economic equality in Ireland. Tax change and cuts to public services affect different segments of the society differently. Whatever package of fiscal policy decisions are taken in these four-year plans will shape our society, as well as the economy, for quite some time.

8 comments:

Anonymous said...

Speaking of ratios would you care to hazard a guess as to what the ratio of tax rises to spending cuts has been thus far in the three "crisis budgets" we've seen?

Nat O`Connor said...

That's a good question. Unfortunately, the official figures are not neatly presented for making this kind of calculation. However, a rough estimate is as follows.

€2 billion in tax in 2009 combined with €1.8 billion in cuts; ratio of 10:9, tax versus cuts.

The supplementary budget speech in 2009 states the intention to add €1.8 in tax/revenue and cut a further €1.5 billion. That's a ratio of 20:17, tax versus cuts.

But Budget 2010 only raised €126 million in tax versus €4 billion in cuts (€3 bn current and €1 bn capital). That's €1 in tax for every €30 in cuts (1:30).

The cumulative effect of all three budgets: €3.9 billion tax, €7.3 billion cuts. That's just over 1 part tax for 2 parts cuts (1:2).

However, I may have missed something as this is only quickly done from the Minister's speeches and summary of measures on www.budget.gov.ie

Anonymous said...

Any opinions as to the motivation behind this apparent sea-change in the tax versus cuts ratio at the last of those three budgets?

Could it have something to do with the fact that the massive increases in tax rates (the marginal rate went up by an eye-watering 8.5%) added little to the total tax yield.

Further increases in income tax rates are likely to have similarly diminishing returns. Which leaves us with non-sensical taxes like the property tax favoured by TASC, or regressive tax-base widening to bring us into line with European norms. Both of which measures will have deflationary impacts.

Seamus Coffey said...

I think this idea of a cuts:tax ratio is a bit misleading. Instead I think we should be targetting appropriate levels of government revenue and expenditure and working towards those.

There have been some discussion of suggested targets on this site (SJI, IBEC). Most of these make comparisons relative to proportions of GDP. I think we should focus on the proportion of tax and expenditure we want from our own income, because of the effect on multinationals on Irish GDP. The foreign sector should not go untaxed but it does seem to have become a 'sacred cow' that will not be sacrificed.

Relative to Gross National Income, our medium-term target should be a tax level of about 46% of GNI. To satisfy the SGP this would allow an expenditure level of about 50% of GNI.

As a percentage of GNI, this is a level of government revenue slightly above the EU average and a level of government expenditure on par with the EU average. This also requires realistic forecasts of our National Income, which we've seen this week are sadly lacking.

To close the gap based on the 2009 outturn this would require an increase in taxes of €6.6 billion and a reduction in expenditure of €11.0 billion. This is approximate cuts:tax ratio of 2:1.

We should note though that the 2009 expenditure figure includes some monies spent on our ailing financial institutions so the reductions on 'normal' government expenditure should be significantly less than €11.0 billion after these once-off costs (ongoing interest excepted) have been accounted for.

This would put the ratio much closer to 1:1, but again I think it is the levels of government revenue and expenditure we should be targetting.

Nat O`Connor said...

Anonymous,

TASC has not proposed raising income taxes. Property tax is shown to be the least deflationary tax option. And our model is designed to allow deferred payment not only for people on low incomes (e.g. pensioners) but also any household whose housing costs plus childcare costs exceed half their net income.

All cuts and taxes are deflationary. But TASC’s proposals for an Economic Recovery Fund are designed to counter-act the inevitably deflationary effect of our other proposals.

How would you reduce the deficit, if you are against anything that is deflationary?


Seamus,

I agree that it would be useful if the parties would set out explicit targets for their vision of long-term state revenue and expenditure (clearly indicating temporary differences to pay for the banks, etc). My post was designed to tease out what are the implications of the Fine Gael statement.

If they cut by €3 billion for every €1 billion they increased tax, they would de facto arrive at a relatively low level of tax and spending as a proportion of GDP/GNI. However, this end-point will vary depending on what happens to national income over those years, which in turn depends on both what mixture of cuts/tax they choose, plus what efforts they make to invest and foster economic activity. Hence, they should indeed also set out their desired level of taxation and spending.

One question with your figures on a tax level of 46% of GNI. Does this include corporation tax and other taxes from the ‘gap’ between GDP and GNI? If so, shouldn’t we filter this out of the calculation, if we are going to make a comparison of Ireland’s tax and spending as a percentage of GNI versus other EU countries’ tax and spend as a percentage of GDP?

Nat O`Connor said...

For information, IBEC's call for no more than €600 million in tax out of at least €3 billion of an adjustment implies a ratio of €1 in tax for every €4 in cuts (1:4). That's just for 2011 though. IBEC haven't given a four-year plan.

Nat O`Connor said...

According to RTÉ, Labour have proposed a 50/50 approach. That's a 1:1 ratio of cuts and tax changes.

One interesting thing is that the pattern, to date, indicates a left-right policy spectrum of options.

IBEC
(Furthest right)
4:1 cuts:tax

FG
(right)
3:1 cuts:tax

FF/GP in Government
(centre-right)
2:1 cuts:tax*

*based on past 3 budgets; might change from 2011

Labour
(centre-left)
1:1 cuts:tax

Sinn Féin has not announced their pre-Budget ideas yet, but chances are from their general statements that they'll opt for even more tax, and less cuts.

ICTU's proposals are also not launched yet, apart from a focus on growth and pushing the deadline out to 2017. They too are likely to focus on tax, although the Croke Park deal should deliver public spending savings too.

Nat O`Connor said...

According to their press release, Sinn Féin are calling for a 1:4 ratio, €1 in cuts ("wasteful spending") for every €4 in taxes.

That makes them diametrically opposed to IBEC's position.

Note, this is not a full plan to close the deficit, but simply their 2011 Budget proposals. So, their ratio of cuts to taxes might shift over the four years.