John FitzGerald: Tax cut promises may be short-sighted

‘Behavioural economics teaches us that people are not especially grateful for today’s income increase, but are mad as hell if, in future, it gets taken away’

The full range of election manifesto promises on tax have yet to be unveiled, but well-placed leaks suggest that parties are likely to compete on who will offer the most generous package of tax reductions

The full range of election manifesto promises on tax have yet to be unveiled, but well-placed leaks suggest that parties are likely to compete on who will offer the most generous package of tax reductions

 

In the run-up to the General Election, many promises of tax cuts are in the air but how these proposals are to be financed is far from clear. So far, no party seems disposed to maintain the tax burden where it currently is, in spite of the fact that Ireland is today among the really low-tax rich economies.

In 2014 Ireland’s tax burden (as a share of GNP), alongside that in Spain and the UK, was lower than that of all other EU 15 countries.

As the Irish Fiscal Advisory Council has pointed out, within the fiscal rules we have adopted, tax and expenditure changes generally have to be matched. So if cuts to taxes on personal incomes that go significantly beyond indexation of bands and allowances are implemented, the corollary must be either a corresponding increase in other forms of taxation or a reduction in spending on public services.

After seven lean years, when public spending was significantly reduced, there are no easy pickings left in terms of spending reductions; indeed, demographic change is increasing pressure on spending.

Taxes differ in their impact on economic output and the distribution of income. Their economic effects are also determined by who effectively carries the burden. For example, depending on how sensitive supply and demand are to price changes, a tax on house sales may be effectively borne by the builder (in terms of lower profits), or by the purchaser (in terms of higher prices), or shared between them.

For workers, higher taxes on income operate like pay cuts and lower taxes like a pay rise. High taxes may result in higher wage demands or a reduced willingness to work at the going pay rate. These effects lead to lower output than would otherwise be the case. Conversely, lower income taxes may encourage increased output.

Indirect taxes, such as VAT, which raise prices and reduce the real value of wages, also reduce potential output, though to a less pronounced extent than taxes on incomes.

By contrast, property taxes can’t be avoided by reducing working hours. As a result, they have little effect on labour supply and a much less negative effect on output and employment. Recent research has shown that shifting the burden of taxation from taxes on income to taxes on property or on carbon would significantly increase national output and employment.

Tiered rates

All economies raise a significant share of revenue from taxes on income which, if appropriately designed, will have a greater redistributive effect than other forms of taxation. Tiered rates take a higher share from those on higher incomes. However, in most economies, including Ireland, the welfare system plays a much more important role in redistributing income than does the tax system.

The full range of election manifesto promises on tax have yet to be unveiled, but well-placed leaks suggest that parties are likely to compete on who will offer the most generous package of tax reductions.

This may be short-sighted. History tells us that today’s tax reductions may need to be reversed in the future if times get tougher. Behavioural economics teaches us that people are not especially grateful for today’s income increase, but are mad as hell if, in future, it gets taken away.

The centrepiece of the only published manifesto, from Renua Ireland, is a proposal for a single flat income tax, at a gross cost of €3.5 billion. While a cash injection on this scale should raise output and revenue, the best economic evidence implies such a cut would be far from self-financing.

Research suggests that, at most, revenue buoyancy might reach 40 per cent, implying an overall revenue shortfall of at least €2 billion. Also, under the fiscal rules, tax cuts totalling €3.5 billion would need to be matched by equivalent revenue-raising measures or spending cuts.

USC take

Political kite-flying suggests that alternative packages of planned reductions in Universal Social Charge (USC) will form a key election battleground. As it brings in €4 billion a year, outright abolition would be extremely costly. Because USC is charged on gross income, without any allowances, it is very effective in raising revenue from those on higher incomes – more effective than income tax.

The major gap in the USC base is that social welfare payments are not subject to USC whereas they are to income tax. Combining the tax bases for USC and for income tax would broaden the base and simplify the system, and, if properly designed, could be more redistributive than the present system.

Abolition of property taxes and water charges will also likely feature as election promises.

The present Government proposes to hold the property valuations unchanged for the rest of the decade. Either way, the share of property taxes in overall tax revenue is likely to fall. Research shows that a shift away from property tax (and water charges) to other forms of taxation would adversely affect output and employment. It would also result in higher property prices, leaving new buyers with bigger debt burdens.

We still await the publication of the full election manifestos. However, even when they are released, we may not be very much the wiser as to how coherent they are in terms of promoting growth and ensuring a sane approach to the public finances over the rest of the decade.

Who really stands to win and lose across different income groups will also not be clear until how the cuts are to be paid for is analysed.

A fully independent economic assessment of the different manifestos would do the country and the voters a real service.

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