Route away from low-tax economy traverses complex terrain

ECONOMICS:Talk of Ireland's need to increase taxes focuses too much on the bald corporation rate of 12.5 per cent, writes PAT McARDLE

EU ECONOMICS and finance commissioner Olli Rehn’s observation that Ireland will no longer be a low-tax economy startled many people because they thought he was alluding to corporation tax, one of our sacred cows.

In reality, what he said was: “It’s a fact of life that after what has happened, Ireland will not continue as a low-tax country but rather it will become a normal-tax country in the European context.”

After Wednesday’s National Recovery Plan, we now have a better idea of what he meant.

Rehn also said a €15 billion package might not be enough, a comment that got surprisingly little attention but remains pertinent. Obviously, the bigger the gap to be bridged, the more taxes are likely to be increased.

In my view, Rehn was merely stating the obvious, but others were quick to make more pointed comments.

An EU source noted that Britain and Germany have long viewed low Irish taxes as a form of unfair competition, and finance ministers of Austria and France said corporation tax may have to be raised as part of a deal.

This was added to by a number of German spokespeople, notably Michael Meister, deputy leader in parliament and finance expert for Angela Merkel’s Christian Democrats (CDU).

Even Nicolas Sarkozy got in on the act.

While this attitude softened in the face of trenchant Irish opposition, and the recovery plan was emphatic that the corporation tax rate will not change, we may not have heard the last of it.

In broad terms, we pay one-quarter of what we earn in taxes on labour, mainly income tax. Another quarter of every euro we spend goes to the Government in taxes on consumption (see chart). We did look different to the rest.

As pointed out by Garret FitzGerald and others, our income tax burden was low. This reflected two factors. First, we collect significantly less PRSI as the social welfare burden on the State is lower here given the high level of private sector pensioning, something which is rare on the Continent.

However, even when allowance is made for this, our income tax burden still looked low. Some of the fruits of the Celtic Tiger went to lower income tax.

In 2008, we had the lowest implicit rate of income tax in the euro zone and the reduction over the previous decade was the highest.

One hears less about the fact we have one of the highest indirect tax burdens outside of Scandinavia.

In the chart, which covers the period up to 2008, only the Netherlands was near us.

After income and spending, the other main “tax handle” is capital. Capital is defined broadly to include physical capital as well as financial investments and savings.

Measured thus, our implicit rate of tax on capital was surprisingly high, albeit well-short of the EU average.

This reflected strong performances by capital gains taxes and stamp duties but was curtailed by the absence of property tax and the low, 12.5 per cent, rate of corporation tax.

When corporate taxes are split out from the rest, the effective rate of tax on corporate profits amounted to about 10 per cent here as compared with 13 per cent in the Netherlands and nearly 25 per cent in the euro zone.

While the imbalance is severe, the difference is not as big as the headline rates of corporation tax would imply. The reason is that other countries have numerous exemptions, allowances and inducements which lower the effective burden but you hear little about them.

Ireland, by contrast, has a single, low 12.5 per cent rate which we market extensively and which earns us much opprobrium.

The most regrettable thing about Wednesday’s announcement was not the income or property tax changes but the decision to hike VAT and excises.

This was justified on the basis that others had raised their VAT rates so we were merely maintaining the differential. Our implicit rate of tax on consumer spending is now about 28 per cent, still well ahead of the EU average.

Income tax hikes were inevitable. The plan added almost five percentage points to the implicit rate of tax on income, bringing it close to 30 per cent. We are now much closer to the average, once the PRSI caveat is allowed for.

Property and other capital taxes announced will boost the average rate of tax on capital but this will not be sufficient to offset the decline of stamp duties and capital gains tax, so we will continue to look low by reference to others.

There is little doubt the low corporation tax rate has been the cornerstone of industrial policy for half a century. The Government’s response to the recent onslaught was to declare the 12.5 per cent rate “non-negotiable” and, so far, it has held the line.

Few now remember the history of this tax which was initially set at zero on export sales. I recall the debate before it was raised to 10 per cent. The fear, then as now, that this would do immense damage was palpable but was not well-grounded.

Subsequently, the rate was raised to 12.5 per cent and the base extended to all companies to bring it into conformity with EU rules.

With hindsight, a somewhat higher rate might have been more appropriate.

Wednesday’s announcements brought us closer to average tax rates. The risk is that we have further to go.

This could happen: if the economy underperforms forecast growth; if interest rates do not fall back; and if the size of quantum of adjustment becomes greater, eg because further capital injections into the banks are needed.

In this eventuality, the question of the corporation tax rate could come back onto the agenda.

The Government would then have to balance the guarantees of fiscal freedom in the Lisbon Treaty against the realpolitik of pressure from those who are silent at the moment but who are waiting in the long grass.