Tax take remains low, especially for lower earners
ECONOMICS:A broad tax base with few exemptions is generally believed to be the best way to raise revenue, writes KARL WHELAN
LIKE MOST economists, I think it’s a good idea to have an exercise like the Commission on Taxation every so often. While the media tends to focus on our disagreements, most economists agree on the basic principles that define a good tax system. A broad tax base, with few exemptions, combined with low tax rates is generally believed to be the best way to raise revenue while doing the least damage to economic activity.
Over time, however, politicians make decisions that run counter to these principles. Lobbying from special interest groups sees them receive special exemptions from tax, and revenue sources that contribute to a broad tax base are sometimes eliminated during good times amid bouts of political populism.
For these reasons, an occasional detailed examination of the tax system by a group of independent experts is helpful. These reports can provide the political cover to allow politicians to remove much of the under- growth from the tax system and return it to something closer to the economist’s broad-base- low-rate ideal. For these reasons, I welcome the report’s long list of tax exemptions to be closed off as well as its highlighting of potential new sources of revenue.
In particular, the report’s recommendation of a carbon tax is to be welcomed on the basis of another basic first principle of taxation, which is that if you have to tax anything, you might as well tax stuff that has negative effects, such as carbon emissions.
Despite these positives, I have a few misgivings about the report. The first relates to the lack of useful context in which to interpret the various revenue-raising measures.
The terms of reference for the commission included ‘‘keeping the overall tax burden low’’ so the report declares that its proposals should be interpreted as being ‘‘revenue neutral’’ so that money raised from new taxes can be used to cut other taxes. In particular, the report recommends using new revenue sources to ‘‘lower the tax burden on labour’’ – ie cut income tax.
Perhaps it is unfair to criticise the commission given its terms of reference but, in light of our current fiscal crisis, this all seems a bit odd. For starters, Ireland’s tax take relative to GDP is very low by European standards. In 2007, Government revenues were 36 per cent of GDP compared with 45 per cent for the EU15 as a whole. Much of that tax revenue was based on property-related activity, so that this tax base has collapsed even further since then.
There are, of course, some good reasons why the Irish tax take should be relatively low. For instance, we do not have large defence expenditures and we also have a tradition of private occupational pensions, whereas pension contributions are collected by the state in many European countries. (Note, however, that I do not believe the argument that GNP, and not GDP, is the relevant tax base – we can and do collect tax revenues from income generated in Ireland that is subsequently repatriated.)
Still, even controlling for these factors, it is clear that our tax take is comparatively low. So, at a time when international financial markets are worrying about our ability to finance enormous deficits, the idea that tax changes must be revenue neutral is hard to sustain, and the public’s sceptical reaction to the revenue-neutral terminology is probably well-judged.
In particular, the idea that additional revenues from carbon or property taxes should be focused on reducing income taxes needs to be interpreted in relation to Ireland’s already exceptionally low rates of income taxation. The OECD has calculated that, in 2007, the combined PAYE and PRSI average tax rate for a single earning married couple with two children, taking home the average wage, was 6.7 per cent in Ireland, compared with an EU-15 average of 23.7 per cent and an OECD average of 21.1 per cent.
The Irish rate has increased somewhat with the introduction of the recent levies but the income tax burden in Ireland for low to middle earners is very low.
Part of the enormous anger the public feels towards the current Government is that people have made crucial decisions, such as purchasing houses or having children and paying for childcare, based on the assumption that they could maintain, and indeed increase, their net take-home pay. So I would not favour further income tax increases in the December budget, particularly when the McCarthy report has outlined a menu of feasible expenditure cuts that can contribute to the next round of fiscal adjustment.
However, over the longer term, we are unlikely to achieve fiscal sustainability without either increasing income taxes in a gradual manner or else implementing spending cuts that will have a profound influence on the character of our country.
Another aspect of the report that I disagree with is its recommendation for the introduction of a third rate of income tax for high earners. Usually, reports of this type recommend tax simplification – for instance, systems based on a large exemption and then a single tax rate are progressive, simple and keep marginal tax rates low. The introduction of a third rate is inconsistent with this generally accepted goal.
The report argues that an additional rate is desirable for ‘‘equity and increased progressivity’’ but we already have a highly progressive tax system. The OECD comparisons show that 2007 tax rates for higher earners were much closer to average international levels than those for low or medium earners, and this progressivity has been increased since then with the introduction of graduated levies.
As of now, even with an income tax system that does not raise much revenue, the combination of PAYE, PRSI and levies have put marginal tax rates for even moderate earners over 50 per cent, which is getting high by international standards. Further moves to raise marginal tax rates are likely to see a return to the wholesale tax avoidance that we saw during the 1980s and, thus, may be self-defeating in terms of raising revenue.
Karl Whelan is professor of economics at UCD