Patrick Honohan: Why tax hikes for higher earners may be best response to inflation

With consumer prices having risen about 7 per cent in the past year, especially but not only because of energy price increases, the erosion of real household disposable income is significant and general.

Any government would feel the need to respond to such a situation. And the Irish Government has responded both with lump sum payments and temporary reductions in some indirect tax rates. But these measures have not been big enough to silence the calls for compensation or insulation.

There is no point in reminding people that this jump in prices follows a lengthy period of almost zero consumer price inflation in Ireland, or that the 2008 peak of the level of consumer prices was reached again only in 2019, so inflation over the past decade and a half has been way below the 2 per cent per annum target now used by the ECB.

Will this price surge be temporary? Some observers believe it will, noting that the price of oil and gas have repeatedly fallen back following surges in recent years. An end to the war in Ukraine could help. But I doubt if we can count on inflation turning negative.

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Whatever policy steps it takes to respond to the clamour for relief, redistribution will be involved

Still, the ECB can be relied upon to prevent the jump in energy prices from metastasising into runaway inflation. After all, being independent of governments and mandated to maintain price stability as its main objective, the ECB will have no excuse for failing in this respect.

What makes the situation especially tricky for the Government is that, whatever policy steps it takes to respond to the clamour for relief, redistribution will be involved. After all, almost all of these price increases come from abroad: Ireland as a whole is worse off. Not all households can be compensated: and some will have to pay, whether now or in the future, for those who are compensated. Furthermore, the scale of the overall loss is very large: therefore only a rather small segment of the population can hope to be fully insulated.

Three methods

Each of the three main ways being canvassed for easing the impact on household budgets has a different distributional implication, and each also has a different impact on the economic behaviour of the people concerned. The first method uses income transfers; the second uses cuts in indirect taxes to reduce the price of energy; the third is to increase public service pay rates.

The €100 lump sum announced just before Christmas was an example of the first method. Commentators were critical, not just because the handout seemed small, but also because it gave a handout to many who didn’t really need it.

As many prosperous households are also big users of hydrocarbons, that is true also of the reduction in petrol and diesel tax, though many lower income households, especially in rural areas, are also faced with heavy transport costs. Clearly, this approach has the merit of being focused on the prices that have risen the most. However, lowering the tax on carbon-intensive energy sources also reduces the incentive for households and businesses to explore and implement carbon-saving alternatives, which they will have to do sooner or later.

Public sector unions have been calling for pay increases to compensate: but these would do nothing for the majority of households who do not receive public services salaries.

Many higher-income households unaffected by Covid saved relatively large sums in the past couple of years, and could have absorbed higher taxes without stress

On the whole, relying on income transfers, for example through the tax and social welfare system, in order to offset some of the loss in real disposable income of low-income households seems the most defensible approach for the Government to rely on.

This leaves the question of whether the measures should be self-financing (for example, by including an income tax surcharge) or whether the Government should once more turn to the seemingly easy alternative of borrowing. Many higher-income households unaffected by Covid saved relatively large sums in the past couple of years, and could have absorbed higher taxes without stress.

Deferring payment

Borrowing will seem attractive to the Government, as it has in the past, because it defers the payment into the future. With the yield on its 10-year bonds at about 1½ per cent, borrowing is still cheap for the Government. Although the ECB is likely to have to raise interest rates if there is a large second-round inflation surge in the larger euro zone countries, financial markets are projecting that the increase will total only about 2 percentage points. As long as Ireland doesn’t overdo the borrowing, that would be affordable. But there is a limit to what can safely be borrowed. Is this really the most worthy purpose that can be imagined for using the remaining headroom?

The Irish Government has borrowed very substantial sums in recent years. It has disappointingly little to show for this in terms of significant infrastructure

Despite the windfall corporation tax receipts from which we have benefited as an uncovenanted side effect of the geographical tax manoeuvres of multinational tech and pharma companies, the Irish Government has borrowed very substantial sums in recent years to protect current living standards. It has disappointingly little to show for this borrowing in terms of significant infrastructure having been put in place to support future living standards.

It would arguably be better to meet most of the current difficulties by redistributing current resources, even though this implies higher taxes on higher incomes now, rather than on all incomes in the future.

Patrick Honohan was governor of the Central Bank of Ireland from 2009-15