News Analysis

Wednesday 3 September 2014

Recovery is under way but it's too soon for income tax cuts

Stephen Kinsella

Published 15/04/2014 | 02:30

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Minister for Finance Michael Noonan and Brendan Howlin Minister for Expenditure and Public Reform on budget day. Photo: Frank McGrath.

It is by now obvious that the Government intends to cut income taxes during the upcoming Budget. This is a mistake. Given how uncertain the international economic situation is, the State's finances are not sufficiently robust to absorb shocks from abroad.

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The Government should not listen to upbeat forecasts in making its decisions on tax policy, nor should electoral concerns weigh too heavily. There is still time for a giveaway Budget before the next election, and forecasts have been wrong, and badly wrong, before.

The Government took power in February 2011. It has two Budgets left. The Budget for 2015 should focus on prudently consolidating the recovery.

I agree the recovery is under way, and the momentum underlying much of this recovery in the domestic economy is increasing.

These increases, particularly in employment, are coming from a low base, in many cases, and could, quite suddenly, stop.

The Government has shown itself adept at imposing austerity, and has some experience in shifting the composition of tax revenue away from income-based taxes to property and soon, water taxes, which should anchor the State's finances better when times are tough.

This movement away from income-based taxes may take place in the new Budget, but it is too soon.

The tax and employment data we have argue for no more austerity, which should help growth by not taking it away in the first place. That would be enough, in my view, for the Government to do in the upcoming Budget.

The Government is aiming for an exchequer deficit of €9.6bn in 2014. This is down from €11.7bn in 2013. It is not prudent to reduce taxes, of any kind, when the State is running a Budget deficit of more than 7pc of national output. Beyond the obvious political gain for the Government, the economic benefits of tax cuts really only come from increases in consumption.

Any economy where the nominal interest rate is nearly zero poses severe challenges for policymakers. When national output is far less than its natural rate, inflation will also tend to fall, and we are seeing this happen in Ireland today with headline inflation going slightly negative last month.

With the nominal interest rate set by the ECB stuck at nearly zero, this will raise the real interest rate, and so depress the output further. Irish and European policymakers, therefore, face the risk of the economy spiralling off on a path of continually falling inflation and output. Fiscal policy can stop that.

The idea is that with increased disposable income from a tax cut, you and I will go out and spend more of our incomes. This will increase demand for goods and services and decrease unemployment, because firms will hire when things get busier for them. Because you are buying things, the Government is getting some of that tax cut back in VAT and other taxes. We should also see increased productivity, as workers will work more hours when their last few hours are taxed at a lower rate. The economy will grow.

All good things. But what if households who get the tax cuts don't spend the money? The single most important household statistic, in my view, is the ratio of household debt to disposable income. In Ireland the ratio is 196pc. In the UK it is 120pc, in the US about 100pc. Ireland's households and firms are also saving more than most other countries in Europe, meaning when any tax cut comes, they will either be paying down debt, or sticking the difference in the bank.

Faced with a vast debt overhang what would you do with any increase in your disposable income from a tax cut?

On average, if more people spend than don't, the tax cut will be a success. If it goes the other way, the Government will help the banks a little, as people pay down debt, but this won't get our fiscal house in order fast enough.

If the Government intends the income tax cut to be big enough to move the economy, it is taking a risk it doesn't need to take. China's economy is looking shaky, the US recovery is not taking hold as well as they would like, the Ukraine and Syria conflicts could yet become major conflagrations – all of which would harm the very open economy that is the Government's job to manage prudently. Let's see them do it.

STEPHEN KINSELLA, SENIOR LECTURER IN ECONOMICS, UNIVERSITY OF LIMERICK

Irish Independent

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