Stephen Kinsella

Friday 1 August 2014

Big cuts in income tax get governments re-elected – but often at a very high cost

Published 15/07/2014|02:30

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Taoiseach Enda Kenny pictured with Minister for Finance in Aras an Uachtarain after the new ministers were presented with their seals of office

Once the bell rings for the Dail's summer recess, only one thing will matter to the Government: re-election. The cabinet reshuffle and other vague policy promises matter only to placate the media and to buy time.

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The line that they must wait to see how the figures look over the summer is actually correct but the underlying truth is that the Government is only asking how little needs to be cut to satisfy the iron-clad requirement that the difference between government expenditure and taxation be less than 3pc of national output.

Let's assume the Government survives into its fifth year, and so has two budgets to go until it must face the electorate again.

There are four large parties – Fine Gael, Sinn Fein, Fianna Fail and Labour – as well as smaller parties and a brace of independents.

Coalition politics implies at least two of these larger parties will merge to form a government in 2016, but two parties currently control the wheels of fiscal policy, meaning they get to decide what tax rates will look like and what levels of expenditure on services will be.

Effectively, the Government must choose between its present welfare and the future welfare of the country.

What does the current Government need to do to increase its chances of re-election, constrained by a need to make sure it doesn't repeat the mistakes of the past? Many elections in Irish history have been 'bought' with promises of lower taxes – for example the 2007 election, and the 1977 election which abolished water rates.

When taxation policy is used for electoral gain, the chances of an unstable 'political business cycle' are very high. The Government could romp home by reducing income taxes substantially and increasing taxes on the very wealthy but that might well blow a hole in the State's finances that a subsequent government would have to impose even more austerity to fix.

Recent research has shown that voters have very short memories when it comes to fiscal policy.

In the parliamentary democracies of the developed world, only the last budget and the rate of growth over the previous six to nine months seems to matter for electoral success.

This may partially explain the resurgence in Fianna Fail's popularity in the polls and it means that, for practical purposes, this budget does not need to be that stimulatory for the economy.

Remember, the economic recovery is still very fragile; and despite better than expected unemployment figures, and taxation figures looking healthy, prudence should be the watchword of the finances – especially when it comes to tax policy for the next few years.

There is a huge literature on how voters react to policy announcements, usually encapsulated in James Carville's phrase 'it's the economy, stupid' which helped Bill Clinton beat then sitting US president George Bush.

Fix the economy and you vastly improve the chances of your re-election, hence the line from government that people need to feel the recovery 'in their pockets'.

The objective of the policymaker is always to maximise her probability of re-election but voting behaviour is always retrospective in that it depends on economic performance under the incumbent in the past.

When voters have short memories a political business cycle will emerge where the next two budgets are giveaways, increasing the fragility of the tax base while incentivising incumbents to act ever more irresponsibly.

But what about voter gratitude? Here the research shows that voters remain grateful for large increases in government spending by rewarding the incumbent party with re-election for several years after the spending takes place.

One study by Michael Bectel and colleagues of the 2002 Elbe flooding in Germany and the vast spending that followed showed a 7pc boost for incumbents which carried over into a subsequent election cycle.

Voters will not respond to cuts that didn't happen, however, they will only respond to positive changes in tax burdens or increases in spending in services.

Voters distinguish between cuts they were saved from and tax increases avoided but only slightly–increases in disposable income are what matter most in changing voter preferences, which will be difficult to achieve if the Government's main policy is altering tax bands.

TASC has shown recently that average earners in Ireland pay the least direct tax of all EU members of the OECD.

Simply cutting the higher rate of tax from 41pc to, say, 39pc, would not have the effect the Government wants of increasing cash in people's pockets.

Only a third of those paying income tax have sufficient eligible income to pay anything at the 41pc higher rate, so any change at the higher band of tax would not actually help the lower middle classes.

Fundamentally, the Government must balance the needs of our future – and its future.

We will know how well it does come the next Budget day.

 

Stephen Kinsella

Irish Independent

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