Monday 22 January 2018

Elastic income tax a threat as new economic woes loom

The Government faces tough choices in deciding which direction to take on income tax and the USC – and previous approaches might not be the way out of future trouble. Stock image
The Government faces tough choices in deciding which direction to take on income tax and the USC – and previous approaches might not be the way out of future trouble. Stock image
Brendan Keenan

Brendan Keenan

THE gist of 'The Undoing Project', the latest book from Michael Lewis ('Liar's Poker', 'The Big Short') is that people don't think the way they think they think.

Instead, they create narratives; stories which make sense of the evidence before them. Except that, quite often, trying to make sense of things gets them wrong. The reaction to last week's triggering of Article 50 may have been an example of the theories developed by the Israeli psychologists who are the subject of the book.

This was a ready-made narrative, complete with diplomat in Savile Row suit, letter in briefcase, flags, and an interview inside 10 Downing Street. Suddenly, everyone was scared, despite the fact that there was nothing much we did not already know.

Indeed, anything which was new tended to be cheering. That, however, was not enough to compensate for the shock of the sight of the UK handing in its dinner pail. Whether by accident or design, consultants PwC and employers' group Ibec picked the right day to warn of what was coming and advise us to be prepared for the worst.

There are some, in business and elsewhere, who worry about too much doomsaying. Ireland has been through several wrenching changes - too many, alas, of its own making, but not all.

Those which were not self-inflicted wounds included free trade with Britain, membership of the EU and the creation of the single market which got rid of the Border so far as commerce was concerned.

All of them had unpleasant consequences: mostly for manufacturing, although even in traded services, nearly all the local players ended up as part of international conglomerates.

Yet, as we know, the country adapted and prospered mightily over those decades. The major interruptions to that prosperity were almost entirely of our own making. There is a danger, in all the transfrontier angst, that we will forget the importance of what we get up to at home - something which is likely to be even more important as Brexit takes its unpredictable course.

There will be little point in companies going through radical readjustments if they are undermined by one of the periodic domestic crises. It is not just business which will have to change the way it does things. Government, and the whole political process, has some serious thinking to do.

The current way of doing things is well illustrated in a new research paper from the Economic and Social Research Institute (ESRI) on the characteristics of the income tax and universal social charge system.

The paper itself is one for the specialist but there is a useful summary of what has been income tax policy for at least 20 years. This is to keep those on the minimum wage out of the tax net; to keep those on average earnings in the standard rate band; and to keep the overall income tax burden low.

Who could argue with that? The trouble of course is that these objectives contradict themselves to some degree. Yet they have become blind articles of faith, which are again being polished off more than six months before the next budget (and whatever number of months before the next election).

The disasters of the bubble and burst seem not to have shaken the faith of politicians or voters in this hoary old formula. The analysis shows its weakness and dangers. It finds that, as it has developed, for every 1pc rise in income, tax revenues rise by 2pc - a high degree of "elasticity".

As incomes soared during the credit boom, Exchequer revenues soared even faster, allowing the three golden rules of Irish tax policy shibboleths to be applied without any apparent effort or danger.

More people were taken out of the tax net, the standard rate band was raised from €28,000 to €35,000 a year and the top rate cut by just over 2pc (although only this last one gets much of a mention).

There was some apprehension of danger. The Department of Finance was harried quite a bit for getting its income tax forecasts wrong. It was applying a lower elasticity, which meant actual revenues were consistently ahead of forecast.

According to those recently in government, then in opposition, we were paying too much tax. In this context that was a meaningless statement, as the same parties found out the hard way as they dealt with the consequences.

The horrid truth about tax elasticity was displayed in the crash, when output fell by 15pc and income tax revenue by 30pc. Irish income tax revenues are especially volatile and the report's analysis of why helps explain why economics is called the "dismal science".

Bright ideas, with good intentions, can have unexpected, unwanted consequences. The villain of the piece in this case is the system of tax credits, where taxpayers get a fixed sum knocked off their bill.

Only Ireland does it this way, as compared with allowances, where a certain amount of income is not taxed. The good intention was that credits result in a smaller average tax rate for those on lower incomes, so they are more "progressive."

Their introduction was widely welcomed at the time, including by your columnist. The unintended consequence is that they make revenues more volatile. When tax credits are exhausted, the automatic increase in revenue for a small increase in income can be extremely high.

It is different with the hated USC, where there are no credits and a wider range of earners is liable for the charge. That is precisely why the USC is hated. It falls on people who are not liable for income tax and offers no offsets to the rest.

There is an uncomfortable choice here; between a tax system which concentrate on raising revenue from the better-off or, like the USC, meets the tax specialist's ideal of low rates, a broad base, simplicity and transparency.

That is natural enough, but it would be wise to remember that hard choice. There is no unintended consequence in the finding that policy from 2002-7 reduced the amount of revenue payable on any particular level of national income. Nor, as another report claimed this week, that the resulting marginal rates on higher earnings are a deterrent to the ambitious and well-qualified.

It is all too possible that the country will need both revenue and revenue stability in the next few years. The most imminent threat from Brexit is not the effects on trade or the Border, which are some years away, but a run on sterling as markets come to grips with the UK's twin public and private deficits of a slowing, isolated economy.

That's not a forecast, by the way, but it is a real and present danger. Ireland's weakness is its high level of public debt. The deficit/surplus looks healthy enough but that would soon change if, in a UK-inspired recession, income tax revenues were falling twice as fast as income.

Politicians are mulling over both income taxes and USC, and no doubt credits as well. One thing they might like to mull is that, while the old three-pronged approach may have had merit in unwinding the emergency tax measure of the crises of 1982 and 2009, more of the same may not be a good way to prepare for the next spot of bother.

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