Tax increases are inevitable: discuss

Garrett had an article in the Irish Times on Saturday which I thought made an important point: the scale of the deficit is so large, that to claim it can be fixed by expenditure cuts alone is inherently implausible. (Although a pay cut for people like us would certainly help.) Presumably (?) the government understands this, and doesn’t really mean it when it claims there will be no more tax rises.

So: what tax increases will do the least damage to the economy? Like expenditure cuts, all tax hikes will obviously drive the economy further into recession, but given that we have no choice here, the question as to what is the least-worst strategy seems worth posing.

8 replies on “Tax increases are inevitable: discuss”

One of this country’s strengths would seem to be the low income tax wedge. Data from the OECD and National Competitiveness Council show that the tax wedge declined from about 22 percent of average earnings in 2000 to less than 15 percent in 2006. That compares an average wedge of 30 percent in the OECD and 45 percent in Germany and France. Relying too much on income tax increases could push the wedge back to levels seen in the 1980s, which would damage competitiveness and employment. Income tax hikes are inevitable, but some pressure could be taken off income taxes by broadening the tax base. A property tax, along the lines of that in the US, could help. Budget 2009 took a step in that direction with a small fee on second homes.
More generally, evidence on successful fiscal consolidations in European countries suggests that governments should try to avoid increases in the tax burden on factor incomes (see Chapter 4, Coming of Age, Based on broader samples of OECD countries, Alesina and Perrotti (1996) and Perrotti, Strauch, and von Hagen (1998) show that fiscal consolidations based on expenditure cuts are much more likely to achieve lasting deficit and debt reductions than consolidations based on revenue increases.

I guess most people agree regarding tax wedges on labour, based on past experience. Kevin Denny and I built a CGE model years ago, which we never published, calibrated to 1985 data. We had fixed real post-tax wages; unemployment; and government expenditures and revenues which fluctuated with the level of unemployment. Much to our surprise (since the model was constant returns) we found multiple equilibria: a high tax, high unemployment equilibrium, and a low tax, low unemployment equilibrium. I always thought we could have tried to sell that paper as a way of thinking about the subsequent boom.

So, carbon taxes are better. Out of interest, I see that various macroeconomic simulations in that ESRI paper assume crowding out; what was the capacity constraint driving that (full employment?) and might you want to modify that now? If you did, how would that change things?

On property taxes: I agree, they are also clearly preferable to taxes on labour. What would be the optimal time to introduce these, given the current state of the market? Would introducing them now be disastrous, and should we wait until recovery? Or is now as good a time as any, and should the country’s finances ebe given priority? How do you deal with people in negative equity? Tax net housing wealth only?

Successful fiscal consolidations are those that last for a number of years. Existing empirical evidence and international experience suggest that successful fiscal consolidations are marked by a strong emphasis on expenditure cuts in particular those that are politically most sensitive such as transfers, subsidies and wages while deficit reductions achieved by raising taxes are short-lived (Perotti, Strauch and von Hagen, 1998; von Hagen and Strauch, 2001; von Hagen, Hughes Hallet and Strauch, 2002).

However given the current challenges and the small size of the government in Ireland, a combination of expenditure cuts and tax increases are necessary. A comprehensive approach to efficiency-enhancing public finance reforms is needed including the composition and efficiency of public spending and the structure and efficiency of the revenue system.

Measured as public expenditure to GDP, the size of government in Ireland is among the smallest in the world. At below 35% of GDP, the size of government in Ireland is similar to the size of the US government and much lower than in high income open economies in Europe such as the Netherlands, Austria, Belgium, Finland, Denmark, Sweden, Norway. In more open economies a large public sector serves to absorb external shocks.The demand for publicly provided goods is expected to have a positive income elasticity which suggests that the size of government should increase with GDP per capita.

The low inflation environment adds to policy challenges. The government should be prepared to act quickly to prevent deflationary expectations from taking root.

All significant tax hikes should probably wait until the economy has begun to recover. Fiscal policy was pro-cyclical during the boom, but that is no reason for pro-cyclical policy during the bust. Of course, that assumes that sovereign debt markets don’t see things differently. For sure, the effects of the introduction of a property tax are not entirely predictable. But one could imagine a wholesale reform of the system of taxing property–e.g. US-style property tax accompanied by reductions in stamp duty–that would carry less risk of choking off a recovery in housing transactions.

I also believe in counter-cyclical fiscal policy, and that applies to the expenditure side as well as the revenue side.

Like you say, the crucial issue then is how the debt markets see things — especially given the sword of Damocles that is the bank guarantee scheme hovering over the economy.

In HERMES, an expanded public sector indeed crowds out the private sector, first through the labour market and second through a higher fiscal burden. Kevin is right that the first mechanism does not work anymore at present and in the near future. This implies that a carbon tax, recycled through increased government spending, is not a bad idea in the short term.

In the long term, though, I disagree with Iulia and rather prefer a small government. In any case, it would be bad idea to expand the Irish government without first improving the way they spend our money.

Richard, my point was about fiscal consolidation and the sustainability of public finances. All I am saying is that expenditure cuts will not be sufficient to achieve a sustainable fiscal position in the medium-term. Also, the government needs to look at both the composition and efficiency of public spending and the structure and efficiency of the revenue system. I agree that in the long-term a large government has a negative impact on growth.

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