Bringing the income tax structure back into sustainable shape

In a previous post I pointed out how growing reliance on cyclically-sensitive taxes had left Ireland’s tax revenue exceptionally vulnerable to a downturn. In effect we were running a sizable structural deficit without noticing.

So clearly we now have to ramp up the more reliable and less cyclically sensitive taxes again.

Rates and bases of lots of taxes need to be changed. The most complicated one is income tax. In 1996, before Charlie McCreevy’s first budget, standard and higher rate income taxes were 27 and 48 per cent. Yet we were happy, growing rapidly and in effect “Europe’s Shining Light”. Such an income tax schedule did not destroy the economy.

Now the tax rates are 20 and 41, plus the new income levies of between 1 and 3 per cent. (I’m going to ignore the health levy, the public sector pension levy and PRSI in this). Even more important, the standard rate band has been about doubled in real terms and the exemption limit increased by an even larger margin.

I thought readers might be interested to compare the average income tax rates (including the 1,2,3% levy) paid under the current tax schedule with what would be implied by the 1996 tax schedule adjusted for CPI inflation since 1996. This is shown in the following charts.

Wow, what a sizable reduction there has been. Average income tax rates in 1996 were 6-15 per cent higher than today. And interesting to see that the changes have not been uniform. That means it would be quite politically contentious to go back to 1996.

But we do have to go some way if sufficient tax revenue is to be generated. And it may take a few years to get there.

Here’s a first shot at a tax schedule that, starting from the current situation, gives a roughly proportionate increase in average tax rates from where they are at present. It’s just a first shot and illustrative of the sorts of decision that need to be taken.

The parameters are: 22% basic rate and 48% top rate (to include the 1,2,3% levies); Tax credit lifted from €1.8K to €2.5K; standard rate band reduced from €36.4K to €25K. This is a lower schedule than in 1996, especially for the lower paid, but still a sizable increase from the present. My guess is that this should yield upwards of €2.5 billion in additional income tax revenue–though depending on savings response there would be a negative impact on expenditure tax receipts.

I know this can be improved upon, with only a modicum of additional work.

I presume/hope these kinds of calculations are being worked on in a much more precise way by the Commission on Taxation and/or in the Department of Finance and discussed with key politicians.

Update: There were some flaws in the original version which I have fixed now. Exemption in 2009 is now achieved only through the tax credit and thus is not tightened in the sample schedule (affects the comments by Colm and Aedin below)

VOX: Ireland in Crisis

Written by Patrick Honohan and Philip Lane, there is a new essay posted on the VOX website that seeks to explain the current state of the Irish economy and recommends a shift in fiscal strategy: you can read it here.

Update:  A shorter version of the article appears in the March 1 edition of the Sunday Business Post.

Update:  The article is also cross-posted at Roubini Global Monitor.

Proposed Anglo Deal: Probably a Bad Idea

RTE is reporting that private-equity group Mallabraca is interested in offering the government €5 billion for a majority stake in Anglo Irish Bank. Now this might sound like good news and RTE is sort of reporting it in this way (For instance the story on the website tells us that Mallabraca “would assume majority control and share risks with the State” and that “It is understood any proposal that would benefit the State and stabilise the bank could be agreed”) Getting the bank back in to private hands quickly sounds like a good idea and hey that €5 billion sure would come in handy.

Before you go getting too excited, remember the old motto about things that look too good to be true. Anglo is undoubtedly insolvent, i.e. its assets are worth less than its liabilities. This means that no private investor would pay a cent to take them over. So, what lies behind the offer? As always, but particularly with this kind of thing, the devil will be in the details. And my guess is that the details aren’t pretty—that underlying this €5 billion offer from Mallabraca is a corresponding €(5+X) billion offer back from the Irish government of good stuff like over-priced loan purchases, and of course, risk insurance, courtesy of the Irish taxpayer.

Beyond the issue of whether this is a good idea, this proposed deal also raises the question of whether the Department of Finance has already worked out its philosophy on things like risk insurance (and is not really waiting for the conclusions of Peter Bacon and the NTMA) or whether the Mallabraca gentlemen have pitched an offer to the government about what goodies they’d like in return for the €5 billion. Anglo is wholly public-owned and has fully government insured deposits and other liabilities.  So, we’re not dealing here with any of the sensitivities associated with takeovers of companies listed on the stock market.  Given that, I would hope that the full details of this offer could be made public and open to debate before the government makes a decision.

The Swedish model for resolving the banking crisis of 1991-93

Lars Jonung at the European Commission has released a new paper on this topic: you can download it here.

Abstract: This study presents the main features of the Swedish approach for resolving the banking crisis of 1991-93 by condensing them into seven policy lessons. These concern (1) the importance of political unity behind the resolution policy, (2) a government blanket guarantee of the financial obligations of the banking system, (3) swift policy action where acting early was more important than acting in exactly the right manner, (4) an adequate legal and institutional framework for the resolution procedures including open-ended public funding, (5) full disclosure of information by the parties involved, (6) a differentiated resolution policy minimizing moral hazard by forcing private sector participants to absorb losses before government financial intervention, and (7) the proper design of macroeconomic policies to simultaneously end the crisis in both the real economy and the financial sector.

De Larosiere on Bank Regulation

On a first reading, there is an elephant in Jacques de Larosiere’s kitchen. The report recommends a new architecture for pan-European supervision, falling short of a single pan-European regulator as Kevin O’Rourke notes. It also recommends revisions to Basel II, without much in the way of specifics. The report has been welcomed by the Commission and is to be considered by EU Finance ministers next month.

The elephant is moral hazard. European governments have instituted wide-ranging guarantees of bank liabilities, amounting to de facto (and potentially free in some cases) unfunded deposit insurance for commercial banks. The report rattles on about the possibility of a limited and pre-funded deposit insurance scheme, with the option of national variations on a European template. But it seems to me that the genie is out of the bottle, and that, if and when business-as-usual returns, the public will not believe that there are deposit insurance limits. If there is a systemic crisis, Governments will be expected to step in. Even if there is just one distressed commercial bank, it is difficult to see how the clamour for retrospective liability guarantees can be resisted. These expectations could be with us for generations.

Clearly there are categories of near-banks (hedgies, prop-trading units) which could credibly (in the eyes of the public) be placed outside the pale, and denied guarantee. But how to prevent banks, believed to be guaranteed, from lending to these entities at inadequate rates, endowed with too-cheap funds from the public deposited on the basis of an assumed guarantee?

The net question is this. What are the implications for regulation and supervision of a European banking system in which liabilities of all the main commercial banks are perceived to be guaranteed?  Can it be less than Glass/Steagel, plus high capital and liquidity ratios, plus intensive supervision and risk monitoring beyond anything thus far contemplated?

Margaret Thatcher lamented, at the end of the Cold War, that nuclear weapons could not be de-invented. Can the perception of perpetual availability of retrospective and ‘costless’ bank liability guarantees be de-invented?

The division of regulation depends on the extent of the market (or at least it ought to)

The FT and IT report on Jacques de Larosière’s call for a reform of European financial regulation. de Larosière’s report

recommended the establishment of a body under the auspices of the European Central Bank to develop policy and provide risk warnings to European Union supervisors. It also proposed another body to co-ordinate the decentralised network of supervisors monitoring individual institutions and markets.

The FT reports that “European banking and insurance groups welcomed the conclusions”, but I don’t suppose that this in itself should lead us to reject them outright. Eurointelligence is extremely disappointed by the absence of a proposed EU-wide super-regulator, while the FT likes the proposal. Supervision and coordination of the existing supervisors, who have failed, does seem much less attractive than having one new central regulator, and so I tend to side with Eurointelligence. On the other hand, the new European supervisory structure “would combat regulatory arbitrage by: deciding compulsory minimum EU-wide standards; providing binding mediation between disagreeing national authorities; and coordinating international “colleges of supervisors”.

Innovation policy: the Cinderella of the current debate?

The immediacy and scale of the interrelated public finance and financial system crises have naturally – and rightly -generated the vast bulk of comment and economically informed analysis to date. I wondered whether this reflects an implicit collective judgement that the third part of the government’s soi-disant strategy, namely that related to the role of innovation securing long term economic progress is at best uncontroversial or at worst irrelevant? I seem to recall most reviews of the government’s “Smart Economy” policy document evidencing general scepticism and disappointment that this focus for policy action was, to put it mildly, misplaced in the eye of the fiscal and financial storms by then well underway.

I would argue the need for more critical analysis to be focussed on this area—understandably more so if and when we’re a little surer we’re not going bankrupt tomorrow, and/or have to ritually abase ourselves before the IMF—but nevertheless at some stage.

My concern is that the policy machine keeps working, explicitly rationalising more government expenditure and significant institutional policy shifts (without much apparent economic oversight), by ritually linking of such policies to economic growth.

For example, Science Foundation Ireland today announced the allocation of €24m in respect of five new “Strategic Research Clusters”. There’s a broad debate to be had here, but one wonders whether this (by now unremarkable type of initiative) prompts the question for example whether innovation policy here, is or could become, merely a Trojan horse for old-style ‘picking winners’ industrial policy, particularly at a time when there are no apparent limits to the scale and scope of government intervention which in other contexts is now deemed acceptable.

Much more specifically, is there any concern that the renewed emphasis on commercialisability (and thus at least partial private capture) of outcomes of publicly funded research on the part of the policy makers is in unacknowledged tension with the original public good rationales for the ramping up of publicly funded R&D?

I was prompted in part to raise this kite by Nicholas Craft’s VOX post of July 2008 on ‘learning to love creative destruction’ which concludes in part:

Politicians find it attractive to wax lyrical in support of the “knowledge economy” and rush to adopt targets for R&D spending and participation in tertiary education. This “happy clappy” approach to addressing Europe’s productivity growth shortfall keeps them in the comfort zone. More progress would be made if the dark side of productivity improvement implied by creative destruction – exit of established producers and re-deployment of labour – were accepted and facilitated.

O’Toole and the Government on the Pension Levy

Tonight’s Questions and Answers featured a heated exchange between Fintan O’Toole and Martin Cullen about whether the government knew how the pension levy was going to work when it was introduced. O’Toole has framed this question as being about whether the levy was applied to gross income or to net income. In his original article about this, he had asked

Is the levy a percentage of a worker’s entire income, or of that income after tax and PRSI? The answer to this question is crucial.

The article went on to heavily criticise the Taoiseach for asserting that the levy was applied to gross income and argued that this is not the case, a criticism that was repeated on Q&A.

Let me attempt to cut through the Gordian knot here and explain why both O’Toole and the Taoiseach are sure they are correct. Continue reading “O’Toole and the Government on the Pension Levy”

Some good news

There are a small number of policy makers whose views actually matter in Europe right now, and up to recently it wasn’t clear to me that they held the right views. And so, it is extremely reassuring to read

Jean-Claude Trichet, the head of the European Central Bank, said that only emergency measures would help the world recover. “We live in non-linear times – the classic economic models and theories cannot be applied, and future development cannot be foreseen,” he said.

OK, we might query whether ‘linear’ or ‘convex’ is more appropriate, but the sense of urgency is very welcome.

A second piece of good news is the widely flagged rethink in Berlin regarding options for financing eurozone economies. If Juergen Stark wants EMU to survive in the long run, he should welcome such initiatives, since in the long run they will be necessary.

A third piece of good news is that Gordon Brown appears to be going along with Continental demands for greater regulation of financial markets. This is going to be a necessary part of any European Grand Bargain going forward, and in turn it is important that Europe speak with one voice at the London conference in April.

Irish Blog Awards – Winner of Best Specialist Blog

The Irish Economy blog won the Best Specialist blog category (sponsored by iQcontent) at the Irish Blog Awards last night. I thank all the contributors and commentators for the success of this blog.  Special thanks to Agustin Benetrix for his technical contributions to setting up the site.

The full list of blog award winners can be found here.

The Irish Times Selects Us Among The Top 20 Blogs

Today’s Irish Times lists twenty ‘essential’ blogs: you can read the article here.

Below is its view of this blog:


Insightful commentary on the Irish economy, from a range of experts.

Taster: “The downside of all of this is that whatever intellectual debt the ICTU document owes to [Swedish economist Jens Henrikkson] is not obvious from the document itself.

“But maybe what [David] Begg is saying is: if you want to know where we really stand, as distinct from the public posture we have to take, you’ve got to read this other stuff too.”

Reinhart and Rogoff, and Ireland

Reinhart and Rogoff have a series of working papers (here) analysing the key features of financial crises, using data over many centuries and from around the world. In their papers 2008a and 2008b (here and here) they highlight  two common characteristics of banking crises: 1. they are usually followed by severe government deficits, but the relationship is not caused by bank bailout costs; the direct costs of bank bailouts are swamped by recession-related tax shortfalls and expenditure increases, 2. banking crises are sometimes followed by sovereign defaults, but again it is not due to direct costs of bank failures including bailout costs, since these are not typically a substantial part of the government budget crisis.  

In another one of this series of papers, 2007 (here) they demonstrate the prevalence and wide ubiquity of sovereign debt crises. They stress that sovereign debt crises are not confined to less developed countries.  The small number of sovereign debt crises in developed Western countries since WWII is a typical trough in the cycle, which by historical patterns is due to end soon. 

Looking around the world and acknowledging the historical patterns shown in their paper, a hidden message of the paper (in my own subjective reading) is that the Euro zone is due for at least one sovereign debt default in the next decade.  Will it be Ireland, and what can be done to prevent such a disaster? 

Rossa White of Davy Stockbrokers argues (here) that quote “the risk of Ireland not being able to meet ongoing debt payments over the next few years is very low.”  The credit default swap market seems to disagree.  The most recent Ireland government bond CDS rate is 3.41% meaning that institutional investor are paying 3.41% to receive the shortfall on par value when and if Irish government bonds default.  If the payment shortfall on default is 50% (a typical disastrous sovereign default) this is equivalent to a risk-neutral per-year default probability of 3.41%/.5 = 6.82%.  Over five years this aggregates to a cumulative default probability of (1- (1-.0682)^5)=28.09%.  Of course investors are not risk neutral so there is a substantial risk premium in the CDS rate, but still this indicates a non-negligible true probability of default reflected in market rates. 

Ireland must make policy changes to set the probability of sovereign default close to zero.  There is an over-emphasis on dealing with the problems in the banking industry as a solution to the current economic crisis.  Going forward, dealing with public finances is at least as important, probably much more important. 

The relative ordering of policy priorities is relevant since there is a finite supply of political capital to address the current crisis.  If all of the political capital is spent on the least important problems, the most important ones will go unsolved.  That increases the medium-term risk of a true disaster: a sovereign debt default.  An article in the Irish Times by Stephen Collins, “The Real Danger is in Political Stalemate as the Roof Falls In,” is disquieting reading (here).

The two crucial intermediate policy goals are broadening and deepening the net tax take from households, and lowering the cost of public services.  The proposed 10% levy on public service pensions is an admirable first start on the second of these goals.  The recent political weakening of the government, in the face of continuing revelations about banking industry shenanigans, has endangered this important first step.   Does the present government have enough political capital to face up to raising taxes on middle earners? 

Another policy goal is to decrease economic policy uncertainty, so that businesses and households can plan and invest.  Mervyn King stresses the importance of economic policy predictability and stability (wittily stated here).  He quips that one of his policy goals as head of the Bank of England is to be extremely boring.  Presumably this comes easy to him as a well-trained economist.  There is also a wealth of evidence that the reason inflation lowers growth is that it creates planning uncertainty for businesses and consumers, see for example Huizinga 1993 (here).  Irish businesses and households are not facing price turbulence but rather government policy turbulence, which can be even worse.  The Irish government needs to make hard policy choices, state clearly that it intends to enact them fully, and then do so reliably.


Bacon, Bad Banks and Risk Insurance

Today’s Irish Times reports that the government has hired Peter Bacon

to assess the possibility of creating a “bad bank” or risk insurance scheme to take so-called toxic debts off the banks’ balance sheets in a bid to free up new lending.

I know I’m at risk of sounding like a broken record on this topic but, given its importance, I’ll add my latest two cents on this. I’m not in favour of either this form of “bad bank” or a risk insurance scheme. Continue reading “Bacon, Bad Banks and Risk Insurance”

Measuring the Liabilities of the Irish Banking Sector

It is certainly quite difficult to measure properly the liabilities of the Irish banking sector, if this term is defined to mean those banks that are embedded in the Irish economy with significant domestic non-bank business.  The main problem is that the aggregate banking data (as published by the BIS and the Irish central bank) are dominated by the activities of international bank groups that run significant volumes through the IFSC. These operations are pure offshore financial intermediaries and should be ignored in terms of assessing the scale of liabilities of the domestic banking system.

Rossa White has a written a useful short note “Irish banking liabilities – True figure is just over 300% of GDP, one-third of bogus ratio being quoted,” which is available via the Davy website.

World trade again

On an annual basis, the volume of world trade fell by 25-30% between 1929 and 1932. If you use quarterly data, you can push the peak to trough Great Depression trade decline up to around 35%.

The latest data indicate that the volume of world trade fell by 13% between August and December 2008. We are not only on track, we are ahead of schedule. Everything now depends on the policy response.