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.