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)

27 replies on “Bringing the income tax structure back into sustainable shape”

Thanks Patrick. This is very informative. You are no doubt right that significant income tax increases are coming. But I am struck by the relatively low revenue yield from what are large increases in marginal tax rates (including, if I understand you correctly, a jump from 20% to 48% for those earning between 25k and 36.4K). I am also surprised by your suggestion to raise the tax credit, which would have the effect of taking even more individuals out of the income tax net and also offset part of the yield from the marginal rate increases.

It is useful to be clear on the distinction between what ought to be done and what will not be done, at least not before the elections… We noted last week: “The Irish Minister for Finance Brian Lenihan is ruling out any immediate rise in income tax. … Mr Lenihan says a rise in income tax might do more harm that good.” here
http://www.independent.ie/breaking-news/national-news/politics/lenihan-warns-of-more-tax-rises-but-excludes-income-tax-1655476.html It is was also impressive to listen to Mr Lenihan’s optimism at the Ard Fheis.

I have heard investors being reassured, that if a push came to a shove, taxes could be raised quickly. Effectively I am also struck by the relatively low revenue yield from such large increases in marginal tax rates.

There is more to life than income tax. Income tax may be easy and large, but it particularly hurts competitiveness as labour costs go up and may drive top people out of the country.

Taxes on carbon, property, and road use could bring in billions of euros, and would mean that the income tax does not need to be raised that much.

Besides, the government owns assets worth billions of euros. These should be sold to keep borrowing and future taxes down. Selling state-owned companies would also further competition in the affected markets, drive down prices, and improve competitiveness.

I may have pitched the revenue estimate on the low side, but bear in mind that income tax “only” yields about 13 billion or about a quarter of total tax and PRSI yield.

That’s where Richard’s points come in, especially on less distorting or even correcting environmental taxes.

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I completely take Patrick’s point about the political issues involved in replicating the 1996 schedule in its entirety. And also Richard’s point about using other, better taxes to gain revenue.

But given that the state was not in a huge fiscal crisis in 1996, and is now; and also that the credibility of the government’s fiscal position is important not just in its own right, but in terms of the credibility of the bank guarantee, I would have thought that overall we are looking at tax burdens which are much higher than in 1996, at least in the short to medium run. Out of curiosity, if you had shifted the schedule up so that it completely mimicked 1996, how much revenue would that have raised?

If income tax is seen as a more reliable and less cyclically sensitive tax, does this not also apply to corporation tax?

Is the degree of cyclicality less for income tax than for corporation tax? To pay income tax, people have to be in employment. As people lose jobs and/or have income reduced, is this cyclical effect modelled in any systematic and consistent way?

When is Corporation Tax going to be brought into play, by Irish policy makers? While it is clear that this was was aimed at inward FDI, why was it introduced as a single measure, without much consideration given to the relationship to the rest of the tax base and government controlled charges/levies etc.
This became clear when Government introduced, on an arbitary basis, a temporary levy on banks during the period 2003-2005.

Is there any point is relying on a comparatively low Corporation Tax rate, when other other Government controlled costs are let rip eg. rates on business premises, water and waste charges, development levies, electricity prices etc.?

Am I reading too much into last Friday’s Irish Times report of Germans waiting for us in the long grass on this issue?
http://www.irishtimes.com/newspaper/finance/2009/0227/1224241894001.html

If so, should be take pre-emptive action rather that being forced to do so as part of €urozone aid?

Perhaps, some work has been going on to find other tax-based incentives to replace this (as it replaced ESR).

Im a little confused about Carbon Taxes . as human beings are carbond molecules in a water base, income tax is a carbon tax.
More deeply tho, is a carbon tax not simply, in effect, a levy on fuel? Calling it a carbon tax sounds good for the greens. will, in the absence of any offsetting changes, this not bear more disproportionally on the lower income areas and will it not just be passed on as another indirect tax. So some idea on how it works and how it differs from say a 30% VAT level on fuel would be useful

Domestic water charges, congestion pricing for roads and third-level tuition fees are policies of inherent merit that could raise significant revenue. What about taxes on assets/wealth (not just property)?

Donal, I put corporation tax with the cyclically sensitive because profits are much more volatile than personal income or expenditure.

Brian, for your sake I can only hope that R. Tol doesn’t spot your comment!

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Ireland is a small, economically very open, English-speaking country with a relatively high-tech industrial mix. These strengths become weaknesses for the purposes of increased tax revenue generation. In the USA economists worry about the incentive effects of high rates, but in the Irish context these direct incentive effects are second-order compared to the effects on inward and outward migration of both labour and capital. Do we have any sense of long-term net tax takes from prospective income tax rates?

It would be a mistake in my humble opinion to have a top rate higher than that in the UK or USA. That would also be damaging to one of the positives of the Celtic Tiger period — Ireland’s newly-won reputation as an entrepreneur-friendly economy. I do not mean fraud-friendly I mean entrepreneur-friendly.

Green taxes are definitely the way forward for the future and the right thing to do. Would they have a large negative growth repurcussion over the short-term or could they be introduced in a way that does not impact duly on an economy already in very tough circumstances?

All tax receipts are cyclical to some degree in Ireland, even population is endogenous. There are two problems: tax revenue is too low if public spending is to be kept anywhere close to recent levels, and some categories of revenue are exceptionally volatile, particularly the transactions-related taxes which have collapsed so spectacularly in the last few years – stamp duty, CGT on non-residential property/equities, and VAT on new house sales. The decline in these appears to be about €6 bn from 2006 to 2009. It is not just cyclical, it reflects the end of the bubble, and these receipts will not be restored in the recovery. They would only be restored if we decide to have another bubble, and manage to finance it.

Patrick’s calculations involve an extension of the tax net downwards into the lower income bands, through the halving of the exemption level, and I suspect a lot of the revenue gain comes from this source. Is it a good idea to drag a large slice of the bottom portion of the earned income distribution back into the tax net? Bear in mind that social welfare income is tax exempt. What is the impact on replacement ratios? The fact that a large portion of lower-paid employed people do not currently pay income tax can be seen either as a problem or as an achievement.

On Richard Tol’s point, it is important to remember that Government revenue can be enhanced without raising actual rates of tax. Tax expenditures can be scrapped, and Government can charge for things it currently gives out for free (water, radiomagnetic spectrum, carbon emission permits). Competitiveness would benefit if these options are exhausted before resort to higher tax on the lower-paid in employment, and no doubt the Commission on Taxation will be looking as well at more orthodox forms of taxation on real property.

I would love to see what happens to the tax line as the graph extends to the right as we move towards 1, 2 or 5 million etc.

Does it continue to slowly rise before levelling off or does it actually begin to drop ? For both the question “and if so where?” are important.

I suspect that this would be a common enough question among Sean & Sile citizen who I suspect might have their own expectation on the answer.
Are they right or wrong?

Perhaps a better way of smoothing the tax take would be to use something that is in constant supply such as land. If we were to move away (to some degree) from income tax and instead levy that which is in constant supply it would allow for better planning and would avoid the kind of tax collapse we have seen so far. It would also stop the likes of land-banking, and reliance on property for capital gains etc.

the reality is that with nearly 40% of the population paying NO income tax and being net receivers to boot, and 6.5% paying 50% of the tax take that we need to see full participation, and that isn’t an ‘attack’ on the poor it is merely ensuring everybody plays a part, in as much as tax revised upwards is progressive it should be regressive to the lowest paid.

@Richard Tol: I don’t see how a tax increase would raise labour costs (assuming you are not talking about employers prsi) when there are so many people out of work the upward pressure on wages is basically non-existent.

It’s time to get down to the heavy lifting.

Making child benefit taxable is another obvious revenue raiser. And I second Colm McCarthy’s comment re: tax expenditures, a distinctly regressive and non-transparent form of social/economic policy in my view.

The proposal for significantly higher taxation ignores a crucial issue which was not a problem in 1996, Ireland is now a high cost country. So surely even a marginally small increase in the cost base (through taxation) will create enormous damage.

The assumption underlying all this is that public spending must be maintained at or near present levels. Reductions in public spending can help in reducing the high cost base of the economy and deliver better value for money. Does anyone really think we have either good public services or get value for money for them?

(Jer) “I would love to see what happens to the tax line as the graph extends to the right as we move towards 1, 2 or 5 million etc.”

Good point. Tax rate != tax take, especially since the farther to the right you are the better your accountant is (publishing rights assigned to a Dutch company, that sort of thing).

At the lower end, all benefit payments of all kinds, including child allowance, should be subject to tax. Tax rates could be recalibrated so that people with no other income would not have to pay anything, but if they went off jobless benefit in June the next six months wouldn’t be a low-tax freebie.

DIRT should also be abolished and integrated into standard income tax by means of end of year interest statements (this is how it works in Canada and the way things are going saying “it works in Canada” is a good way to get the Irish government to do something – first the Official Languages Commissioner, now financial regulation…). The tax could still be withheld at basic rate but low-income families would get refunded some of it (not just pensioners) while high-rate earners would have to pay the full whack of marginal rate.

I just found this quote on progressive income tax from Hayek. Friedrich A. Hayek in “The Constitution of Liberty” (1960), on the myth that progressive tax rates are necessary to fund large increases in government spending, lest an intolerable burden be placed on the poor:

“Not only is the revenue derived from the high rates levied on large incomes, particularly in the highest brackets, so small compared with the total revenue as to make hardly any difference to the burden borne by the rest; but for a long time . . . it was not the poorest who benefited from it but entirely the better-off working class and the lower strata of the middle class who provided the largest number of voters.

It would probably be true, on the other hand, to say that the illusion that by means of progressive taxation the burden can be shifted substantially onto the shoulders of the wealthy has been the chief reason why taxation has increased as fast as it has done and that, under the influence of this illusion, the masses have come to accept a much heavier load than they would have done otherwise. The only major result of the policy has been the severe limitation of the incomes that could be earned by the most successful and thereby gratification of the envy of the less-well-off”.

I think we can see in the Irish situation that government spending is directed disproportionately to the richer through various programmes such as free fees, higher rate relief, child benefit, tax loop holes, etc. Be careful what you wish for!

Richard Tol says higher rates of income tax “…may drive top people out of the country.” If only we had thought of it in time think of the misery we would have been spared.

Colm sounds a note of caution about bringing lots of low-paid workers back into the tax net, and I second this caution. Remember that the tax-free portion of income is pretty much set to exempt those working full-time, full-year on the minimum wage; if 38% of the working population aren’t paying tax, it’s because we have a lot of people working part-time and/or on low hourly pay.

This point struck me very forcibly at the Crisis Conference when Philip put up a table showing how out of line with other countries Ireland is in this respect. The table showed, among other things, that the average tax rate for a single parent with two kids earning (if I remember correctly) the average wage was -35% in Ireland (i.e. income is increased by 35% on top of labour market earnings), but is +35% in France, with an EU average of about 20%. Rather than thinking, Wow, Ireland is too generous, I was sitting there wondering how it made any economic sense (not to mention how it was fair) to take 35% or even 20% of the labour market earnings of someone on average wages trying to bring up two kids alone. Of course, part of the problem is that these figures aren’t comparable at all – such a person would be entitled to essentially free childcare in France, for example – but it does illustrate the problems of benchmarking to other countries, when it’s quite possible that it’s the other countries that have it wrong.

In my view, widening the tax net should be considered only after all possible tax expenditures have been pruned away, and the extent to which any one individual can benefit from them strictly limited.

I also believe that the income levy should stand for as long as the fiscal crisis continues (but no longer), which would bring the top rate for very highly paid workers to 51%, rather than Patrick’s 48%. Unlike Greg, I don’t think this is a problem if it’s temporary, as I don’t see where all these high fliers are going to go in the next couple of years.

Expenditure should be made to fit the tax revenue.

Governments and Councils for decades have applied this policy of adjusting the tax rates to match expenditure.

I would prefer if the contrary was adopted. At least then the growth sectors of the economy would have less variables to worry about.

The other thing to remember is that the people who the government claim pay no tax at all actually pay 21.5% on their consumption already, i.e. VAT, a highly regressive tax, so the government’s line is nonsense, cut spending & tax reliefs first.

I agree with Ciaran that this idea that income tax is the only tax that really counts is a bit odd. However, I also agree that if you want to raise the requisite revenue you just can’t afford 40% of the workforce outside the income tax net.

However, since we find ourselves in the dire situtation of considering a pro-cyclical fiscal retrenchment just when private sector activity is collapsing, ought we not take into account which adjustments will have the least anti-stimulatory effects in the short run? In this light is there a case for delaying taxes likely to depress consumption and frontloading taxes on those more likely to save?

The assumption that consumption is always better than saving seems to be almost universally accepted, at least by Keynesians. I think there’s a case for saving. Saving is not just hoarded, it is invested in businesses and production. This is what creates wealth and jobs. This article may be useful:-

http://www.mises.org/story/3353

Also, see Hayek for criticisms of Keynes’ theories.

Aidan: I meant people who are top, not people who are at the top. Unfortunately, the correlation is imperfect.

Brian: Once full-grown, the human body is in fact in carbon balance. Although we emit a lot of carbon dioxide, we absorb the same amount. If not, we’d balloon or shrink to nothingness.

A carbon tax is indeed a tax on fuels, albeit differentiated by fuel type.

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