Taxes and the Price Level

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It looks like the CPI will fall by a substantial amount during 2009 due to the economic slowdown, the weakness of Sterling and the cut in mortgage interest rates, amongst other factors.

This provides an opportunity to raise VAT and excise taxes, in view of the fiscal situation (less painful to raise indirect taxes when the CPI is in decline than when the CPI is increasing). The is the mirror image of the situation several years ago, when Ireland’s relatively high inflation rate led to widespread calls for cuts in indirect taxation in order to combat inflation.  While there would be undoubtedly some leakage across the border,  an increase in indirect taxes should be a significant source of revenue.

In a way, an increase in indirect taxes can be interpreted as a mechanism by which the government can reap some of the gains from the terms of trade improvement that is embedded in the appreciation of the euro against Sterling: this provides a real income gain for Ireland vis-a-vis other euro area countries, since Ireland imports much more from the UK than is the case for other euro area countries.

The regressive nature of indirect taxes can be taken into account in terms of the overall package of tax and welfare policies.

16 Responses to “Taxes and the Price Level”

  1. Niall Says:

    The only sensible adjustment to VAT is downward. Any further movement upwards creates an increased discrepancy between Ireland & countries such as the UK & Luxembourg with the lowest possible rate @ 15%. This has huge implications to the delivery of software, which is now normally done by electronic means. It is treated as the provision of a service when delivered in this manner and is charged to VAT in the country of supply ( B to C)

    If the UK could hold their standard rate @ 15%, literally thousands of Irish software jobs would go to the UK. A low consumption tax is far better for such companies than a low rate of Corp. Tax.

    I would suggest two basic changes could yield substantial amounts of tax,

    a) A tax on all car parking spaces @ €1000 per annum. The pollution arising from out of town shopping centres create huge amounts of traffic and pollution. This would be an appropriate Pigovian solution. The owners of the car parking spaces would be free to pass on the charge to the actual users or absorb it.

    b) A property tax chargeable based on the lower of a % of the value or an amount per sq. metre. Houses, which are not principal private residences would be charged at double the standard rate. All holiday homes, including those located outside the State would be chargeable.

  2. colm mccarthy Says:

    Niall, tax competition is pretty important, I think, and our top VAT rate, now 21.5%, is well ahead of UK. But our indirect taxes on petrol and diesel are below UK, and we don’t have a land frontier with anyone else! There are other issues – tobacco taxes are below UK, but there is already a serious smuggling problem. Alcohol taxes cannot drift significantly ahead of Northern Ireland.

    Under current arrangements, if your employer gives you a car, you pay income tax on the benefit-in-kind. But if you receive a free parking space, there is no BIK. In central Dublin, a parking space is worth €3,000 pa, as much as the annual value of a mid-range company car. Charlie McCreevy, when he was Finance Minister, announced that he wished to explore BIK on parking spaces, but it never happened. BIK could be a better option than Niall’s €1,000 per space tax – it’s incidence is automatically on the end-user.

  3. Mark Dowling Says:

    VAT > 21.5 will only increase cash deals and other evasions, queues between Dundalk and Newry and bookings for transatlantic shopping flights. Decreases in prices will be welcome news for the tourist industry – I was fleeced last time I was home. A new 25pc super rate could be considered for services which have low evasion possibilities like cable TV with importable goods reduced to 20.

    This would be part of my hitlist of revenue sources and taxpayer reliefs:

    1. Taxing *all* State supports as income – no more tax free money of any kind. This would include child benefit, rent supplements, bill payment assistance, student grants, first time buyers grants etc. That’s not to say you automatically demand large tax bills at the end of the year for those above the exemption threshold, but allow deferment so that in the event of an increase in income, it can be progressively recovered.

    2. Convert DIRT to a withholding income tax by requiring a PPSN for all domestic bank accounts, converting the post-annual return hit to marginal rate. (It’s how it works in Canada so it must be right)

    3. Convert the TV licence to an equal level block grant (it’s how it works in Canada so it must be right), dismiss the inspectors and withdraw all pending evasion proceedings from the courts. They’ll be busy enough in the coming months.

    4. Parking tax on ALL commercial parking spaces including shopping centres, with the local authority obligated to demonstrate the equivalent cost rather than a nationwide flat rate. Local authorities permitted to levy tax on off-street residential parking which entail the loss of an on-street space – I pay about C$140/year to the City of Toronto for mine. I think a BIK is only tenable in cases where a specific space is reserved for an individual.

    5. Abolishing Seanad Eireann. It would be a shame to see David Norris turfed out but we have no real need for a trainee TD factory/retirement pasture which has historically shown little of the gumption and necessary correction of their Lower colleagues delivered by their Lordships in London.

  4. Graham Stull Says:

    Can I hold up the flag for tax progressivity? A not-so-much mentioned point is that excise – that most regressive of taxes – must now account for a greater percentage share of the total tax take than it did a year ago, making the whole tax system automatically more regressive.

    Increases in our already-regressive indirect tax system will only exacerbate this situation.

    Aside from the human dimension, we cannot forget that increasing progressivity is a cheap way of stimulating consumer spending.

  5. blk Says:

    Philip Lane’s arguments have been already refuted by the present day reality. Ireland raised VAT in October 2009 and saw massive fall-off in VAT revenue and lines of cars going across the border to shop in Northern Ireland. Go ahead, hike the VAT rate again and see revenue vaporize. The idea that taxing consumption more at the time of collapsing consumer confidence, rising unemployment, rampant build-up of precautionary savings and shrinking (real) incomes can be revenue enhancing exemplifies some of the worst disconnection with reality that some of our academics exhibit from time to time.

  6. Philip Lane Says:

    As blk lays out, many negative factors are hitting the Irish economy. Accordingly, the question is whether, conditional on all of these negative factors occurring, an increase in VAT raises revenue relative to a no-change scenario. The vast bulk of consumption spending still occurs domestically, such that revenues should rise (relative to a no-change scenario). I do agree this may not be true for ‘concentrated’ expenditures such as alcohol.

    It is always regrettable to raise distortionary taxes – but the choice now is to design a tax programme that exerts the least harm and an ‘interior’ solution that looks at (nearly) all dimensions of the tax base is a natural benchmark.

  7. Paul Power Says:

    I am not sanguine that a “temporary” increase in VAT will easily be reversed. The politicians may vote to reduce the rate but retailers will keep the higher prices. (Think of what happened when minister McCreevy reduced the VAT rate not long ago)

  8. John McHale Says:

    If VAT is to be increased, there is an argument for announcing the rate increases now but deferring their implementqtion until later (say a year from now). While the announced rate increase would have an immediate negative income effect, there should be a positive intertemporal substitution effect as purchases are brought forward.

    (Following an argument made by Larry Kotlikoff and Ed Leamer, I had earlier toyed with the idea of a temporary VAT reduction: http://blogs.ft.com/economistsforum/2008/10/running-a-national-sale/. The recent exchequer returns make that a non-starter.)

    The advantage of the deferred increase approach is that it lessens the immediate contractionary effect while still supporting a medium-term fiscal consolidtion. The disadvantage is that there is no guarantee domestic demand will be in any better shape when the actual increases go into effect.

  9. Ismail Alyanak Says:

    Raising VAT may actually a good way to keep prices up, in a situation with falling prices this may indeed induce people to buy more rather than less, in particular just ahead of the rise. This is exactly what happened in Germany in late 2006 when the VAT rate was set to rise from 16% to 19% in January 2007. Furthermore, if prices are falling a VAT increase will not cost the customer anything.

  10. Antoin O Lachtnain Says:

    The problem is that the customer has less money in his pocket, making him more price sensitive and more likely to go further afield to save on the tax.

    Tax is now a competitive game to some degree. Surely it would make sense to bring a lot of our rates into line with the UK? If we brought everything into within 2.5 percent of being in line with the UK, generally slightly higher, where would that land us? I presume we can rely on some increases in indirect taxation in the UK in 2010 when they are supposed to put VAT rates back up?

    Re the VAT rate – the biggest effect of this at the moment is in the TV business. Satellite subscriptions are generally paid to Luxembourg companies (this includes subs to Setanta, an Irish company). However, this loophole is going to go away within a few years from what I understand. I don’t think this loophole will exist too long for software, but I don’t really know. I can’t see it having an effect on the software writing industry, but it certainly makes a difference to the structure of how you sell it.

  11. Robert Browne Says:

    Philip, the government has no logical prospects for raising VAT levels, which are already seriously out of kilter with NI. There seems to be a wishful thinking bias coming through from certain quarters. The idea is, that, there is a Klondike out there. That, all the government has to do, is, put another few percentage points on to indirect taxes and they will strike the mother lode.

    Basically, consumers know where to get cheap drink, cigarettes and other goods and have more than demonstrated their willingness to get them. The problem, as Colm McCarthy has said, is the substitution effect, both legal and illegal. It accelerates as the government tries to raise taxes. Especially, in the type of illiquid, cash strapped consumer market that we have at the moment. it ends up, actually driving down returns. This has already happened and why people choose to ignore this is beyond me. There is an unhealthy bias amongst economists towards economic paradigms and a sort of slavish kowtowing to graphs, indices and models.

    All of which, I might be impressed with, had they been able to predict the current disaster before it happened rather than in retrospect. We have witnessed unprecedented wealth destruction and only a handful of people predicted it and even those individuals were way out on the severity of their forecasts.

    Sometimes I think economists are against common sense. It’s as if, common sense being so uncommon, is not to be trusted. Let me remind people, if they need reminding, that the sacred market place, was neither rational, intelligent nor self-regulating. However, the fallacy, which this logic represented, continues to be pursued unabashed by the majority of the Irish economic intelligentsia.

    I have spoken about this before, but will repeat it, the biggest challenge the government faces, at the moment, is the irrationality in the market place and the psychological warfare being played out across the economy by consumers of goods and services. The government have shown themselves to be totally bereft of policies to deal with this. Furthermore, when I look at consumer spending I am not just talking about disposable income or discretionary spending. Rather, I am talking about significant buffer savings, cash and other near liquid assets that people can, and would bring into play, if the right climate was created. But it is simply not being created. Because the government and their advisors are myopic when it comes to the psychology of the market place or behavioural finance.

    In Ireland, we economists still believe we can calculate likely exchequer returns with a calculator and a spreadsheet. We should know by now it is not that simple. We are the only economy in the world at the moment, that thinks it can achieve economic stability by cutting expenditures and putting indirect taxes such as VAT and other taxes through the roof. It is the WRONG policy. At a minimum, It will lead to catastrophic job losses.

  12. Stuart Blythman Says:

    I was at a conference in NI a couple of weeks ago and was heading home Sunday evening around 6pm. I was stuck in heavy traffic all the way to Dublin along the M1.

    Stick VAT up and watch the VAT take come down as more people switch to the North.

    Look at CGT, it was reduced by half and the take increased.

    Higher tax does not result in automatically higher revenues.

    Why not try a reduction in VAT to the UK level and see what happens. If it converts shoppers to shopping at home it could be worth it. Retailers who don’t pass on the reduction can be named and shamed. Retailers are more afraid of negative publicity in newspapers than government inspectors.

  13. Marcus Says:

    Just read this IT article on calls for a €2 increase in cigarette prices. The Irish Cancer Society claim it would raise €420m – is this likely? Have they taken elasticity/smuggling into account?

  14. Brian Lucey Says:

    The VAT revenue in particular is so fragile that it is worth, imho, an experiment in reduction to more sensible levels. Apart from the issue of substitution, it adds to the cost base here making this country eyewateringly expensive. I had a japanese journalist in the office today- she was comparing costs (unfavourably) to london and Tokyo…..

  15. Mark Dowling Says:

    “Look at CGT, it was reduced by half and the take increased.” Cut it as far as you like now – not much capital to gain these days. CGT was a windfall which married a pent up demand to sell assets previously inhibited by the tax rate to a market willing to pay whatever was asked. Who’s got a big capital gain to book now?

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