Written for the RENUA flat taxes event today.
When all the little economists are in short pants, we learn the principles of public finance. Governments have to tax households and firms in order to provide services the market won’t, like libraries, street lighting, and national defense, as well as redistributing income from the rich to the poor as an aid to social solidarity. Taxes are a necessary evil. All taxes induce distortions to people’s behaviour. Some distortions, like the plastic bag tax, are clearly good. They make almost no one worse off and make lots of people better off. Recurrent taxes on property are in fact the least distortive to long run GDP per capita we have. While a site value tax would have been perfect, the LPT does a similar if suboptimal job.
Some taxes are highly distortionary, such as a very low corporation tax rate, or a very high income tax rate. These make lots of people better (and worse) off and damage important incentives. An efficient tax structure would deliver the funds to power public services with the minimum of distortions to individual and collective incentives. The theory of public finance has come around to the view that marginal taxes are not the most important thing to worry about, in information-opaque systems, the average tax rate should be relied on most heavily. The all-in tax rate for personal income tax & employee social security contributions is 52% here, relative to 46% on average across the OECD.
Perhaps more importantly, the ability to balance the average tax rate with a corruption-resistant tax structure through which taxes are collected and disbursed is a major asset of any public finance structure. Important results have now been established showing the spread of corruption is quite badly affected by the ease with which the variables which determine the tax base can be manipulated by those in power. If we worry about the Noonan-end of the tax gathering element first, then, two principles which therefore make sense are simplicity and certainty with respect to the tax system.
None of the above is an argument for a flat tax: they are desirable elements of any taxation system. Given what we know about the Irish taxation system and its highly pro-cyclical features, we are aware that how the taxes are collected, and from whom, matters. The income tax system is really complicated by many tax credits, reliefs, exemptions and deductions. Figure 1 shows in percentage terms just where we got those taxes over the last 10 years or so. The transition to an income-tax based system by 2015 is clearly a result of large negative changes occurring elsewhere in the system, and I needn’t spend time on that for this audience. Figure 2 shows who pays these taxes, and in what quantities. Clearly there are progressive and regressive elements within our taxation structure, with the poorest households paying a whack of their income in taxes, and the richest 30% accounting for the vast bulk of the taxes we need to run the system. Only 18% of all tax payers pay the higher rate, while 45% pay the standard rate and 37% are exempt. Figure 3 shows the disjunction we have between our average and marginal tax rates by income category.
The system, by the way, costs about 44 billion to run in a given year, before we think about paying interest on the national debt or other obligations. A de minimus requirement of the flat tax would be that it generates as much, or, more, in revenue, as the current system—roughly €18 billion by the 2016 forecast. But more on that in a few paragraphs.
Figure 3 shows Ireland’s taxation system is pretty biased against those starting up businesses, and those in the €30,000-50,000 threshold, who get hit with the same taxation structures as those on €100,000, but without the creature comforts or access to accountants to allow them to offset these impositions. The marginal space is non-linear, while the average space is fairly curva-linear. The theory of public finance suggests that when the tax is collected only from one sector of the economy, the effects are highly distortionary and suppressive of economic activity. Differentiating who actually pays taxes and in what amounts therefore makes lots of sense purely on equity grounds.
The system is a mess. Starting from scratch, you would not start here. Does a flat tax deliver large changes to the system? The advantages of a flat tax are simplicity, a constant average tax rate, and no weird threshold effects. It would be corruption resistant since, with one stroke, you would remove large chunks of the tax code to the trash bin.
A flat tax works by levying a percentage on all income above a minimum threshold. The welfare loss to the poorest households. Single people earning less than €20,000 and married couples earning more than €30,000 both are taxed at a rate less than 5%, for example, in the current system. They would clearly need to have their income taxes under a flat tax system offset using a tax credit, which drains the system some what.
The political considerations would be quite large in the calculation of where the tax credits and the rate would go.
To my mind, given the system that we have now, a move towards a flat tax rate of 35%, with quite a large basic income support of €4,000, would move the system towards a minimal distributional impact. A 23% policy would be harmful to the poorest in the current set up, with the winners here being those at the top of the income distribution.
Update: Karl Whelan wrote on the subject of flat taxes a while ago, I missed it, his thoughts are here.
Contrast this to a simple change where the USC is put in place of the current income tax structure, with a non linear pickup from 2%, 11%, 17% in rates towards the OECD average of 46%. This would yield the magic €18 billion but would of course be hugely regressive.
So here, then, is the challenge RENUA faces: it has to calibrate its flat tax to be as progressive as possible while making the system produce €18 to €20 billion or so a year. This is a technical challenge but perhaps the more difficult challenge will be explaining the taxation change to the public.