Tax breaks for pensions

The Sunday Independent reports that an important debate is taking place within the Commission on Taxation:

“But its report may also call for a reduction in tax relief for ordinary private sector pension-holders and a “fierce argument” is raging within the commission over the €2.9bn cost of this relief versus the incentives that it gives to provide for the future.”

The idea of limiting tax breaks on pension contributions has received a good deal of attention, with Fintan O’Toole a notably vocal advocate (see here).  This focus is understandable given that the better off are the primary beneficiaries of the tax breaks.  

The fact remains that many households – even better off ones – are not saving enough to sustain their living standards in retirement.  This is compounded by staggering losses in both defined contribution and defined benefit pension plans.  (See Brendan Walsh’s post from December on the crisis in occupational pension plans.) 

The tax incentive can be viewed as a device to overcome the inertia that keeps people from making adequate pension provision.  As such, I would agree that it is not particularly efficient.  But it is encouraging to see that at least some on the Commission believe it is important to approach pension reform in a comprehensive manner rather than simply eliminating the existing incentive.

The Green Paper on Pensions looked at the possibility of moving to some sort of mandatory or “soft mandatory” (with default) contributions to retirement savings accounts.   Unfortunately, with households being squeezed from so many different directions, it is hard to see from where they would find the money.  In a post a few weeks back, I proposed the idea of a Swedish-style system of unfunded – or “notional” – defined contribution accounts that could at least reduce the pressure for other tax increases.

What is most important is that reforms take place in the context of an overall plan for the retirement income system.   The complexities and importance of pension reform are such that it should not be driven solely by short-term fiscal considerations. 

What makes fiscal consolidations successful?

Athough I don’t detect that much interest in the expansionary fiscal contraction hypothesis, I think it is important we don’t try to reinvent the wheel.   The determinants of successful fiscal consolidations was the subject of a large research effort in the 1990s.   The following passages from a paper by Alesina, Perotti, and Tavares give a flavour of the findings:

“Empirical work on the effects and sustainability of fiscal adjustments has consistently reached two conclusions.  First, long-lasting adjustments rely mostly (or exclusively) on spending cuts, in particular, in government wages and social security and welfare; by constrast, short-lived adjustments rely mostly on revenue increases.  Second, fiscal adjustments are not always associated with reduced growth, or with a deterioration in the macroeconomic environment in general.” (p. 200)

“Fiscal adjustments that rely on cuts in government transfers and wages and are implemented in periods of fiscal stress are long lasting and not contractionary.  On the demand side, the expansionary aspect of such fiscal adjustments works through an expectation effect, which is stronger the worse are initial fiscal conditions.  On the supply side, the interaction of certain types of adjustment — those without tax increases but with cuts in government employment and wages — lead to wage moderation, reduced unit labor costs, and increases in profitability, business investment, and production.” (p. 214)

The Minister for Finance might be interested in this:

“Furthermore, governments do not seem to be systematically punished at the ballot box for engaging in fiscal adjustments, nor do they lose popularity, as measured by opinion polls.  In principle, one can think of two explanations for this result.  One is that voters do not like fiscal profligacy.  The other is that governments are particularly skillful at choosing the appropriate moments to implement unpopular policies   While it is difficult to decide definitively, we conclude in favor of the first interpretation.” (p. 241)

Alesina, Alberto, Roberto Perotti, and Jose Tavares. (1998). “The Political Economy of Fiscal Adjustments,” Brookings Papers on Economic Activity, 1998.1, pp. 197-266.

Déjà Vu

“Indeed it was entirely through increases in taxation that the reduction in the primary deficit was achieved.  This also weakened the credibility of the government.   The failure to reduce public expenditure, or indeed the growth in the share of current expenditure in GNP, was a result of three factors.   First, the operation of automatic stabilizers, especially through a mushrooming of income support resulting from the sharp rise in unemployment.  Second, a conscious decision to maintain (and even, to improve) the real value of income support payments in an attempt to shelter the worst off from the fiscal adjustment.  Third, the inability of the government before 1987 — a coalition of trade-union and middle class interests without a parliamentary majority — to agree on the elimination or curtailment of any significant programmes [fn. Other than the deferment of some public investment plans] or to implement real wage rate reductions in the public service.   This last factor had a most debilitating effect on confidence in the government’s determination to set things right, especially considering the repeated government announcements that such retrenchment would be inevitable.” (p. 205)

Honohan, Patrick. (1989), “Comment on Rudiger Dornbusch, Credibility, Debt and Unemployment: Ireland’s Failed Stabilization,” Economic Policy, 4(8), pp. 202-5.

Expansionary Fiscal Contraction

The February exchequer returns combined with ongoing default risk perceptions mean the government has little choice but to bring forward its fiscal adjustment.  I have doubts, however, about one argument for front-loading the adjustment that seems to be gaining currency – that it will be expansionary.  

The classic argument for an expansionary fiscal contraction focuses on cuts to government spending.  Permanent cuts in government spending lead to expectations of permanent cuts in taxes.   The expenditure effect of the latter can outweigh the former (especially if starting from a large and distorting tax burden).   In contrast, the current Irish debate is focused on adjustment through tax increases.   With apologies for oversimplifying, the argument seems to be that households and businesses already expect higher taxes, but uncertainty about the precise nature of those taxes is causing increased precautionary savings and investment delays.  Eliminating this uncertainty would lead to increased domestic demand.   

Two comments:  First, if the economy contains a significant share of myopic/liquidity-constrained individuals as well as forward-looking Ricardians, the reduced precautionary savings effect of the latter would have be very strong to offset the reduced spending of the former.  Second, and less speculatively, the empirical work of Alberto Alesina, Roberto Perotti and co-authors finds that fiscal adjustments based on tax increases tend to be less durable and more likely to be contractionary.

I draw two tentative lessons.   The first is that a cautious approach should be taken to front-loading until we understand better the role of discretionary fiscal contraction in the extremely sharp slowing of the economy.  The second is that a narrow intertemporal macro perspective suggests a significant part of any adjustment burden should fall on expenditure.   I would be very interested to hear views on the relevance of the expansionary fiscal contraction hypothesis to the current Irish situation.

Crisis Prevention

The Irish economy is well removed from a full-blown financial crisis.   (I take it that the outstanding feature of such a crisis is the inability roll over liabilities.)  Even so, it is useful to review, with the Irish situation in mind, the list of crisis-prevention actions that received broad assent after the Asian crisis.   A reasonable overall assessment is that Ireland is still in a relatively strong position, but it is worthwhile to concentrate on minimising the remaining tail risk.    Here is a partial list: 

Exchange rate regime:  Avoid soft pegs.   This became known as the “bipolar view” – completely fixed or freely floating exchange rate regimes are the least crisis prone for countries with open capital accounts.   (See here for a recent thoughtful account.)  Being part of the euro zone is an unmitigated blessing in this regard. 

National balance sheet:  Avoid serious currency and maturity mismatches.  Here again the ability to borrow in one’s own currency is a huge advantage.   It also appears that the NTMA is doing a good job managing the maturity structure of the national debt.   The existence of the NPRF is also fortuitous – even if initially put in place for another purpose.   It should be viewed as a critical liquid reserve and not tapped as an easy source of funding.  Although no one likes to hear about IMF intervention or bailouts from our EU partners, I see nothing wrong with careful contingent planning and agreements.   I think it is highly unlikely that Ireland will need such funding.   But I think it is even less likely if arrangements are in place to smoothly access funding under extreme circumstances.   This would be a clear signal that the government will do everything possible to pay its debts, and would limit the risk of falling into the bad equilibrium that Philip Lane discussed in yesterday’s comments. 

Macroeconomic management:  Avoid destabilising fiscal policies.   Although Irish fiscal policy comes in for much deserved criticism, the dramatic reduction in the net debt put the country in a strong initial position.   Unfortunately, the running of a structural budget deficit during the property boom and the reliance on asset-based taxes left the country vulnerable.  The key question now is what deficit can safely be run.  One plausible view is that significant short-term consolidation is required to protect creditworthiness.   The danger is that this will deepen the recession and potentially even deepen the fiscal hole.  An alternative approach is to make the minimum adjustment necessary to show that the public finances are under control – clearly not a risk-free strategy either.  This debate will continue. 

Transparency:  The combination of non-transparent financial-sector balance sheets and implicit or explicit government guarantees is lethal.   It is indefensible that analysts are still trying to figure out how bad the bank balance sheets really are.  An open, Obama-style stress test is urgently needed to reduce uncertainty.

Regulation:  Err on the side of prudential regulation.  Evidently, the emphasis on prudential regulation lost out in the ever-present tradeoff between encouraging innovation and minimising systemic risk.   We have now had further confirmation of the tendency of financial markets to produce bubbles and the incredible damage that ensues when those bubbles burst.   There needs to be root and branch reform of the regulatory system to restore confidence in the system and ensure that balance sheets are never allowed to accumulate such vulnerabilities again.