Category: Economic Performance

The media reports suggest that ICTU has proposed a new top income tax rate of 48 percent. If various levies are added to that, the effective marginal income tax rate for high-ish earners could exceed 50 percent.

I am interested in the views of this blog’s readership on the extent to which a top tax rate in this range might adversely affect economic performance, in the specific context of the Irish economy and the Irish labour market.   For myself, I think it is important that the top tax rate in Ireland does not deviate too much from the UK top rate, which is due to be raised to 45 percent after the next election, in view of the high labour mobility between Ireland and the UK.

Richard Tol is today’s contributor to the Irish Times series: “The Right Cuts in Spending Will Not Hit Recovery‘” . Richard moves beyond the ‘broad parameters of adjustment’ approach by specifying a detailed list of expenditure items for pruning.  Let us see if ‘An Bord Snip Nua’  follows his advice.

With the massive hole in the public finances, it seems unavoidable that the tax take will rise sharply.   On the positive side, Ireland at least has more tax room than other countries.   On the negative side, near-term, large-scale increases in taxes will further harm demand leading to a further turn in the vicious cycle.   Indeed, the expectation of lower after-tax income must already be curbing household spending.    Moreover, higher taxes will undermine the incentives-based model that has underpinned Irish growth. 

What to do?  

I have previously thought Ireland was fortunate to have avoided an unfunded earnings-related state pension system.   But it is time for some new thinking in what is now a full-blown economic emergency.   Weighing the benefits against the costs, I think a “notional defined contribution” unfunded system would be a large net positive.   Under this system, benefits are rigidly linked to earlier contributions.   For a given contribution rate, contributions receive a “notional” rate of return equal to the growth rate of the wage bill.   But the system is unfunded, so that the revenues are made available to the government today.   There is effectively a “free” period where the government receives revenues but does not have to pay out benefits. 

Why is this a good idea?

First, and most immediately, it would allow for a sizable inflow of funds to the exchequer.   With a contribution rate of 6 percent and a base equal to the entire wage bill, the government would raise roughly 4 percent of GNP (assuming a labor income share of GNP of two thirds—hopefully someone can fill in the correct labor share).    This would largely meet the massive correction penciled in for 2010 and 2011 (though it might make sense to phase it in more gradually).  

Second, the disincentive effects of higher marginal tax rates would be greatly diminished by the strong link from contributions to benefits.   Indeed, it is reasonable not to refer to the contribution rate as a tax rate at all.   The alternative of dramatically higher income tax rates is likely to be a huge drag investment and enterprise going forward. 

Third, the adverse effect of the fiscal correction on expected lifetime income would be minimized as today’s contributions lead to higher future benefits   This is critical in an environment where household confidence in their future after-tax income has collapsed. 

Fourth, the decimation of many private-sector defined-benefit schemes has left many workers dangerously exposed.   At least for those earlier in their careers, this scheme could help build pension “wealth.”

One way to view the policy is as a form of long-term borrowing from current workers.   It is a response to the fact that traditional borrowing through the debt markets is, many believe, reaching its limits.   In return for their contributions, workers under this policy receive a special form of asset–a promise of future benefits that is tightly linked to their contributions.   While there is a risk that the government will renege on its benefit promise.  The recent experience with losses on financial wealth should be borne in mind in assessing the extent of risk in this system.    

A word of caution:  I think it would be critical to avoid turning this into a redistributive scheme.   Lifetime redistribution should continue to take place through the flat rate pension/proportionate PRSI contribution system.   Blurring the link between contributions and pensions would greatly undermine both the incentive and relatively benign income expectation effects of the policy.  

I think it would also be a mistake to demand employer contributions.   Unlike the employee contributions, employer contributions would be a pure labour tax, the last thing that is needed right now.   It would probably also make the policy a political non-starter in the current climate. 

I don’t pretend this is a free lunch—future generations would be stuck with it.   But it may be the closest thing to a free lunch we have.   As a general rule, it is not wise to make long-term policy such as pensions policy to deal with a crisis.   However, it is worth remembering the US Social Security system was introduced during the Great Depression.  

It is far from perfect.  But what are the alternatives?