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I’m pretty sure many of our readers who missed it will get some entertainment from the archived version of Jill Kirby’s interview on Morning Ireland. For those who don’t know, Jill is the resident Austrian macroeconomic theorist at the Irish edition of the Sunday Times (double jobs as their personal finance expert, apparently.)  Late in the clip, a highly puzzled Tim Harford of Undercover Economist fame struggles to cope with the full breadth of Jill’s Austrian vision.

If media reports are to be believed, the government looks intent on pursuing a large, tax-led fiscal adjustment on April 7.  While determination to take resolute action in the face of the recent exchequer returns is understandable, I am concerned that both the size and composition of the proposed adjustment will deepen the risks facing the economy. 

(1) Size.   My first concern is that the planned adjustment is too large.   As pointed out by Jim O’Leary in Friday’s Irish Times, the adjustment is equal to a massive 3.5 percent of GDP in an already reeling economy. 

The government faces an unenviable risk-management tradeoff.   On one side, it must reduce the risk of unstable public finances.  An out-of-control deficit – with the contingent liability of the bank guarantee looming in the background – increases the risks of higher interest rates, a sudden funding stop, or an even more dramatic forced adjustment later on.   On the other side, a fiscal adjustment of this size runs the risk of intensifying the vicious cycle of contracting economic activity and falling willingness/ability to spend. 

If we assume the 9.5 percent deficit target was appropriate before the news of weaker than anticipated exchequer returns, then continuing to aim at this target means the risk-balancing response is focused only on the public-finances element.

This strikes me as extreme.  The rationale appears to be that the government has tied its credibility to keeping the deficit in single digits.   I think this stance would be correct if there were solid signs that domestic demand is stabilising.  As it is, a too-firm commitment means the government is locked into a potentially increasingly contractionary fiscal stance as the economy spirals downwards. 

(2)  Composition.  Again based on media reports, it appears that tax increases and capital investment cancellations/deferrals will bear the brunt of the adjustment.  Alesina and Perotti (1997)* refer to this as a Type-2 adjustment.   In contrast, a Type-1 adjustment focuses on cuts to the government wage bill and transfer payments.  Although credibly establishing causality with available data is challenging, the international literature has quite strongly concluded that Type-2 adjustments are both less likely to be sustained and more likely to be contractionary. 

The evidence points to both demand-side and supply-side explanations for the relative superiority of Type-1 adjustments.  On the demand side, Type-1 adjustments have a more positive effect on expected future incomes and on interest rates.  On the supply side, these adjustments tend to be more effective in reducing unit labour costs and thus in improving competitiveness.  Added to these effects, I believe there is reason to worry that a shift towards higher marginal tax rates will undermine future growth potential and lead to large deadweight losses.  (Even the relatively innocuous-sounding removal of the employee PRSI income cap will raise the marginal tax rate of those earning more than 52,000 euro by four percentage points.)  And, assuming tax rate increases reach deep down into the income distribution, there is a danger of higher equilibrium unemployment as a result of rising income replacement rates.

Is there a better way?  With a large tax-led adjustment as the default, is it possible for a union-supported “grand bargain” that is better grounded in what we know about successful fiscal adjustments?  

I believe this would be a more modest Type-1 adjustment combined with a well-specified medium-term fiscal consolidation plan.   Interestingly, this is likely to have a good deal in common with Ireland’s successful 1987-89 adjustment. 

I have no illusions about how politically difficult this would be in the poisoned aftermath of the pension levy.   However, the impressive NESC report gives some reason for hope, especially its emphasis on the power of shared understanding:

“[W]hile a fair sharing of burdens is critical to overall success, the politics that can ensure a sense of fairness (such as taxation and holding financiers to account) will not, in general, be very effective in addressing the economic crisis of firm closures and unemployment.  In this sense, the paper seeks to draw on the Council’s particular contribution to Irish policy – the willingness and ability of diverse actors to engage in honest, joint deliberation and analysis of evidence and explanations . . . It is the shared analysis that warrants an integrated response, not the joint engagement that warrants an agreed response.” (p. 5)

I urge the key actors to examine the literature on successful fiscal consolidations in forming this shared understanding.  I believe it would considerably lessen support for a Type-2 adjustment. 

Possible elements of a Type-1 adjustment adapted to Irish circumstances:

• A 10 percent nominal wage cut and (at least) a freeze in transfer payments in real terms
• Cancellation of capital expenditure projects where they fail a cost-benefit analysis on current information.   Deferral of projects only when there is substantial doubt about net benefits given the uncertainty about Ireland’s future trend rate of growth.   Projects with a high certainty of positive long-run net benefits should be funded now.
• The announcement (with as much detail as possible) of phased plans to broaden the tax base (including a residential property tax and a carbon tax)
• Announcement of plans to raise income tax revenues while limiting increases in marginal tax rates to the greatest extent possible (e.g., phasing out tax credits and child benefit payments at higher incomes)
• Removal of tax shelters of unproven effectiveness that contribute to a sense of unfairness
• If necessary, introduction of a Obama-style higher third rate of income tax that raises marginal tax rates only in the thin part of the income distribution
• Announcement of plans for comprehensive pension reform to deal with what is now a major source of social insecurity

*Alesina, Alberto, and Roberto Perotti (1997), “Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects,” IMF Staff Papers, Vol 44, No. 2 (June), pp. 210-248. 

The CPI has fallen 1.0% sa in February and 3.9% in the four months since the turn in October (versus 4.4% unadjusted). HICP is down 1.1% sa in the three months since its later turn in November. The HICP fall of 0.6% sa in February is its largest to date. The difference between the two is mainly mortgage interest – owner-occupied housing costs are excluded from the HICP.

Year-on-year carryover in the CPI (what the year’s avg for 09 would be versus 08 if there is no further change from Feb) is now -2.7%. At Budget time in October, the expectation was for about +2.5%, so a prospective gap has already opened up of over 5% against Budget-time expectations, even if there are no further CPI falls. The recent ECB cut would have been too late for the March CPI (taken on second Tuesday) but will impact April, as will electricity and gas price reductions. If there are excise duty increases on April 7th., they would be just in time to impact April figs also. It is difficult to know if the currency appreciation against sterling has passed through yet, and there could be some increased outlet substitution bias problems for the CSO to grapple with. Overall there could be some further monthly falls, but the 1%-per-month drop in the CPI can hardly continue for long.

For 5 marks: What would the Budget in October have contained had the Minister known what was going to happen to CPI inflation?

In a recent post, Patrick Honohan raised the issue of what a sustainable tax system would look like, and in a follow up to that post, discussed whether a goal of keeping low income workers out of the tax net implied, with the current tax revenue requirement, tax rates on other earners that were so high as to have serious disincentive effects. In the ensuing discussion, John McHale suggested that I was being too sanguine about the incentive effects at the top of the distribution and helpfully pointed me towards a literature that I wasn’t familiar with, on the tax rate elasticity of taxable income, and particularly to a paper by Gruber and Saez (J.Pub.Econ., 2002), which finds an average elasticity of 0.4, with higher elasticities for high earners.

There are two reasons why we should be worried if income elasticities for this group are so high. First, a pragmatic one: it suggests that revenue will rise relatively little if we increase tax rates on this group. Second, a more worrying one: this group contains the job creators; if they’re discouraged from taking the risks and reduce their labour market effort, then there are far bigger knock-on effects in jobs that would have been created with lower tax rates, but now won’t be. The latter concern dominates much of the discussion on this matter – see, for example, Greg Connor’s comment here.  

And so, an elasticity of 0.4 would indeed have to cause a rethink on my part. So I went off to read the paper.  

The paper is fascinating. It does indeed find an elasticity of taxable income to marginal tax rates of 0.4, with an even higher elasticity of 0.57 for high earners. (Note to explain the counter-intuitive sign: this is actually an elasticity wrt the net-of-tax rate, i.e. if the marginal rate goes up by 1%, so that the net-of-tax rate goes down by 1%, this causes a 40% decrease in income). But the elasticity of ‘broad’ income – income before tax exemptions are taken out – is much lower; it is 0.12 on average, and 0.17 for high earners. The bulk of the difference between these two elasticities is due to changes in what the authors call ‘itemization behaviour’ – in other words, tax avoidance. This point is reinforced by several other analyses in the paper.

One of the two policy conclusions drawn is that 

“[t]he large elasticities that we observe are driven by ‘holes’ in the tax base that allow taxpayers, particularly at higher income levels, to reduce their tax burdens. With a broader tax base we would distort behavior less and could therefore raise revenues more efficiently.” 

[The second is that concern about the distorting impact of high implicit tax rates in the $10k-$50k income range due to changes in effort (hours) “…may be overblown”, and that attention should instead be paid to incentives that reward participation rather than marginal increments to hours worked.]

So the paper’s message is (i) that the effect on (potentially job-creating) effort by high fliers of increasing tax rates is not zero, but is not high and (ii) that getting rid of tax write-offs should be a priority, particularly if marginal rates on high earners are to be raised.