Wednesday, April 1, 2009

Budget anyone

At its simplest taxes can be grouped into three categories: income taxes (when you earn money), sales or consumption taxes (when you spend money) and wealth taxes (when you have money). In Ireland we use income and consumption as tax bases but the third tax base of wealth has been largely ignored.

With our existing consumption and income taxes, tax revenue for the Government peaked at €47.3 billion in 2007. In the following year, 2008, the figure had fallen to €40.7 billion. The latest Government estimate for 2009 revenue is only €34 billion and without substantial changes in Tuesday's budget this figure is likely to be optimistic and I imagine that it will not be much over €30 billion. This decrease represents a collapse of tax revenue of about 33%. Not even the most pessimistic of forecasts have the economy contracting by anything more than 8% to 10%. Why has tax revenue collapsed at a speed more than three times the rate of the economic downturn?

The main reason is that tax revenue was closely tied to activity in those sectors that have been hardest hit by the downturn - construction activity and property sales. For example in 2007 stamp duty receipts were €3.2 billion, in 2008 this had halved to €1.6 billion. Early indications for 2009 suggest that stamp duty revenue will be below €1 billion. Almost 80% of stamp duties come from property sales. Similar patterns can be seen for income tax, VAT, capital gains tax and other receipts from the construction and property sectors.

Over the last few years we have used these transitory revenues as if they were permanent and have expanded the public service such that it now costs roughly €50 billion to pay for the day-to-day running of the government and public sector. When revenue is over €47 billion this is not a problem. As the windfall taxes from the property sector have now dried up and revenue will be no more than €34 billion we can see that there is a huge "hole" in the public finances.

When we add in long term or capital expenditure of about €10 billion the gap between revenue and expenditure for 2009 could be in excess of €25 billion. At the end of 2007 our total National Debt was just €37 billion. By the end of this year it could have doubled in just two years and will continue growing rapidly in the medium term.

In 2007 the level of economic activity in Ireland as measured by GDP was just over €190 billion. The €47 billion tax take of the government was about 25% of that. This is low by international standards so we do not pay a lot for government in this country. The average in the 30 or so richest countries that make up the OECD was 36% with rates of 50% in Sweden, 38% in the UK, 36% in Germany and 28% in the US. The collapse in tax revenue will see this ratio head towards 20% for 2009.

Clearly there are long term structural problems in Irish budgetary procedures that allowed the temporary tax revenues of the construction boom to be considered permanent. A time of crisis is not the time to be undertaking a radical overhaul of the system but the simple fact is that we are not paying enough tax. In fact about 40% of workers pay no income tax, though they do pay the levies.

In the space of two years the amount of tax we are paying has fallen by over €15 billion a year. This is money that the government was collecting from tax payers. As the source of much of the revenue has dried up (the construction and property sectors) our taxes have to be rebalanced in order for revenues to rise. There should also be continued adjustments on the expenditure side to row back on the increases in pay and size of the public sector that were financed by the now departed boom.

On the tax side it must be decided who will shoulder the burden and whether the taxes will be on income, consumption or wealth. Increases in income taxes are inevitable but most people would prefer to be paying income tax than face the unemployment alternative. We are unlikely to see significant changes in consumption taxes as our VAT rates are already high when compared to the UK but there may be some increases in some specific excise duties. The use of wealth as a tax base of has been missing from the Irish tax system since the abolishment of the short lived Residential Property Tax in the mid-1990s, but maybe it is time for us to reconsider wealth taxes.

This may mean the re-introduction of a property tax. Although house prices are falling they are still significantly ahead of where they were a decade ago and many people have seen a significant rise in their net worth. One danger of introducing a property tax is that it will simply place an unbearable burden on those who got on the property ladder in the last few years and have paid huge amounts of money for their home. A significant portion of the cost of a new house goes to the government (upwards of 25%) while buyers of second-hand homes will have paid stamp duty of tens of thousands of euro. These buyers are trying to pay off substantial mortgages that in many cases are now greater than the value of the houses as the spectre of negative equity has become a reality. Although these people "own" their home they are not wealthy and in buying a house have already contributed heavily to the Exchequer.

If a property tax is going to be introduced it should be a tax on actual wealth rather than on simply owning an asset. Owning an asset does not make you wealthy if you have the matching liability of a mortgage. We tax income not work and buying goods rather than using them. Although we have work and consumption taxes we only tax work when it generates income and consumption at the point of sale. If we are going to introduce a wealth tax it is important that the tax actually targets wealth. Imagine a work tax that imposed a tax liability on the work of cutting the lawn or cooking the dinner!

A second problem with a property tax is people who are asset rich but cash poor. These are mainly older or retired people who continue to live in the family home that can be worth hundreds of thousands of euro. However, their pension incomes may be relatively low and the imposition of a property tax may place a burden on them that is impossible to meet from their income. This may force some people to sell their home in order to pay the tax and this is a distortion that should not be caused by the tax system.

Taxing flows of money with income and consumption taxes is relatively straightforward and people only pay tax if they actually earn or spend money. We have seen that this is not the case with taxing wealth but that means that the introduction of a such a tax has to be carefully considered rather than just dismissed.

So what will happen in the upcoming budget? (When did we stop calling it a mini-budget?) In all likelihood it will not be as bad as some commentators are suggesting. The ground has been well cleared for most of the major announcements. There will be some further cut backs in expenditure. What they will be is anyone's guess but there is the possibility of some cuts in social welfare (taxing or reducing child benefit). On the tax side there will be increases in income taxes (the income levies and PRSI). There will be increases in some of our specific consumption taxes (fuel and alcohol). In all likelihood a wealth tax will not be introduced but we will see the path set for the introduction of a property tax in the next budget. As outlined above they have some issues to iron out first. All we're missing is the token "green" measure (it will not be a text tax!) and that's pretty much it.

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