Belfast Telegraph

Saturday 25 October 2014

To fix current tax issues we must go back... to the future

There comes a point in life when one becomes convinced that they did things better in the old days.

The arguments in favour of this proposition seem quite overwhelming but, since one heard one's parents and grandparents say the same thing, the best policy seems not to mention it - or at least mention it as little as possible.

So it is a bit confusing to find nostalgia becoming part of the economic consensus. Even more so since it is not a question of looking back wistfully to the dim and distant past, but to those not-so-far-off happy days of, ahem, 2004.

The new Central Bank governor, Patrick Honohan, has suggested that we should fix our eyes firmly on five years ago.

There was much of the same at last week's gathering of economists in Kenmare, with the only argument seeming to be whether the land of lost content was 2004 or 2002.

The idea is simple and, on the face of it, attractive.

Five years or so ago was the last time the economy was in balance, before the credit bubble began to inflate. The government finances were in surplus, the balance of payments was in surplus.

It need hardly be added that the banks had lent only their own money, rather than foreigners', and that unemployment was 5%.

Happy days of yore, indeed. The fact that it is such a short time ago gives force to the idea that it should be feasible to restore some, at least, of those conditions. It is only five years ago, for goodness sake!

The point about 2004 is that economic output and tax revenues have now returned to those levels - a bit less in the case of tax revenues.

As befits a man who was not only on the first Bord Snip, but invented the name, Colm McCarthy has been drawing several historical analyses from the past 30 years, as well as the past five.

One of the things he notes is that around half the growth since 2004 was driven purely by borrowed money, and has disappeared with the credit which delivered it.

The other half, maybe 7% of Gross Domestic Product (GDP), should return when recovery comes. The rest - €9bn (or so) of construction and consumption - is gone for good.

The attractive bit of the back to the future idea is those tax revenues. If €36bn in taxes could deliver budget surpluses in 2004 and, as Mr Honohan said, give most of us what seemed at the time a remarkably comfortable living standard, is there any need now for big tax rises at all?

There will, after all, be some automatic increases in tax revenue when growth resumes. Several economists, including John Fitzgerald and Jim O'Leary, believe this natural 'elasticity' will be greater than the Department of Finance predicts. We could perhaps get back to €36bn without any new taxes.

What is true, is that past tax revenues tell a more complex story than the popular version that Charlie McCreevy cut tax rates in a blind ideological fit, and now we can't pay for anything. Yet, even under Mr McCreevy's tenure, the bulk of tax cuts came in the form of increases in bands and credits, which was the preferred option of the trade unions and much of the media.

As might be expected, the cutting kept pace with the bubble economy after Mr McCreevy's defenestration to Brussels. The personal credit increased by 22% from 2003, and the one-income married tax band went up by 16%. The effect - indeed the ostensible purpose - was to take people out of the top rate and take others out of the tax system altogether. Up to 800,000 workers - one third of the total - were not liable for income tax last year - something which makes Ireland very unusual.

It raises the politically terrifying question as to whether the public finances can be balanced without more of these 800,000 paying income tax.

Only an optimist would expect credits and bands to be increased in the December Budget - but could they actually be cut? It seems unthinkable, especially if Mr Lenihan sticks to his opposition to a third rate of tax for higher incomes.

This had already gone long before 2004, but a two-rate system is also unusual and makes it difficult to keep down the marginal rate for middle earners. With PRSI and levies, that marginal rate is already 51% for a single person's earnings over €35,000.

Even though the tax burden is at 2004 levels, that marginal rate is closer to 1980s stuff. And, of course, it is not the only thing reminiscent of the 1980s.

The 2004 tax burden could pay for a 2004-sized public sector, as it did. But we have a 2009-sized public sector - which means government spending is at the same level as 1983, relative to the size of the economy.

That is why there is no easy road back. In 1986, after four years of fiscal correction, the tax burden was 37% of national income. In the happy year of 2004, it was just 27%.

In this year of recession, tax revenues look like being about 22% of Gross National Product (GNP).

I fear that even 2004 was a land of illusions. One cannot fund a modern society from not much more than a quarter of income.

The 37% tax burden of that annus horribilis of 1986 looks a much more realistic figure for what should be the cost of running the Irish state.

The operative word is 'should'. The year 1986 was horrible, not because of the size of the tax burden, but because of the reliance on income tax and the fact that borrowing was 11% of GNP. If we're paying 1986 taxes this year, borrowing would again be 11% of GNP -perhaps more.

It would appear that, to achieve any long-term stability in the public finances, not only must there be a significant increase in the tax burden, but the size of the public sector must be cut by a similar amount - perhaps 5% of GNP in both cases.

They had to raise taxes in the 1980s, but they did not have to shrink the State.

They did not even have to think such things in 2004, when the day-to-day surplus was €5.5bn. As the British prime minister Harold MacMillan said, there is no time so distant as the day before yesterday.

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