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The scope for tax cuts is spelled out Back  
As the political parties draw up their election manifestos - one (or two) of which are likely to be the primary foundation of economic policy over the coming five years we compile the policy recommendations on a series of central economic issues in the election from a panel of professional economists, whose job is to get policy and forecasts right on a consistent basis the economic advisers in Ireland?s financial services industry. The survey results have been mailed to the policymakers of all of the political parties, as well as each TD and Senator in the Oireachtas.
The panel members were: Colin Hunt, chief economist and head of research at Goodbody Stockbrokers; Olivier Mangan, chief bond economist, AIB Group Treasury; Dr Dan McLaughlin, chief economist, Bank of Ireland; Alan Mc Quaid, chief economist, Bloxham Stockbrokers; Dominic Sutton, chief economist, Investec Ireland Limited; Eoin Fahy, senior economist, KBC Asset Management; Austin Hughes, chief economist, IIB Bank; Jim Power, chief economist, Friends First.

The first question was: ‘Can Ireland have more self-financing tax cuts?’.
There was unanimity within the panel as to the efficacy of tax cuts in regard to promoting faster growth in both the economy and in tax revenues, as indicated in the analytical assumptions put forward by each respondent.
For example, Eoin Fahy’s point that ‘while those opposed to lower tax rates suggest that the higher revenues were ‘just’ because of higher economic growth, they miss the point that the higher economic growth was in large part due to lower tax rates, which increased the incentive to work and to invest, and therefore increased the capacity of the economy to grow’ would be echoed by all respondents, although some members of the panel, such as Austin Hughes and Jim Power, make the point that if current expenditure is not reined in then tax cuts, whether self financing or not, will be impossible. The moral of the tale therefore for our politicians is that tax cuts can, and still could be, self financing in the next five years but this can only be guaranteed if public expenditure is kept under reasonable control.
Dan McLaughlin in his response (below) attempts to provide us with some measure of what ‘reasonable control’ might consist of he suggests that if real GDP growth is pegged at 6.5 p.c. and inflation at 3 p.c. then spending growing at a nominal rate lower than this would allow for further tax cuts.
Of course, an election manifesto costed on the basis of such projected growth in current expenditure might run the risk of being criticised as involving too much risk no account being taken of the possibility of economic downturn, or a growth in inflation more in line with the ECB’s target inflation rate of 2 p.c., above which Irish inflation might see the Irish economy progressively becoming less competitive by a rate of 1 p.c. a year.
However, a conservative growth and productivity assumption of, say, 3 per cent, combined with the ECB 2 per cent figure, could allow an annual projected growth in current expenditure of 5 p.c. a year (not necessarily capital expenditure, which includes necessary investment in infrastructure, for example).
This would leave Ireland in the happy position of being able to fund an annual improvement in public and social services of, say, 3 p.c. a year in real terms while at the same time, contemplating further self financing tax cuts. However, public spending commitments in excess of this would threaten to derail the productivity of the real economy the ultimate paymaster after all with the consequent risk of implosion, and the end of the Irish economy’s ability to out-compete the rest of the world.
Analysing the responses below we conclude that all 7 responses printed below are in the ‘Yes’ camp, with Austin Hughes, Jim Power, and Colin Hunt’s doubting comments all explicitly conditional on public spending getting out of control.

McLaughlin: Governments have no money of their own to spend and so the growth of tax receipts is the key constraint on exchequer spending. Revenue generally grows in line with nominal GDP, or at a slightly higher pace, so the economy’s potential growth rate is the ultimate determinant of the exchequer’s fiscal room to manoeuvre. Incidentally, it is GDP tha determines employment and taxation and not GNP, and as the Growth and Stability pact is also couched in GDP terms it makes little sense to concentrate on GNP. I would put Ireland’s potential GDP growth at 6.5 per cent-7 per cent over the next five years, declining from the higher level to the lower by 2006. Labour force growth has slowed from the heady days of the mid to late 1990s but is still likely to rise by some 35,000 per annum, equivalent to a 2.6 per cent-2.9 per cent annual increase in employment.
Productivity growth has averaged over 4.5 per cent in the past five years so if that is maintained the potential growth rate would be over 7 per cent Perhaps a more conservative assumption would be to use 3.7 per cent as the productivity variable, the average over the past 40 years, which yields the 6.5 per cent-7 per cent GDP figure. If inflation averages 3 per cent we then have nominal GDP growth of 9.5 per cent-10 per cent. If current spending is kept below this the tax burden could be cut or a higher surplus run on the current budget.

McQuaid: Given the deterioration in the public finances over the past twelve months or so, due mainly to a sharp fall-off in tax revenue, it is probably fair to assume that the numbers of people in the tax base are not sufficient to produce the required revenue. The current Government set itself a target of having a lower personal tax rate of 20 per cent and a higher rate of 40 per cent by the end of its five-year term. While it achieved the former, the latter is currently, 42 per cent. Personally, the most that can be hoped for is that this is reduced to 40 per cent, but in overall terms, I don’t see much further scope for self-financing tax cuts.

Fahy: The evidence of the last decade is that cuts in tax rates have accompanied substantial tax revenue increases. This was most clearly seen when the rate of capital gains tax was halved, but revenues soared. While those opposed to lower tax rates suggest that the higher revenues were ‘just’ because of higher economic growth, they miss the point that the higher economic growth was in large part due to lower tax rates, which increased the incentive to work and to invest, and therefore increased the capacity of the economy to grow. Can we imagine the state of the economy today if the top rate of income tax was raised to 65 per cent, and corporation tax and capital gains taxes were doubled?

Hunt: Given the maturity of the economy and the related normalisation of Exchequer revenue flows, any future tax cuts will have to be self-financing. That said, Ireland will be having more corporation tax cuts which in an improving FDI environment should be self-financing. Stamp duty on property and share transactions remains onerous by international standards and reductions here could be self-financing. Looking beyond those particular revenue headings, it is difficult to identify significant scope for further reforms. In the income tax area, the changes of recent years have dramatically improved the supply-side efficiency of the labour market and there is little to be gained at a macro level from further reductions. Tha t said taxation changes directed at eliminating social exclusion by reducing the costs of taking up employment are always desirable and self-financing.

Hughes: The evidence from the weakening of tax revenues in the past year is that we have passed the ‘sweet point’ where personal tax cuts boosted activity anything near sufficiently to be like self-financing. On the corporate tax front it is difficult to argue that there is scope to cut taxes sufficiently to deliver another wave of inward investment. At the margin, cuts in indirect taxes could have some economic benefits through
their potential impact on competitiveness. They might also help restrain public sector pay increases, but again, it might be a stretch to suggest these could be self-financing.

Power: Over the next five years I estimate that the potential growth rate for the Irish economy will be around 5 per cent, comprising labour force growth of around 2.2 per cent per annum and productivity growth of 2.8 per cent. It is unlikely over this period that actual growth will be capable of growing very much in excess of this level. Consequently, in this more sober economic environment, the scope for self-financing tax cuts will be very limited. How limited, will of course depend on the success achieved by the incoming Government in bringing current spending under control. Growth in current spending, which ran at 22 per cent in 2001, needs to be brought back to no more than 7 per cent per annum on average over the next 5 years. Failing this, the Irish deficit will test the Stability & Growth Pact. If these spending targets are not achieved quickly, self-financing tax cuts will be very difficult to deliver and on the contrary economically disastrous tax increases could become a reality.

Mangan: If growth in current government spending is reigned in, there could be scope for modest cuts in income taxes. The focus of income tax cuts should be to remove the lower paid from the tax net and widen the standard rate tax band. There is no pressing need for further reductions in income tax rates. Meanwhile, the surplus on the Social Insurance Fund means that there should be scope to reform the PRSI system and cut employees’ social insurance contributions. Otherwise, the rising surplus in this fund is likely to be tapped into by the government to finance increases in general government spending, as happened in the 2002 budget.
To help our Party Political Economic Policy Makers further, we elicited the estimates of each of the economists on the likely growth potential of the economy which, of course, is crucially related to the potential rate of growth of the labour force.

The two related questions, and the panel’s answers are listed under 1a and 1b below.

1a. How much can the labour force grow?

Hughes: The big boost to Irish labour force growth from demographics and increasing rates of female participation is behind us. Going forward, the key swing factor is likely to be migration flows, which could vary significantly from year to year. Realistically, we are probably talking about a sustainable pace of labour force growth averaging 2 per cent or less each year.

McQuaid: Irish demographics are still favourable and should remain so over the short to medium term. I don’t see any reason why the labour force can’t grow by two to three percent on average over the next five years.

Hunt: How long is a piece of string? From indigenous sources, we estimate that the labour force can grow by between 1.9 per cent and 2.2 per cent over the next five years. However, a coherent economic migration programme would increase the elasticity of labour market supply substantially beyond this point.

Fahy: At the end of the last decade, the labour force grew particularly strongly for two years, but that very strong growth has now fallen back somewhat, so that last year’s growth looks to have been around 2.5 per cent.
Growth of the labour force has been primarily driven by the extent of inward immigration, and the number of women who opt to work outside the home. With regard to immigration, the government has recently announced a tougher stance towards granting work permits, which may serve to reduce the flow of immigration slightly. And it also seems unlikely that there will be acceleration in the rate at which women will opt to work outside the home. All in all then, labour force growth of around 2.5 per cent seems likely over the next couple of years or more.

Mangan: The Irish economy faces much more moderate growth in employment and output in the next five years than during the past five years. Employment growth in 2002-2006 is unlikely to average much more than 2 per cent per annum, down from 5 per cent in the 1997-2001 period.

1b. What is the real potential growth rate for the Irish economy for the next five years?

Hughes: As the Irish economy is likely to see more modest growth in the high-tech sector and a greater impetus from service sector activities, productivity growth could slip somewhat. As a result, I think potential growth could be between 4 and 5 per cent.

McQuaid: This is a difficult one to answer. Personally, all things being equal I believe the real potential growth rate for the Irish economy over the next five years is around 5 percent, though infrastructural problems like traffic congestion may limit the growth rate over the period. Improving the infrastructure is essential if Ireland is to achieve the growth potential over the medium-term.

Hunt: We estimate the sustainable rate of growth to 2006 at 4.5 per cent. Moving further out, the trend growth rate should settle in the 4 per cent area.

Fahy: The trend growth rate of any economy is determined, in broad terms, by the sum of productivity growth and labour force growth. The OECD estimates that over the last three years productivity has grown at a little over 4 per cent p.a. But the technology sector has driven much of that growth, and it does not seem likely that that sector can maintain that level of productivity growth. So productivity is more likely to grow at about 3.5 per cent p.a. over the next few years, which when added to the labour force growth estimate of 2.5 per cent, means that the trend rate of growth will be around 6 per cent.

Mangan: Economic growth in 2002-2006 is unlikely to average much more than 5 per cent per annum compared to 8 per cent in the past five years. As a result, the next government will not be able to continue with the policy of the outgoing administration of simultaneously delivering large tax cuts and big expenditure increases. The first economic priority of the new government must be to bring growth in current public spending under control. It is currently growing at a rate of 20 per cent per annum, which is simply not sustainable. Dept of Finance figures show that even if growth in current spending is brought down to 8 per cent per annum in the next two years, the Exchequer finances will be in deficit to the tune of 3 per cent of GNP.

Question No 2 to the panel was designed to get some gauge of the appropriate final level to which Irish tax rates should descend. In a competitive global economy, economic theory would dictate that that level would be pitched at a rate which was sufficiently below that of a basket of competing economies to ensure a continued flow of FDI into the Irish economy, which would ensure that, as far as tax policy was concerned, the economy’s competitiveness would remain superior.

2. Should Ireland benchmark its personal and corporate tax rates against the UK?

Hughes: No. Ireland competes in a global economy and it would be very unwise to focus policy on benchmarking tax rates against any one country. Clearly, we need to keep a close eye on developments in the UK but it would be wrong to slavishly follow their lead.

McLaughlin: As a small peripheral economy on the edge of Europe, Ireland needs all the fiscal incentives it can muster to retain and attract corporates. Benchmarking to the UK is therefore inappropriate.

Power: The UK will continue to represent the main competitor to Ireland for FDI and labour. Consequently, it will be important to keep Irish tax rates below their UK equivalent to maintain the balance of advantage.

Hunt: Certainly not on the corporate side where Ireland should retain its status as the lowest corporation tax environment within the EU. On the personal side, much progress has been made since 1997 in aligning the income tax systems in these islands. Given the reality that Ireland competes with Britain for high-quality labour flows, our income tax system should not discriminate unduly against those who choose to live and work in this state. Completion of the individualisation process would further improve benchmarking comparisons.

Fahy: Ireland should benchmark its corporate tax rates against the most successful economies in the world, wherever they are. It is wrong to benchmark our rates against only the UK or other European countries. On income taxes, the UK would seem to be a more appropriate benchmark due to the fact that Irish labour is more likely to move there than anywhere else, due to the common language, geographical proximity, etc.

Sutton: This is not to argue that Ireland should benchmark against developments in the UK, including taxation rates. The UK has a very different economy, is not part of the European Single Currency and has very different development needs. Irish tax rates should be selected to suit Irish circumstances, constrained as they are by EMU membership.

3. Are there any conceivable circumstances in which the balance of advantage will be to raise direct taxes in the next 5 years?

This was an easy one for the panel! no, was the unanimous conclusion.

Hughes: If the Irish economy was to experience severe overheating there might be some case for what would have to be clearly identified as a temporary rise. More realistically this might entail not fully indexing tax credits. However, the recent turnaround on taxation relating to property investment should serve as testimony as to how difficult it is to use taxation in order to achieve very specific short term or sectoral goals. The overwhelming evidence from the past twenty years is that the main focus of Irish tax policy must be to ensure that it enhances rather than hurts this economy’s competitiveness. There is considerable merit in sending a clear signal that this will remain the case. That would imply not resorting to ‘ad hoc’ measures.

McLaughlin: It is difficult to raise taxation as a percentage of GDP. Higher tax rates tend to dampen economic activity particularly in a world of mobile capital and labour and hence defeat the original purpose. Raising tax rates to fund higher current spending would not work therefore, and raising tax rates for macroeconomic purposes is pointless in a small open economy.

McQuaid: This is really a case of getting our priorities right. In my view higher public spending and lower taxes are incompatible, especially at times of slowing economic growth. If we want better public services (e.g. health, transport, education), we will have to fund them either through higher taxes or through Exchequer borrowing. Borrowing just for the sake of it, whatever about the short-run, will do no good over the long-term, it is a recipe for disaster. Politicians must stand up and be counted. Politicians of all parties must come clean, and educate the generate public that money does not grow on trees, the Exchequer money, is not some obscure fund administered by the mandarins in the Department of Finance, but rather taxpayers’ own money. Accordingly, the money has to be managed in the same way as a normal household budget. There are no free lunches, borrowing has to be paid back, and sometimes (particularly when finances are tight) due to a downturn in the economic situation, hard choices have to be made. In simple terms, the public should be given the choice, and asked what their priorities are. In other words if they want lower personal taxes, they can’t have the highest standard of public services. However, if they want state of the art services, they will have to pay for them through higher taxes. Politicians have failed on this front over the years, kidding themselves and the public.

Power: I cannot envisage any set of circumstances where this might be the case. The low corporate and income tax stance pursued in Ireland is the cornerstone of our economic success and needs to be preserved and built upon if possible. Low taxes provide incentive and encourage effort. It will be squandered at our peril.

Hunt: Should the public finances deteriorate to the extent where Ireland’s reputation for sensible fiscal management is threatened or where the risk of a breach of the Stability and Growth Pace becomes significant, a need for higher direct taxes would arise. However, while higher direct taxes might become necessary, I do not believe that they are desirable given the negative consequences of such a move for activity, incentives and economic efficiency. A diminishing role for government in economic activity has been the prime driver of Ireland’s economic transformation. A move towards higher direct taxes would potentially unwind some of the economy’s structural adjustment and would reduce our rate of sustainable growth over the medium to long-term.

Fahy: None that I can imagine!

Mangan: A low direct tax regime, along the lines of the US and UK, has proved to be a far more successful model for economic growth than the high-tax regimes of mainland Europe. It has proved particularly successful in Ireland in attracting inward investment and stimulating employment growth. Thus, the new government should desist from increasing direct taxes.
Replying to Question No 4 below the panel were on balance optimistic that Ireland would, and should hold out against the forces arguing for tax harmonisation in the EU, However there were some worries expressed by Alan McQuaid, whose pessimism on the issue sees Ireland finally caving in to tax and fiscal harmonisation but not for another twenty years or so. Nearer term, Eoin Fahy sees ‘ominous’ signs of weakness on the issue amongst some politicians and Government departments.
3. Will Ireland be able to hold out against tax harmonisation in Europe?

Hughes: It is to be hoped that the persistent under-performance of many European economies in the global market place will eventually register with those who would run economies by dictat. So, the drive for harmonisation may die a natural death. In the interim, Ireland should be sufficiently committed to the principle of low taxation to hold out.

McLaughlin: Tax harmonisation is nonsense in a monetary union as it removes the only policy lever national governments have to cope with economic shocks. Worse, proponents of tax harmonisation mean high taxes, which ultimately reduces the tax base and hence the tax take.

Power: Ireland has no choice in this matter. If tax harmonisation is forced upon Ireland, then we can be pretty certain that harmonisation of Irish unemployment up to European levels will follow as sure as night follows day. By all means allow European taxes be harmonised down to Irish levels, but not the opposite. This should become a key issue for the next Government. It is a matter of national survival.

McQuaid: In the short-term, yes, but in the long run, no. I believe the major EU countries like Germany and France will continue to press for this in the coming years, and will eventually get their way. That said, I don’t see total tax harmonisation across the EU coming to fruition for another twenty years at least.

Hunt: The State can only surrender its fiscal sovereignty by permission of the electorate through a referendum. Given that fiscal discretion is central to the economy’s continuing success, I find it difficult to foresee a set of circumstances, which would convince the electorate to cede power over taxation and spending to Brussels. Ireland can and should resist tax harmonisation.

Fahy: It will be able to hold out, but only if there is a consensus among all the major political parties and government departments. That consensus shows signs of breaking down recently, which would be ominous. Any move to introduce tax harmonisation would have to have unanimous consent at EU level, so Ireland does have a veto. We should be sure to use it!

Sutton: With monetary and exchange rate policy dictated from the centre it is important that national states maintain as large a degree of fiscal policy independence as possible in order to adjust for differences between the different constituent parts of the Zone. These differences are real, persistent and widely recognised, not only in Ireland. Loss of fiscal power would also threaten the usefulness of local national parliaments, something the various political systems would be loath to tolerate. As a result there are likely to be many candidates for any coalition to ensure tax harmonisation is resisted.

Mangan: It is vitally important for Ireland that any attempts to impose tax harmonisation across the EU are torpedoed. Ireland has a veto in this regard, which it should not be afraid to use. Otherwise, Ireland might as well become another German laender.
Finally, the panel were asked how important policy actually was to ensure a continuation of the ‘golden years’ of the Irish economy.

4. How important do you think economic policy will be for the continuation of Ireland’s economic golden years?

Hughes: Very important. It is vital that we don’t make significant policy errors. The desolation this economy suffered through most of the 1980s should be a salutary lesson that it is far easier to get things badly wrong than to get them right. There are some worrying signs both in recent trends in the public finances and indeed in the early electioneering that many believe that a strong budgetary position and a strong economy are ours by divine right rather than through determined and sustained effort.

McLaughlin: Policy is asymmetric-bad policy can stifle economies, good policy can only encourage the private sector to create wealth, but governments cannot do it themselves. Ireland has a very successful economic model as it stands.

McQuaid: Very important. Hard choices will have to be made as regards the level of public services, infrastructure and taxes that we need/desire over the medium to long-term. While improved public services and infrastructure will undoubtedly improve the quality of life in Ireland, maintaining competitive tax rates (while we can) will be essential for Ireland’s continued development on the world stage going forward. One can’t underestimate the positive impact on the country from the low corporate tax rates, and maintaining these taxes at a low and competitive level is essential in my view, if the Celtic Tiger is to continue to roar.

Power: Economic policy will be vitally important, but its complexion will change. In an EMU world there is little scope for independent macro-economic policy, with interest rates and the exchange rate gone as independent tools of management, and the Stability & Growth Pact has rendered fiscal policy pretty impotent. The key emphasis will need to be on micro-economic policies. Areas like de-regulation and the introduction of competition, privatisation of everything possible, competitive tax arrangements, and a new more flexible wage-setting environment will need to be addressed in a forcible manner. The control of current government spending is of course a pre-requisite for success, as is the need for massive investment in the infrastructure. However, where capital spending is undertaken by the state, value for money and an economic return should become guiding principles. A national stadium funded by the Irish taxpayer should not be part of the equation. The role of Government should be to create a physical and fiscal environment to facilitate entrepreneurial endeavour, risk taking and employment creation. Governing over the next five years will not be easy in less buoyant economic circumstances. Tradeoffs will have to be made between taxation levels, public spending and the provision of adequate public services.

Hunt: Ireland’s future success as a mature, regional economy within the EU is dependent on our ability to attract and manage quality labour and capital resource flows. Given the proven efficacy of fiscal policy in this arena, it is essential that room for manoeuvre be maintained through the delivery of exemplary budgetary outturns. The duration of the golden years will be determined largely by government’s ability to manage spending expectations.

Fahy: I’m not sure that the ‘golden years’ period can continue for several more years, at least if that is taken to mean the kind of growth rates we have seen since the second half of the 1990s. But that said, if growth is to continue to be reasonably strong, and if unemployment is to be kept very low, then formulating and executing the correct economic policy will be essential.

Mangan: A prudent economic policy and favourable external environment are required if the economy is to grow at full potential and sustain full employment in the coming five years. Maintaining a low tax regime, removing infrastructural bottlenecks and prudent management of the public finances are key requirements in this regard. A close eye also needs to be kept on inflation, especially wage inflation, which is rising at a double-digit level. Much lower rates of wage increases will be required in the years ahead if Ireland is to sustain its competitive advantage, especially in circumstances where the euro starts to appreciate.

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