| Economists back supply-side policies for forthcoming Budget |
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| As this is the time of year that the Budget gets written, we thought it would be useful to get the policy views of some of the best brains amongst the country's economists summarising the policy views of those working in the Irish financial sector. They were asked to identify several points which they would like to put before the Minister. Here is what they had to say. |
Eoin Fahy, chief economist, KBC Asset Managers Ltd.
Increase competition in the economy: As Ireland struggles with a relatively high rate of inflation, the government should consider all available avenues to reduce inflationary pressures over the medium term. Jawboning various interest groups (medical consultants, lawyers etc) may be politically useful, but not likely to achieve much on a sustained basis. But increasing competition would help. If the government sees the restraint of inflation as being the number one priority, it could, for example,
• abolish the Groceries Order,
• abolish all quantitative restrictions on licenses, including taxi and pub licenses,
• open up the electricity and gas markets to full competition,
• scrap the ‘cap’ on supermarket floor space,
• create competition between airports and between airport terminals.
The above are just some examples, and raise difficult issues, for example, is the reduction of inflation ‘worth’ hurting local corner shops which provide a useful service? These matters can only be decided by politicians, but the basic point is simple; prices are a function of supply and demand, the government should forget about restricting demand and instead focus on increasing supply.
Reduce bureaucratic delays
It’s common for major transport and development schemes to be delayed for years, even decades, by planning and other delays. The M50 around Dublin, to take one example, was planned in the 1970s, but it is still not much more than half complete. The Port Tunnel scheme to Whitehall was announced in the early 1990s, but work has not yet even begun. The national convention centre site in Dublin’s docklands remains in the planning process several years after the first competition for the convention centre was completed. There simply must be a way of reducing these delays without preventing legitimate objections receiving fair process.
Sort out industrial relations in the public transport sector
For most of the summer months, only a limited train service was running due to an industrial dispute. New DART units have been delivered but are not yet in service despite the fact that there is severe overcrowding at peak hours. The DART extension to Greystones was finished up to two years ago yet there is still only a very limited service, while the extension to Malahide is well behind schedule. In Dublin, Limerick, Cork and Galway there are in existence railway lines that could be used as commuter lines (for example, the large Raheen industrial estate in Limerick has a railway line from the city centre which passes within a half mile of the entrance to the estate). But quite apart from planning and financial difficulties, experience so far shows that it would be very difficult to conclude negotiations, with the workforce, for additional or new services. At a time when traffic delays are becoming an important issue for business, additional public transport services are essential. The industrial relations climate needs to be addressed as a matter of urgency.
Hold firm on public sector pay
As part of the negotiations on the PPF, it was agreed that a benchmarking exercise would be carried out for the public sector, with the aim of broadly aligning public sector pay with private sector equivalents after the expiry of the current deal. The Government and the taxpayer should not be afraid of paying the ‘going rate’ for a particular job, always remembering, however, that public servants have greater job security. But the Government should hold firm against any pay claims that are outside this framework. In particular it should resist recent demands for ‘compensatory’ pay claims in response to higher than expected inflation this year. The government should point out that:
• inflation will fall sharply next year, and the PPF is after all a three year agreement,
• during the currency crisis in 1992/1993, public sector unions adamantly refused to accept any amendments to the previously agreed wage deal, despite the fact that inflation was far lower than expected, and that the economy was facing an absolute crisis,
• simply paying out an additional wage rise to every public sector worker would surely lead to an equivalent demand in the private sector, and paying everybody more simply pushes up inflation still further, in an old-fashioned wage-price spiral.
Focus on labour market issues
Clearly, a major issue for Irish employers, and indeed the economy as a whole, is the emerging labour shortage in many sectors. Substantial progress has been made in recent years in attracting new entrants into the labour market, principally immigrants (including those who have returned from overseas) and married women. The forthcoming Budget should continue to address this issue, in particular by continuing to cut marginal tax rates, continuing the ‘individualisation’ policy, and increasing the supply and affordability of childcare facilities.
Continue to cut income tax rates
Many, though not all, international commentators are taking an extremely simplistic approach to the Irish economy. In their view, high inflation is a result of strong economic growth, so the best way to restrain inflation would be to increase taxes to get the economy to slow down. In Ireland’s case, this is not correct. Much of the current high inflation rate is due to temporary or once-off factors (cigarette tax increase, weak euro, and high oil prices), and is not related to the strength of the Irish economy in any way. The ‘Irish’ bit of the current rate of inflation reflects the imbalance between demand and supply. The solution is not to reduce demand, but to increase supply. In order to achieve this, tax rates must be cut still further. To follow the standard overseas prescription of higher taxes would make matters worse, by reducing the supply of workers as married women, in particular, no longer thought it worth their while to re-enter the labour force.
Cut the standard rate of VAT and some ‘old reliable’ taxes
The trade unions are strongly urging the government to take substantial measures to get inflation down. At the same time, our standard rate of VAT is well above the EU average, while the Exchequer’s finances have rarely been healthier. In this context, it would seem to make sense to reduce the standard rate of VAT. This would (provided it was passed on to consumers) immediately reduce the reported rate of inflation, helping to maintain the PPF. Depending on the size of the cut, it could reduce the rate of inflation by as much as 1 per cent next year. In addition, the government could cut taxes on some old reliables, such as petrol.
Jim O’Leary, Davy Stockbrokers
The first question is whether fiscal policy has a meaningful role to play as a stabilisation tool in a very small very open economy like Ireland. In other words, is raising the budget surplus by a couple of % points of GDP likely to materially mitigate inflationary pressures in the economy? In deciding the overall ‘stance’ of fiscal policy, I start from the position that the answer to these questions is ‘no’. I would add two further observations. The first is that large budget surpluses may undermine budgetary disciplines, in so far as they are perceived to obviate the need for rigorous evaluation of spending proposals on both the current and capital accounts. The second is that, while the overall fiscal ‘stance’ may not matter much, individual budgetary measures can exert powerful influence on the behaviour of economic agents.
I have no problem with the prospect of income tax cuts of a similar magnitude to those of last year, provided they are part of a coherent strategy to enhance incentives to participate in the labour force. Last year’s package lacked such coherence, but only because of the measures announced after Budget day. The Minister should press on with his individualisation plans, and make it clear that they have as much to do with removing the present discrimination against single people as they have to do with altering the relative positions of single- and double-earner married households. Nor should he allow his plans to be derailed by distributional arguments: in a progressive system it is difficult to implement significant tax cuts that don’t favour middle and upper income groups. In the limiting case, tax reductions cannot benefit those who don’t pay tax at all. Is this a valid argument against cutting tax? Of course not.
It follows that poverty-proofing of the budget should be strenuously opposed, if poverty-proofing means rejecting measures that would have the effect of increasing inequality of after-tax income. Some campaigners for the poor appear to think that poverty and inequality are synonymous. They are not. The position of those who are deprived or disadvantaged in our society would be much further advanced by ensuring that they have access to decent health and education systems than by renouncing tax cuts that favour the better off.
Abolish DIRT. There is a strong case for strengthening incentives and removing disincentives to save on the part of households and firms. A number of initiatives could be taken under this general heading, but the most obvious one is the abolition of DIRT (or, if that is problematic) its reduction to 0%. It is bad enough to have a situation where deposit rates are substantially below the prevailing rate of inflation; it is ludicrous to compound it by taxing deposit interest.
Abolish mortgage interest relief. Almost everyone is agreed that membership of EMU has resulted in a situation where interest rates in Ireland are lower than they should be and that the low level of interest rates has been an important factor in driving up house prices. Almost everyone is agreed that the high level of house prices, not to mention the likelihood of further house price inflation over the next couple of years, is a big problem. Yet, mortgage interest relief (MIR), which is equivalent in effect to an interest rate subsidy for house purchase, remains in place. Under EMU, abolishing MIR is the nearest the Government can get to engineering an interest rate increase.
All existing legislation should be proofed for its effects on labour supply. There are many schemes currently in operation that date back to the time when unemployment was our overriding economic and social problem. Some of these schemes are designed to encourage early retirement, for example the Pre-Retirement Allowance Scheme and the Pre-Retirement Credit Scheme. At this stage, we should be providing every encouragement to people to stay on at work up to and beyond the normal retirement age. There is considerable scope for increasing labour force participation rates in the relevant age-groups.
I have an open mind on the question of whether indirect taxes should be cut. On the one hand, I accept that the CPI-friendly impact of such a move is largely cosmetic; on the other hand, it cannot be ruled out that it would have some dampening effect on inflationary expectations. However, if a reduction in indirect taxes is to take place, I would urge that it not take the form of an across the board cut in excise duties on motor fuel. The guiding principle here has to be the need to discourage the use of private cars.
Austin Hughes, chief economist, IIB Bank
Know your limitations: A good budget may not dramatically improve the economy or the political fortunes of the Government but a bad budget. The economy needs a fairly dull budget that continues along the path set by its predecessors but, most importantly hastens slowly along this path. By this I mean a budget centered on modest tax reductions and restrained Public spending, particularly on the current side.
Cut Inflation
The one area where I would suggest something ‘radical’ needs to be done is in relation to inflation. I would favour a significant reduction in excise duties on petrol, probably of the order of 3-4 pence per litre. Given the scale of the increases in oil prices in the past year this shouldn’t be too threatening from an environmental perspective. I would also advocate a one-percentage point reduction in the upper VAT rate, or possibly even two percentage points partly offset by further increases in cigarette duties. By pre-announcing a reduction, say to come into effect in February, the Government might be able to marginally restrain demand and/or encourage early price-cutting by businesses. It might also allow time to focus consumer attention on the range of goods and services that should see price cuts. A cut in the upper VAT rate would also assist e-commerce although the main intention would be to buy time and limit the response of wages to the current spike in inflation.
Cut direct taxes modestly
Exceptional as the Irish economy’s recent performance has been, there are clear signs that supply is straining to keep pace with the buoyancy of demand. Hence cuts in income taxes should not be so large as to worsen any imbalances between demand and supply. I would favour cuts in direct personal taxation amounting to ?500 million. It should be possible to justify smallish tax cuts in the coming year on the basis that overheating risks in the economy have clearly increased. On equity grounds, these reductions should be predominantly targeted towards the lower paid. However, economic efficiency argues that reduction must occur across the earnings spectrum. This might be accomplished through a combination of cuts in the standard tax rate and increased allowances.
Continue to increase spending on infrastructure
The longer-term health of the economy depends critically on the capacity of the Government to upgrade infrastructure. However, I would favour a capital deficit of 2- 2.5 per cent of GDP. Again because the capacity of the construction industry, in particular, to meet additional demand is severely limited.
Hold the line on current spending
The Minister must show a determination to restrain growth in current spending. With virtually no chance of the Government meeting its self imposed 4 per cent spending increase, the Minister must ensure an outcome of no greater than 5-6 per cent. This is possibly his most difficult task as there are good grounds for increasing spending in many areas notably Education and Social Welfare (see below). Tough decisions likely require absolute reductions under certain headings. Perhaps we need to see the return of ‘an Bord snip’ of the late 80’s, although its job now would be to ‘cut and paste’.
Recognise social obligations
While Budget policy must increase incentives to work, it must be remembered that many have been left untouched by the tiger economy. Increases of ?8 per week in the main Social Welfare headings could be afforded. I would also recommend increases of around ?10 per month in child benefits. This would have a social dimension but would also make some contribution towards childcare. The greater part of the response to childcare needs should come through the supply side rather than through the demand measures such as specific tax allowances.
Do not exceed commitments entered into in the PPF
The terms of the Partnership agreement were reasonably generous, albeit affordable in current economic circumstances. The risk, however, is that if Charlie McCreevy front loads spending increases/ tax reductions, expectations will run away. With some risk that current voted Government spending could threaten a 10 per cent increase next year and large tax cuts potentially dangerous, there is a clear need for the Minister to deliver a less generous than expected budget on both short and longer term considerations.
Colin Hunt, head of research, Goodbody Stockbrokers.
Minster, don’t let the doomsayers get you down. Economic policy is on the correct course and should not be altered because of the recent deterioration in inflation readings. Rather than tightening fiscal policy, you should continue with the supply-side approach of recent years with an emphasis on using both taxation changes to enhance the efficiency of the labour market and higher capital expenditure to increase the capacity of the economy. Short-termist reactions have no place in successful economic strategies.
Excise duties
The Budget which you will present in a few weeks can of course have an impact on the inflation visuals through changes in indirect taxes and excise duties. With pressure for another increase in tobacco duties likely to come from the Department of Health, you should be ready to cut excise duties on other goods. As long as oil prices stubbornly refuse to behave themselves, a temporary reduction in energy duties would be sensible from an economic viewpoint but would draw fury from some quarters on environmental grounds. The safest and most logical option lies in the alcohol area. I know that the drinks industry has been causing some problems on the prices front of late and you may not be terribly well disposed towards reducing taxes in this area. However, our wine duties are out of kilter with those of our European Union colleagues and are ripe for a significant reduction. Not only will such a move have a benign impact on inflation readings, it would also prove very popular politically. It might even get the thumbs up from the Department of Health which is doubtless aware of the advantages of having one or two glasses of the stuff each day. At worst, any changes in excise duties should have a neutral impact on inflation readings.
Income taxes
It didn’t play very well last year but you have to stick with the roll-out of individualisation. It makes good sense from an economic viewpoint because it does enhance the attractions of work, increases labour market supply and reduces wage pressures. It also, at completion, will allow for an alignment of the British and Irish income tax regimes and will remove an unnecessary barrier to mobility between these islands. So this year, you should consider broadening the width of the standard income tax band by ?5,000 and with the fiscal bounty at your disposal, it will be hard to resist cutting the standard rate by 2 per cent. Such a move will provoke criticism from the economically orthodox (get ready for lines about putting fuel on the fire) but will help to compensate workers for continued wage moderation.
I can understand the political attachment to having two rates of income tax but a new lower rate for those on moderate incomes should be considered with a view towards reducing some of the wage pressure in the services sector in particular.
The Budget should include measures to increase the tax efficiency of productivity-driven pay. Lower taxes on share options for instance would be a welcome addition to the flexibility of the labour market with employee rewards becoming increasingly dependent on the success of the employing organisation. By encouraging people to take remuneration in the form of shares or bonuses rather than regular wages and salaries, the Budget can improve the competitive position of Irish industries and would protect their profitability and employment levels in the event of a sharp downturn in global economic activity. Of course, the embarrassment of riches at your disposal should not be used to fund excessive increases in current government spending. The buoyancy of fiscal conditions and reduced demands for welfare payments can’t be used to disguise higher day-to-day government outlays. Your cabinet colleagues are only too aware of the magnitude of financial resources at your disposal. While a 6 per cent inflation rate will encourage spending Ministers to seek double-digit increases in their budgets, you must hold the line here. Selling tax reforms and capital spending increases as vital pillars of a supply-side strategy is one thing. Doing that while simultaneously explaining away an unwarranted increase in current spending would be nigh on impossible.
Stamp duty
Stamp duty on share transactions should be abolished. OK, I might have a vested interest in such a move but I believe that the call for abolition of this unfair tax is based on more than selfish considerations. Thanks partly to the current stamp duty regime, we have a farcical situation where the vast bulk of trading in the Irish Stock Exchange’s largest quoted stock, Elan, takes place in New York. The higher cost of dealing in Dublin is driving volume in Irish shares offshore and is undermining our local exchange. Moreover, it adds to the effective cost of capital for Irish industry and deters unquoted companies from coming to the market. Stamp duty also erodes returns to investors and does not sit well with a commitment to popular privatisation. In the interests of corporate Ireland, private and institutional investors and of course the stockbroking industry, you should abolish this outdated and anti-enterprise tax.
Lastly, let’s give some real meaning to multi-year budgeting. Tell us what you will do in the next two budgets if the overriding demands of fiscal stability are met. If nothing else, this would help to keep the unions and their memberships on board the PPF. It would also allow you to demonstrate unequivocally that taxation reforms are an intrinsic part of your economic strategy rather than mere tactical ploys.
Best of luck.
Dan McLaughlin, chief economist, ABN AMRO
Taxes
Use the tax system to encourage savings as Irish interest rates are currently negative in real terms, and are likely to remain low relative to economic growth in the medium term as rates are set by the ECB, largely with reference to developments in Germany and France. This means that there is every incentive for Irish individuals to borrow and spend and little or no incentive to save. The Government can do nothing to affect interest rates in general but they can use the tax system to encourage savings. For example, individuals can put 15% of salary tax free into a pension system and this should be changed, perhaps doubled .to 30 per cent. The witholding tax on deposit accounts should also be scrapped and a tax-efficient scheme like the UK TESSAs might also be considered.
Cut direct tax rates
Direct tax cuts boost supply and hence are ultimately anti-inflationary. The current targets of a 20 per cent basic rate and a 40 per cent top rate are hopelessly outdated given the fiscal position and new targets of 15 per cent and 30 per cent should be set for the medium term. For 2000 both rates should be cut by at least 1 per cent and the importance of having a competitive tax position on labour should be emphasised. For example, the take home pay of a UK worker is much higher than his Irish counterpart on anything above low incomes so the risk is that the inflow of workers returning from Britain will stop or actually reverse. Cutting indirect taxes has no positive supply effects on labour and may not be passed on anyway in the form of lower prices.
Cut Government spending
The current pattern of discretionary Government spending is appropriate to a low employment economy with excess labour, and inappropriate to one with high employment and scarce labour, Therefore a lot of Government spending is a waste of money with no return and as such should be scrapped. By the same token one has to question the numbers working in some Government departments and semi-state companies in an economy crying out for workers in more highly productive sectors of the economy.
Announce an audit of the health service
Ireland spends a large amount of money on the health sector but few users are happy with the service. Clearly there are some areas where funding is inadequate (e.g. mental health, drug rehabilitation) but the problems are deeper than inadequate resources. Vested interests distort the underlying picture and an audit by an outside body would be able to isolate where resources are inadequate and where they are more than ample.
Scrap stamp duty on shares
The stamp duty on Irish shares merely accentuates the drift of Irish share dealing offshore and to have any chance to survive as a viable entity the 1 per cent duty on the buyer should be abolished.
Admit that housing intervention is a mistake
Subsidising demand in any market merely pushes up prices, particularly in those areas where supply is slow to respond, as in the housing market. So admit the farrago of ad-hoc measures taken to tackle the ‘housing crisis’ was a mistake and abolish the latest wheeze, the discriminatory stamp duty on and tax on investment property which is already pushing rents higher.
Appoint a Minister for Transport
The transport system is a mess. This is partly due to the inevitable lags between policy implementation and completion but in Ireland the problems are exacerbated by the plethora of public departments and bodies involved, which breeds vested interests and bureaucracy. Transport should have its own ministry with a cabinet minister in charge.
Emphasise micro-policies to fight inflation.
Bang home the point that over 40 per cent of Ireland’s GDP is imported from outside the Euro zone, which is over 3 times the Euro average. This means that the weak Euro has hit Irish prices harder than any other country in the zone. The key corollary is that fiscal policy, per se, can have little influence on Irish inflation, and that the main weapon left to the Government is pay and micro policies to encourage deregulation and competition. The latter is painful to incumbents and so although every one welcomes it in theory it is less welcome in practice. This means the Government have to stand up to vested interests protecting entrenched positions-one can’t please all the people all the time.
Dermot O’Brien, chief economist, NCB Stockbrokers
The most important thing from an economic point of view is that two of the key elements of existing policy should be persisted with, namely continuing the process of reform in personal taxation, especially as a means of reducing disincentives to labour force participation, and concentrating increases in public spending on the implementation of the infrastructural elements of the National Development Programme. Persistence with these elements of policy necessarily imparts a short-term stimulus to domestic demand. At a time when the pool of unutilised labour resources has been depleted, however, fiscal policy needs to be careful about the degree of stimulus it imparts to avoid exacerbating the existing tightness of the labour market. A degree of overall budgetary restraint is advisable.
Assuming further moves towards full individualisation, income tax reductions should be devoted to the widening of the standard band and the raising of thresholds. Current tax rates are not in obvious need of reduction. The problem remains that the higher rate bites at too low an income.
Leave expenditure taxes unchanged.
Conscious of the CPI impact, it is assumed increases will not be part of this year’s budget but pressure for reductions for cosmetic, CPI reasons, e.g. on oil/petrol, should be resisted. The CPI effect is temporary and such tax cuts lower the incentive to adjust behaviour to the reality of a shift in relative prices.
Rescind the 9 per cent across the board stamp duty on non owner-occupied houses in line with the recommendation of the Commission on the Private Rented Residential Sector. The upward shift in house prices relative to incomes of recent years is not likely to be reversed and, as a result, some aspirant house purchasers will have to wait longer to enter the market. Demand for rented accommodation will continue to rise but this tax is detrimental to the provision of an adequate supply.
Irish equities
In the financial markets area, the 1 per cent stamp duty on investment in Irish equities should be abolished. There is no such duty on investment in US or European stocks and the rate in the UK is 0.5 per cent. At a time when Irish equities are suffering from misconceived worries about the economy, they do not need an additional penalty. In addition, the existence of this levy is a disincentive to Irish companies listing in Dublin.
Still in the area of equity investment, action is needed to either abolish Special Portfolio Investment Accounts or change the terms under which they operate. These accounts were established to encourage investment in Irish equities, offering a lower rate of capital gains tax as the incentive.
Apart from the restriction to Irish equities, the account holder also had to pay the tax each year on the account’s unrealised gains. Since the tax rate was raised to 20 per cent in the 1999 Budget the tax advantage is gone. However, account holders who paid tax on earlier unrealised gains but who now have accumulated losses as the result of the underperformance of the Irish equity market are at a disadvantage relative to other investors since those losses can be offset only within the account. The change in the tax rate effectively turned an incentive into a penalty.
Jim Power, chief economist, Bank of Ireland
Tax cuts of the magnitude and complexion delivered in budget 2000 would be a mistake and would just serve to accentuate the overheating tendencies that are now very obvious in the economy. In fact it is now becoming quite clear that the package delivered last December is already causing problems and was mistaken. The political logic behind cutting personal taxes is very obvious, and indeed the economic logic is also reasonably clear. The biggest problem facing the Irish economy at the moment is the chronic shortage of labour and in theory it is possible that reducing the tax burden would serve to attract more labour into the market both from domestic and external sources. However, it is not clear that the tax measures have actually achieved this. Even if they have had a positive effect on labour supply, they have had a much more stimulatory effect on consumer spending and the net result is higher inflation. At the end of the day one can blame everything from alcohol to tobacco for the sharp increase in inflation, but its primary cause is one that any economics textbook would predict: if demand exceeds supply, prices will rise. Tax cuts have just served to fuel this demand.
Labour force participation
Cutting taxes further will not increase the supply of labour. It is fine to make headlines about the need to attract foreign workers into the country, but the reality is that we are not in a position to house these workers, so the emphasis needs to be directed towards potential workers at home until the housing crisis is sorted out. The participation rate for females in this country is just 48 per cent, compared to over 70 per cent in countries such as Sweden. The lack of affordable child-care facilities is a key impediment to increased participation in this segment and rather than fuelling demand through tax cuts it would be much more appropriate to invest heavily in child-care. If there are to be any tax cuts in December, they should be directed towards the lower paid rather than middle and high-income workers who will merely use the proceeds to trade up the BMW. We would all be better off to forego tax cuts and use the surplus to enhance child care and the creaking infrastructure.
Public transport
The Government’s plans for public transport are too long-term in nature. A more immediate response is required. The introduction of private operators on bus and rail routes is essential if traffic congestion is to be sorted out. The introduction of BIK (benefits in kind) on company provided parking spots is not acceptable until a public transport alternative is provided. That is not the case at the moment.
Health-Care
The health care system is now in a shambles. Increased spending is essential on health but merely throwing money at the area is not the answer. Careful analysis of how the money could be used efficiently and effectively is essential.
Education
Class sizes are too large, so more teachers need to be provided and better schools need to be delivered. Greater accountability from teachers is essential as happens currently in most areas of the private sector. Education is one of the most important issues that needs to be addressed if Ireland is to maintain its FDI status in the face of increased international competition.
Share option schemes
The tax treatment of share options should be amended. The 20 per cent CGT rate should be applied. This would increase their attractiveness, help control wage costs and ensure greater employee loyalty in such a tight labour market.
Oliver Mangan, chief bond economist, AIB Treasury
The capital expenditure side of budgets for the next few years has already been la |
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| Article appeared in the September 2000 issue.
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