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Change the stamp duty regime and don’t cut capital spending Back  
Ahead of this year’s December budget, Ireland’s leading financial services economists outline their Budget ‘dos and don’ts’ for Minister for Finance Brian Cowen, which include amending the stamp duty regime, maintaining capital spending and implementing some tax cuts.
The 2008 Budget is likely to signal a departure from the profligacy of last year’s pre-election give-away, as changing economic circumstances dictate that Minister for Finance Brian Cowen will face his sternest challenge in steering the country’s fortunes. However, while the Minister will have to make some tough calls, particularly with regards to public spending, financial services economists responding to this pre-budget opinion poll maintain that there will still be room for tax cuts and increased capital spending.

Property prices – to intervene or not to intervene?
As investors and industry alike get used to the new reality of the Irish property market, expectations are that the Minister will look to put some of the much spoken of ‘heat’ of the last decade or so, back into the market in the Budget.

Reforms are expected in two key areas - stamp duty and mortgage interest relief. Already steam is building behind lobbying efforts to encourage the government to change the much-maligned tax. In its pre-budget submission, the Construction Industry Federation (CIF) called for a reduction in the top rate of stamp duty from 9 per cent to 5 per cent amidst claims that ‘confidence has presently deserted the housing sector’.

While many of the economists express concern over government intervention in the market – Ulster Bank’s chief economist Pat McArdle for example cites the impact of the ‘ill-fated Bacon reports’ - almost all concur that something will be done in December.

Stamp duty is the main bug-bear of both the property industry and consumers, and several of the economists argue that with prices continuing to fall (the latest Permanent TSB/ESRI survey indicated a drop of 3 per cent in the year to July, but some would argue the drop has been as high as 15 per cent), now is the time to change the system.

McArdle says that the government now has ‘a unique opportunity’ to ‘ameliorate some of the worst aspects of the stamp duty regime without the proceeds going directly to the builders’.

Previously the Minister has expressed concern that changes to the stamp duty regime would result in any benefits ‘ending up in the pocket of the seller’. With housing prices on a downward slant however, McArdle’s assertion that stamp duties can only be lowered when house prices are falling is shared by Austin Hughes, chief economist with IIB Bank, who says, ‘it would make sense to reform an unwieldy and inefficient tax at a time when it would not threaten a surge in property prices’.

The government’s previous strategy of focusing on First Time Buyers (FTB) by removing stamp duty for buyers in this category is a ‘mistake’ and is ‘sub-optimal’ argues Davy’s head of research Robbie Kelleher. ‘There are many who are living in relatively poor quality existing accommodation who are looking to trade up and who deserve State support every bit as much as many FTBs do,’ he says.

Instead, he asserts that it would be better to change the system to a tiered structure, ‘so that when a particular threshold is passed only that portion of the price that exceeds the threshold should be taxed at the higher rate’.

Dermot O’Brien, chief economist with NCB Stockbrokers, also favours changing the stamp duty regime, but his argument centres on the philosophy that stamp duty is simply a ‘bad tax’. He says that the Minister should consider reforming stamp duty – not in the interests of propping up the housing market - but because the tax is a bad one, ‘in terms of its incidence, its onerous rates, the absence of banding and its discriminatory treatment of different tax payers’.

Two economists - both from stockbroking firms - would rather the Minister did not change stamp duty. Goodbody’s chief economist Dermot O’Leary argues that the decline in house prices seen to date has been ‘modest’, and that overall this is beneficial. ‘Slight real house price declines over the next two years will be a positive development, given the rapid growth that has been seen over the past ten years, as it will help to re-balance affordability and rental yields in the sector’.

While he would like to see the government provide full mortgage interest relief to first-time buyers, ‘in light of the anaemic nature of the housing market’ he maintains that, ‘further tax breaks for the property market are not the correct approach to solving the current problems of the market’.
Alan McQuaid, chief economist with Bloxham Stockbrokers, espouses a similar view on the ‘soft landing’ currently being experienced by the housing market, but adds that in his view the main driver of house prices remains interest rates.

‘With clear signs now that we are unlikely to see any further tightening from the ECB in 2008, certainly in the first half of the year, I would be inclined to let the market find its own feet. Now is not the time to be rushing in with more significant changes in stamp duty,’ he says.

Mortgage interest relief is another area where the government can wield some influence on the housing market, and is the area tipped most for reform in the upcoming budget. The proposal currently on the table is to increase the interest relief for first-time buyers (FTBs) from E8,000/E16,000 to E10,000/E20,000.

For his part, McArdle says that he would prefer to see action on stamp duty rather than interest relief, while Hughes is in favour of extending the relief to, ‘a rate above the standard rate, say 25 per cent’, while also extending it beyond seven years for first time buyers to all owner purchasers.

Eoin Fahy, chief economist with KBC Asset Management, highlights the strange ‘crisis situation’ we are now in, ‘until recently the ‘house price crisis’ was because house prices were rising so fast that younger people couldn’t afford to buy. But now the ‘house price crisis’ seems to be that prices are falling so fast that the economy is being damaged and consumer spending is under threat,’ is against changing interest relief.

‘The Minister should NOT increase mortgage interest relief, particularly as new home buyers are in any case gaining from the falls in house prices, a lower future rate of interest than was expected until a few weeks ago, and the abolition earlier this year of stamp duty for first time buyers,’ he says.

Keeping inflation under control is going to be key to maintaining competitiveness going forward, with the government itself cited by O’Leary as being one of the ‘culprits’ in price rises over recent years. He says that policy should act to encourage competition in the economy to contain inflation pressures.

Similarly, Kelleher recommends that indirect tax increases which would add to the headline rate should be avoided and he proposes that public contracts (including National Wage Agreements) should use the HICP rather than the CPI.

McArdle warns the Minister to avoid ‘McCreevy stealth taxes’, as well as further hiking tobacco taxes, ‘until he finds a way of keeping this out of the CPI,’ as last year’s 50 cent increase added 0.4 per cent to consumer prices.

Fahy suggests that one way of bringing down inflation over the longer term would be to support more competition in the many sectors of the economy where it is still absent, and particularly in the services sector.

‘A report by the Competition Authority just this month pointed out that it is still not possible for a dentist, for example, to advertise the cost of his or her services or to give a discount to new customers. While dental prices are not exactly the single most important factor pushing up inflation, they are symptomatic of the lack of competition that keeps service sector inflation at a high rate,’ he says.

Improving infrastructure was also put forward as a way of improving the competitive position of the Irish economy,with Hughes recommending that the government focuses on ‘areas that impact on the cost of doing business in Ireland’.

While McQuaid maintains that Ireland is still attracting foreign direct investment in high-value added industries, he is concerned that a continuation of the recent trend of rising prices and costs relative to trading partners could leave the economy in a vulnerable position, particularly given the relative strength of the euro exchange rate vis-?-vis the dollar and the weaker productivity performance of recent years.

Against this background of fears over foreign investment, Fahy argues that as Ireland becomes a more expensive country in which to do business, ‘we need to generate a higher amount of manufacturing and service sector business from activities which have a high value-added content’.

As such, he recommends a real focus on encouraging research and development in all sectors.’ This Budget will not be remembered for the ten cents per packet of tax put on cigarettes, or the extra E100 million allocated to this or that hospital. But it could and should be remembered as the Budget that kick-started a real focus on R&D and scientific and technical innovation’.

O’Leary backs up Fahy’s assertion by saying, ‘the goals set out in the NDP as regards to developing a Research and Development and innovation-led culture in the country must be followed through with real action’.

Benchmarking was also mentioned as another thing to avoid.

Public spending - ‘First, do no harm’
The government’s approach to public spending in the forthcoming Budget is going to be key to keeping its finances in the black over the coming years. ‘To maintain a prudent tack, current spending growth must be kept in check and within this, increases in public-sector pay must be kept to a minimum,’ says O’Leary.

However, one of the economists, Fahy, is weary of all the talk about the need to restrain public spending growth, ‘and year in and year out successive Ministers for Finance say the same things, but then when it comes to Budget Day they routinely increase day-to-day public spending by far more than inflation’.

In the current year, spending is budgeted to increase by almost 13 per cent, which follows an 11 per cent increase last year and a 9 per cent increase in 2005. But, as Kelleher points out, tax revenues are expected to increase by just a little over 5 per cent in 2007 and less than 5 per cent in 2008.

‘Clearly increases in current spending at the rates we have seen in recent years are not sustainable in this environment. At worst the increase in current spending (post Budget) should be contained to a mid to high single digit percentage increase,’ he says.

McQuaid says that he would be looking to keep the increase in current day to day spending in single digits, adding that, ‘it is imperative that spending on public sector pay and pensions as a percentage of total expenditure is reduced further’.

For his part, McArdle maintains that current spending should grow at the same rate as nominal GNP, i.e. 6 per cent instead of the 16 per cent that is the average of the first eight months of 2007 or the 8 per cent that some are speculating upon.
But despite concerns over the level of public spending, Kelleher adds that, ‘the Minister should not be unduly cautious about fiscal targets,’ and he states that the Minister should be willing to run a GGB deficit of at least 1 per cent of GDP next year, ‘given the low level of opening debt’.

O’Brien is also in agreement, saying that the government has plenty of scope within EU budgetary rules to borrow, should it need to. ‘Indeed, a budget deficit of the order of E6 billion could be run without breaching the 3 per cent of GDP deficit ceiling under those rules. National debt is very low by any international standard, at 14 per cent of GDP in net terms. There is every reason, therefore, to use a little of the available fiscal elbow room rather than tightening policy unnecessarily. Moreover, if Minister Cowen believes the economy is in danger of slowing seriously in 2008, a pro-cyclical tightening of fiscal policy is the last thing he should be contemplating,’ he says.

The public sector also needs to be reformed, adds Kelleher, and he recommends:

- Reforming the hierarchical structures and moving to a structure that replicates the private sector with regard to organisational structure and remuneration
- Encouraging more open competition from outside for positions at all levels within the public sector
- Automating as many customer facing functions as possible, following the model of e.g. the Revenue Commissioners and road tax

Also recommending reform is McArdle, who says that the government needs to find a way to abolish programmes that have outlived their usefulness. He says that a section in the Budget could be devoted to the termination of programmes that are no longer needed. ‘That is what any commercial business would do,’ he adds.

Infrastructure programme remains vital
There is consensus on the issue of whether or not the government should continue its capital spending programme at a time when the public finances are beginning to be squeezed.

As Kelleher says, ‘Keeping the commitment to the National Development Plan (NDP) is vital. In the past in times of fiscal tightness the capital programme has always been sacrificed for current spending’.

He is backed up by McArdle, who argues that, ‘Cutbacks at this stage would torpedo this initiative which is far more important than the procedural budgetary reforms announced recently’.
McQuaid says that the Minister should actually increase capital spending in the Budget, particularly with regards to transport and energy investment.

O’Leary argues that focus must be placed on public transport projects first and foremost, while the roll-out of the National Roads Programme is ‘imperative’, ‘given the deep-rooted traffic problems and the associated costs that these incur on the Irish economy’.

However, while the panel advocates continued spending on the NDP, they warn that achieving ‘value for money’ is also important. ‘The main priority should be to ensure that a speedy delivery does not result in significant cost overruns,’ says Hughes, while O’Leary says that it will be necessary to keep the pressure on organisations like the National Roads Authority and the Railway Procurement Agency to keep up the momentum so that the various projects do materialise on time and budget.

Still room for tax cuts
As with infrastructural spending, many of the economists don’t believe that the Minister’s tax reduction package should be abandoned. As Hughes says, ‘While there may be some temptation to err on the side of fiscal tightness because of a somewhat weaker outlook for the public finances, a failure to underpin disposable income growth could prompt higher wage demands in some key sectors. In the light of the central contribution of low taxation to the advances made by the economy in the past 20 years, it would be dangerous to send any signal that even unintentionally hinted at the prospect of a rising tax burden in coming years’.

Moreover, O’Brien remarks that as the current generation of taxpayers, ‘is footing more than its fair share of the bill for benefits that will be enjoyed by future generations, Government could reduce this generational imbalance by cutting taxes’.

Different methods of reducing the tax burden are proposed by the panel.

Kelleher says that the Budget should focus on increasing bands and allowances rather than reducing tax rates. ‘The current system of having two separate income tax codes makes no sense i.e. the traditional one and the PRSI/health levy system alongside it. It creates all sorts of anomalies, poverty traps and disincentives. A start should be made in integrating the two systems,’ he suggests.

In agreement is McQuaid, who says that tax changes should be geared towards ‘widening bands, and to taking more of those low-income earners out of the tax-net’.

Indexation is the method preferred by McArdle and O’Leary - ‘anything else is taxation by stealth’ says McArdle. Under this method, all income tax bands and allowances would be raised by 5 per cent if the indexation was backward-looking and about 3 per cent if it was forward-looking. O’Leary is also in favour of indexation, so that ‘workers’ real incomes are not eroded’.

With regards to indirect taxes, O’Leary recommends that no added upward pressure should be put on inflation by altering indirect taxes such as VAT. For his part, McQuaid recommends that the Minister refrain from raising indirect taxes on the ‘old reliables’, and instead argues that the level of VAT charged on certain goods and services, particularly on the likes of gas and electricity, should be reduced. McArdle says that indexation should be extended to excises as well,which should be raised in line with inflation ‘even if this does add to the CPI’.

Fahy only suggests tax increases that are justifiable on social grounds. for example increases in duties on cigarettes and perhaps cars or motor fuel.

Other features of this year’s Budget should deal with female involvement in the work force and employers’ PRSI contribution.

McArdle would also like to see female participation in the labour force further encouraged as he says, ‘it is preferable to immigration on cost and infrastructure grounds’. As ‘it is practically impossible to continue working once a second child is born as the cost of childcare frequently exceeds the marginal take home pay’, McArdle is looking for more imaginative ways to keep women in the workforce. As such, he argues that all tax measures focused on the family should be contingent on participation in the workforce, and therefore the stay at home tax allowance should be abolished and individualisation of income tax bands should be completed.

Following the contentious abolishment of the employers’ PRSI ceiling in 2001, McQuaid argues that this contribution should now be cut as it would ‘boost jobs’.

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