Budget 2016 and the consequences of taxation policy choices

Budget 2016

We need to set personal tax rates at levels that are likely to generate economic growth, writes Conor O’Brien of KPMG.

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Budget 2016 and the consequences of taxation policy choices

Budget 2016 is the first time that we see most Irish taxpayers reaping significant fruits from Ireland’s economic recovery. Tax cuts for low and middle incomes will result in more money in the pockets of individuals, many of whom have seen their after tax incomes significantly eroded by a series of pay cuts and tax rises over the past number of years.

Following such an extraordinarily difficult financial crisis, this is very much to be welcomed and it is to be hoped that this will be the first of many budgets where measured relief can be afforded to Irish taxpayers while still taking steps to protect and enhance Ireland’s economic competitiveness.

During the financial crisis, Irish policymakers acted resolutely and ultimately very successfully to protect and enhance the competitiveness of Ireland’s attractive corporation taxation regime. Further enhancements were outlined in the budget – most notably the announcement of a best in class, OECD-compliant, 6.25 per cent rate Knowledge Development Box regime.

The focus on remaining competitive on corporation tax during the crisis was very understandable. OECD research, and a wealth of other evidence, has made it clear that the tax which has most impact on economic development is a country’s corporation tax regime.

Ireland has assembled a very impressive and attractive corporation tax regime – certainly one of the most attractive in the world. This has been critical in retaining the exceptionally strong multinational sector and related employment in Ireland, which in turn has been key to our economic recovery. Key features of Ireland’s corporation tax offering include:

  • A 12.5 per cent rate of corporation tax for trading activities. 
  • A 6.25 per cent rate of corporation tax from January 1, 2016 for activities qualifying for the new Knowledge Development Box regime.
  • Attractive and competitive research and development tax credit and intellectual property taxation regimes. 
  • A substantial and well-negotiated network of double taxation agreements. 
  • A highly transparent, law-based corporation tax regime which is compliant with EU and other international law and best practice.

The final point above is increasingly important as the EU and the OECD are becoming ever more assertive in policing the taxation policies of national governments. In the case of the OECD, its recent Base Erosion and Profit Shifting (BEPS) project is likely to cause economic activity to flow towards those countries that are most BEPS compliant, as non-BEPS compliant locations, which may be targeted by countermeasures from other countries, fall out of favour.

The economic imperative of defending our corporation tax competitiveness combined with tight budgetary arithmetic has meant that personal tax relief has been relatively low on the agenda. Indeed, a series of income tax, CGT and CAT increases during the crisis meant that, in contrast to the corporation tax regime, Ireland emerged from the crisis with the competitiveness of its personal tax regime for domestic entrepreneurs significantly worsened.

Perhaps in recognition of this, and of the many voices clamouring for reform, the government launched a consultation on the taxation regime for entrepreneurs earlier this year. Some positive measures have emerged as a result. In particular, the proposed reduced 20 per cent CGT rate for entrepreneurs (subject to a lifetime limit of €1 million of net gains) is to be welcomed. Although it is significantly less attractive than the equivalent relief in Britain, it is a move in the right direction and it is to be hoped that it can be further enhanced over time from both a rate and lifetime limit perspective.

It is to be regretted that the budget continues the policy of denying tax reductions on incomes over €70,000 per annum. As the minister noted in his speech, the top 1 per cent of income taxpayers already pay more than the bottom 75 per cent combined. They also bear marginal income tax rates which are very high by international standards.

Juxtaposed with this, there is a wealth of evidence that income tax rates at such levels may well discourage business to such an extent that the total yield to the exchequer is less than it would be at lower marginal tax rates.

For example, assume a country collects €10 billion in income tax by levying an average income tax rate of 50 per cent. A analysis would suggest that by raising the tax rate to 60 per cent the yield to the exchequer would increase by €2 billion. Similarly, a cut in the rate to 40 per cent would “cost” the exchequer €2 billion. Such analysis is flawed in two important respects.

Firstly, it assumes that changes in income tax rates will cause no change in the behaviour of taxpayers, ie the results are based on a “static” analysis. This is rarely borne out in practice and there is a wealth of academic research that demonstrates that such behavioural effects are real and very significant. They arise because people do less overtime, start fewer businesses and even emigrate in response to increased personal tax rates.

As a consequence, tax rate increases beyond a certain level will actually reduce, rather than increase, the total yield to the exchequer. By comparison, reducing tax rates will, in some cases, increase the yield to the exchequer.

A local example of this is the halving of the Irish CGT rate from 40 per cent to 20 per cent between 1995 and 2000 – on a static analysis, the Irish exchequer’s CGT yield ought to have fallen by 50 per cent. Instead, the yield increased more than twelvefold (over 1,200 per cent) in real terms when one compares the CGT yield in 1995 with the CGT yield in 2000.

The second flaw in simplistic income tax models, is that they ignore the broader revenue raising effects outside of the income tax area. These are many and varied. Models that ignore them greatly overestimate the “cost” of income tax rate reductions and the yield from income tax rate increases.

An obvious example of one such revenue-raising effect is that if a taxpayer has more after-tax income, they may spend more money in the state and the state will collect more VAT, excise duty and so on.

Of similar importance is the fact that reduced income taxes will increase inward investment and growth – OECD research has found that, after corporation tax, income tax rates have the greatest impact on economic growth. Increased inward investment and growth will create more jobs and more tax revenues of all types. It will also enrich the state by reducing the need for unemployment and other welfare payments.

The aforementioned OECD BEPS project brings the broader effects of income tax policy changes right into focus, as the BEPS proposals insist that economic activity ought to be located for corporation tax purposes where key decision-makers are located.

Well thought through tax reductions can therefore spur great growth, as benefits multiply each other in a positive feedback loop. The British Treasury and the US Congressional Budget Office now routinely try to factor broad and dynamic effects into their tax policy planning.

Small economies with few natural resources, such as Switzerland, Singapore, Luxembourg and Hong Kong, have become some of the richest countries in the world on the back of sound economic management, rule of law and consistent pro-growth low taxation policies.

The experiences of similar open-economy countries and related independent research, has shown that broad and dynamic effects will be greatest in small economies (such as Ireland’s) in peripheral locations, with few natural resources, and a high propensity to emigrate (eg, due to English as a first language, good education, long history and culture of emigration etc).

It is also noted that broad and dynamic effects are greatest in relation to taxation changes on higher earners. Therefore, the Irish policy of deliberately maintaining high marginal tax rates on incomes over €70,000 combined with high CGT and CAT rates over the medium term is, in our view, likely to be more negative than positive to exchequer yield.

It is to be hoped that, as Ireland’s economy continues to recover, we will build on the success achieved to date, and set personal tax rates at levels most likely to generate economic growth, wealth and jobs for all of our people.  

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