The ‘Sticky Tax’ Phenomenon

Philip Lane of the IIIS discussed the future of Irish fiscal policy. This included the nature of the revenue deficit, the constraints around fiscal policy in the current environment, the political realities of tax policy, and what he considers the optimal path of public sector pay cuts and tax hikes.

Firstly, we’ll discuss the consequences of the composition of the budgetary deficit. In recent years, tax revenue became heavily reliant on assets. These sources have now dried up, and won’t ever recover to the same levels. Thus, it becomes a question of what, not whether, tax hikes will be permanent.

Right now, the primary objective is getting the budget deficit under control. The optimal means of achieving this requires consideration of the ‘stickiness’ that new taxes will have, and the effect this will have on the economy post-recovery.

For example, raising the marginal tax rates for high-income earners will be difficult to undo in a few years. This is why Lane prefers levies to increases in tax rates, as they can more easily be reversed.

The behaviour of middle-income earners are less sensitive to changes in the tax regime over the long-term, so their tax increases will unfortunately have to become a permanent fixture. Thus, they should be raised as soon as possible to reduce the impact of precautionary saving on aggregate demand.

If all that matters to the taxman is how much money is raised, then it would be preferable to introduce taxes that don’t distort the labour market. Consumption taxes are preferable to taxing income, as they will actually increase labour supply when coupled with falling wages.

Carbon taxes are the obvious solution to the problem. They are certain to be introduced over the next few years anyway, and are easily justifiable to the public.

Consumption will also be fairly elastic in the short-term, so the government can be certain of raising income. They might be regressive in nature, but this will only alleviate the rampant progressiveness of the current tax regime and especially recent changes.

Although not capable of raising enough revenue to make anything more than a dent in the budget short-fall, such alternatives to simple income tax rate hikes should be given consideration. The difficulties involved in regulating carbon emissions through trading permits are not large, and could be quickly and easily introduced. There are other examples.

If political factors make tax changes ‘sticky’, but they are unsustainable with regards to competitiveness, they should be avoided. More likely, the government will raise tax elsewhere, and introduce the carbon tax later regardless.

That will necessitate one more tax hike that needs to be reversed. The return to limited tax imposition on Irish citizens will be made that bit more difficult.

© The Free Marketeer 2009

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2 Responses to The ‘Sticky Tax’ Phenomenon

  1. I disagree that middle income earns taxes have to remain the same. Obama(I know, heresy)suggested that reducing taxes on middle income earners could “motivate” the economy. Unfortunately, he has shelved that idea.

  2. thefreemarketeers says:

    You’re certainly right that they shouldn’t remain exactly the same. Some of the deficit will be cyclical (and need to be reduced to limit the cost of borrowing, with tax raised from temporary sources). But I think we will need to see some part of the tax increases at middle income remain permanent.

    Since such a large portion of the budget deficit is structural, and public services aren’t going to disappear any time soon (although obviously, in my opinion massive reductions in government spending would be preferable), it’s just the lesser evil amongst the other options.

    Philip Lane (again!) wrote a paper in January in which he outlines the reduction in net tax burden on middle-income families. It’s quite startling. The paper is at http://www.irisheconomy.ie/Crisis/LaneCrisis.pdf. It’s quite clear that there is substantial room to tax middle-income earners, especially families, without disincentivising work.

    What was Obama’s reasoning? I presume the exigencies of actually financing a massive budget deficit caused him to shelve the idea..

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