The companion post to this one discussed the different issues around measuring who pays what in tax in Ireland. It also asks you to give your own thoughts (free from the constraints of the data!), so if you haven’t yet read it, please do before reading on.

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The post from 2009 outlined how the typical earner in Ireland in 2007 paid just 4% of their earnings over in income tax. Coupled with other information, primarily from the OECD on all-in tax rates for average earners, it painted clear picture of just how messed up Ireland’s income tax system was at the end of the bubble. Very generous tax credits, plus other reliefs, meant that most people had high marginal rates but low actual rates of tax: people thought they were paying a lot in tax while in fact they weren’t.

But, as discussed earlier, income tax is just one of the unavoidable blanket taxes, along with VAT, PRSI and the USC. Also, things have changed considerably since 2007, not only incomes but also the taxation system. What does the picture look like now, taking into account other forms of taxation?

Typical household income, by decile (Source: CSO Household Budget Survey)

Who earns what?

First things first, we need to set out what household we are looking at. The graph above outlines the ten stylised households analysed in this post – their incomes are taken from the CSO Household Budget Survey. (Remember – when looking at all these stats – that “household” here refers to all types of households, from students and OAPs living on their own to the nuclear family.)

The typical household in the poorest decile (10% of the population) earns just €1,400 a year and is given a further €7,400 in benefits. This is approximately the same level of benefits given to the second wealthiest 10% of the population. It is less than half the amount of benefits enjoyed by households in the 3rd-5th deciles (who earn annual incomes of €6,000-€20,000), who on average receive more than €16,000 a year in benefits.

The poorest 40% of households make ends meet by borrowing – in fact more than half of the €18,000 a year spent by the poorest 10% of households is financed by what economists call “dissaving”, i.e. either borrowing or running down savings. The richest 10% of households earn typically just under €150,000 and save almost €65,000 of that. In terms of inequality, the 90th percentile has almost 9 times the income of the 10th percentile and over 2.5 times the income of the middle household.

Who pays what?

With that out of the way, we can look at what households actually pay in tax. The second graph shows the euro amounts paid in tax by each of the ten stylised households, from the typical household in the poorest 10%, which pays about €1,500 in VAT, to the typical household in the richest 10%, which pays just under €10,000 in VAT, the same again in USC, about €6,000 in USC and almost €37,000 in income tax. In the companion post, a poll question asked what readers thought the household earning the industrial wage paid in income tax, PRSI and USC: the answer is about 15%, although if the question had been income tax alone, the answer would have been just over 5%!

Typical tax paid, by tax type and income decile (based on RC, ESRI and CSO data)

By these figures, the richest 10% of households pay almost 40% of all receipts from income tax, VAT, USC and PRSI. The second richest 10% pay a further 20%. Each of the poorest five deciles contributes less than 5% of all tax receipts – their combined contribution is just over 10%.

Simultaneously both excessively progressive and regressive

The third graph below shows the all-in tax rate (across income tax, USC, PRSI and VAT) for each of the ten income deciles. It takes into account earned income and transfers/benefits – which as I’ve stated before I believe should be treated as any other income source, to level the playing field between work and welfare.

Effective tax rate (Income tax+USC+PRSI+VAT) on all income (earned+benefits), by income group in Ireland

The graph shows the quirks of the Irish system. The system is, with one important caveat, extremely progressive, with the tax rate on wealthiest households (40%) more than twice that on average households (16%). In fact, it is probably too progressive (at least the non-VAT elements), as the marginal rate on income above relatively low thresholds (when compared internationally) is 52%, above the mental barrier of 50% that resonates when foreign executives look at where to base their new operation.

But the system is also hugely regressive. Because poorer households have to spend all their income (and then some), and all that spending is liable for VAT, their effective tax rate surpasses all other income groups in the bottom half of the income distribution.

If a tax is simple and fair, it will be popular (or at least as accepted – when was a tax ever popular?!). The €100 household charge is simple but not fair. The current income and VAT regimes are neither fair nor simple – who here knows their “Widowed Parent 5th yr. after death” tax credit from their “Farmers’ flat-rate addition” rate of VAT? But with some clarity of thought from the Government, and perhaps a prod from Europe or the IMF, it is within our grasp to have fair and simple tax regimes.

A flat rate of VAT, perhaps 15% (the lowest permitted by the EU), would address much of the regressiveness of VAT. And a 15% flat rate of income tax, where all income is treated as taxable, even when it is gifted by the State rather than earned, would do much to address the other oddities of Ireland’s tax system.

Based on patterns of spending and saving, though, one concern might be that this new system as a whole would not be progressive enough. This suggests two simple tweaks to the flat income tax is needed, namely issuing tax credits for the first €10,000 of income and adding a second rate, e.g. a further 10% tax on all income above say €40,000.

Such a system would generate about 7% more income, and the effective tax rate of the poorest 10% of households would be reduced. (In this Ronan-dictator-for-a-day scenario, this new system would be brought in along with a Site Value Tax that would shift the burden away from economic recovery.) This system would also be significantly fairer, with effective tax rates varying from 15% (for the poorest decile) to 36% (for the richest decile).

Tweaking a broken system, however, is unlikely to get us back on the right path.

Nearly three years ago, I posted a little quiz on Ireland’s income tax. There were four questions – on what percentage of income was taken in tax for the typical millionaire and for the typical worker, on what proportion of workers paid less than 10% in tax and what rate they *should* pay. The answers were then compared with the latest available information – for the year 2007.

The post has been very popular and is repeatedly linked on popular forums such as boards.ie, askaboutmoney.com and politics.ie. There were a couple of limitations to it, however:

1. Firstly, the figures were for 2007 and there have been such dramatic changes in employment and income since then, more up-to-date statistics would be ideal.
2. Secondly, while one of the “Big Two”, income tax is still just one form of taxation. VAT is the other biggie and there is research to show that VAT affects poorer households more: put another way, when you say “the average household in Ireland pays too little in tax”, people do not think you are talking only about income tax.
3. Thirdly, in addition to income tax and VAT, there are two further unavoidable distortionary taxes, PRSI (which is technically a form of compulsory insurance) and the Universal Social Charge. It would be nice to include all four of these taxes in any analysis.
• At this point, it’s worth noting the following: other taxes, including those on alcohol, cigarettes and petrol, and service charges (such as bin or water charges) are not unavoidable taxes – they are charges for a particular service or else designed to bring the market cost up to match the social cost. Those four taxes above are the only major indiscriminate taxes, which apply to all households but which don’t serve any particular purpose other than the very general funding of public services.
4. Fourthly, the different income brackets given by the Revenue Commissioners are relatively arbitrary. It would be nice to talk instead about households in specific parts of the distribution, for example, different deciles (e.g. richest 10% versus poorest 10% of households).
5. Lastly, looking at earned income is not exactly using a level playing field. Someone earning €20,000 a year through hard work is treated very differently to someone gifted €20,000 a year by the State – but income is still income. In my own opinion, all income – regardless of whether it is earned or benefits – should be taxable, and the rate of tax that is paid can then be chosen by policymakers.

With updated figures from the Revenue Commissioners, the publication of the CSO Household Budget Survey and ESRI research on the distributional effects of VAT, each one of these issues can now be addressed. What these combined datasets allow us to do is calculate the average all-in rate of tax paid by the typical household in each decile, i.e. the typical household from the poorest 10% up to the richest 10%, as measured by income.

But before finding out exactly who pays what in tax in Ireland these days, let’s see what we think is and should be the case.

Note: There is a poll embedded within this post, please visit the site to participate in this post's poll.Note: There is a poll embedded within this post, please visit the site to participate in this post's poll.Note: There is a poll embedded within this post, please visit the site to participate in this post's poll.Note: There is a poll embedded within this post, please visit the site to participate in this post's poll.Note: There is a poll embedded within this post, please visit the site to participate in this post's poll.Note: There is a poll embedded within this post, please visit the site to participate in this post's poll.

Now, on to the answers!

Over the past month, I’ve given a couple of talks on the Irish economy and the Irish property market in particular. While not exactly following the model of the “Single Transferable Speech” adopted by some, there was understandably – given the similar topics – a good deal of overlap between talks given to the public at the Central Dublin Library and an-EU sponsored conference on the Irish Economy in NUI Galway.

Both talks build on not only some of the academic research I’ve been doing recently but also material that only exists thanks to this blog and the feedback from readers, such as this post “Are we nearly there yet?“, comparing house prices now to their long-run level and to incomes and rents in Ireland since the 1970s.

A video of my talk in Galway is up on Vimeo here, while the slides are available both on Slideshare and on Scribd: both are embedded below also. All five sessions from the Galway conference are up on the Digital Revolutionaries Vimeo page. John McHale’s presentation contained a really neat graph with revisions to Ireland’s growth expectations by various bodies over the past 18 months, while Aidan Kane’s talk contains lots of fascinating information on Ireland’s historical debt issues, going waaaay back into the 1600s!

Ronan Lyons – The Irish property market from Digital Revolutionaries on Vimeo.

The end of the first quarter of 2012 saw not just the usual quarterly reports – such as the Q1 2012 Daft.ie House Price Report discussed elsewhere on the blog – but also the deadline for paying the €100 Household Charge. The charge has been the focus of a campaign of resistance that is surely more to do with the principle than its size (the increase in Band A motor tax was almost as large as the Household Charge but I don’t recall anyone complaining against that particular flat tax).

In fact that campaign has succeeded in one way already: while it had originally talked about the charge applying for 2-3 years on an interim, the Government is now not going to go through all this again and desperately wants to bring in a fairer property tax with Budget 2013 this coming December.

Where’s all the property wealth?

What sort of base is there for property tax? The latest Daft.ie Report gives county-by-county figures, which can be combined with information from 2006 and subsequent completions (or alternatively Census 2011 information) to reveal what wealth there is in residential real estate around the country.

The total amount of wealth in residential property peaked in 2007Q4, at €564bn. 37% of all this wealth (€208bn) was in Dublin (home to just 28.5% of households in 2006). A further €37bn was in the four other cities – their 6.5% being roughly in line with their 7% share of all households. Since then, the trickle of new completions has not been nearly enough to offset the fall in property values. The stock of homes as of Census 2006 has fallen in value from €525bn to €255bn, as of Q1 2012, while including the value of new completions in the years since 2006 increases the total value of all residential property to €294bn.

Households and housing wealth in Ireland

Dublin is now home to just under €100bn of housing wealth, as of early 2012, while the rest of Leinster and all of Munster are home to €70bn and €76bn in housing wealth respectively. Connacht and the three Ulster counties are home to about €48bn of housing wealth. The relative proportions that each of four regions makes up of Irish housing wealth and Irish households is shown in the two pie charts above – you can see that rural households need have no fear that any property tax will hit them hardest. Quite the reverse: any property tax will have to make sure that it doesn’t overly punish urban life, which is so crucial to subsidising the rest of the country.

Where’s all the wealth?

These are statistics that the political class would do well to heed. To recap our Econ1010, there are three main types of tax: those on incomes, those on consumption and those on wealth. Ireland is also home to some of the world’s most punitive rates of taxation on income and consumption, so hence there is increasing interest in wealth taxes.

There are four main forms of wealth: (1) cash/deposits, (2) equities/shares, (3) debt/bonds, and (4) real estate/property. In Ireland, as of 2006, deposits made up 10% of Irish wealth, equities a further 8%. Pension and investment funds – wealth holdings of unknown type but likely to be a mix of mainly equities and bonds – made up a further 11% of wealth. But it was property that was the overwhelming type of wealth in Ireland, making up 72% of all wealth. The vast bulk of this was residential property. And that picture is not likely to have changed substantially with so much of Irish equity wealth being invested in the banks, which are now all next to worthless.

So when people talk about taxing wealth in this country, they are talking principally about taxing the homes that we live in. In second place comes taxing the deposits we have in the bank. Make sure to mention this to the next person who says “We don’t need a property tax, we need a wealth tax”.

The latest Daft.ie House Price Report was released this morning and contains what may be surprising reading for some. Across three different metrics, there were signs of improved activity in the market in the first three months of the year. Given we sent out press releases to journalists before midday on April 1, I did worry that some of them might think it all just an April fool!

Increased optimism

But the signs are there. The fall in asking prices in the first three months of the year was, at 1.4%, the smallest fall in asking prices seen since prices started to fall in 2007. “Smallest fall” mightn’t sound like particularly good news for homeowners but what was particularly interesting was the fact that the average asking price rose in a number of regions.

Of 26 counties, the average asking price rose in eleven. An average price increasing at the county-level despite general falls is not unheard of – every other quarter might see one or two counties buck the trend, before falling again the next quarter. However, eleven in one quarter is as many county-level increases as the previous seven quarters put together.

Quarterly change in asking prices, by county, Q1 2012

Over on Manyeyes, I’ve visualised the changes over the last three months by county – an overview is given in the graph above. I think what’s interesting is that there is an obvious difference between the “bottom half” of the island, so to speak and the stretch from Galway over to Dublin. This less than random scattering of increases also suggests something more fundamental at work.

Shifting properties

Why are sellers in many parts of the country being more optimistic, though? Some – such as NAMA Wine Lake – believe that we can read very little into analysis of the actions of 27,000+ sellers and this is probably just noise. However, what are other metrics telling us? Sellers may be more optimistic if properties are shifting.

There is some evidence, particularly in Dublin and Leinster, that properties are shifting. The total number of properties for sale in Dublin is at its lowest since mid-2007 while the slow and steady decline in the stock sitting on the market in the rest of Leinster continues: there are now 14,000 properties for sale in the province, down from a peak of 18,000.

One other metric we’ve been pioneering in the Daft Report is the proportion of properties selling within a certain number of months. Typically, one might look at time-to-sell of the average property coming off the market but in a market where some properties have been up for three or more years, averages will get skewed and not give a fair indication to someone selling at a realistic price now of how long it will take to sell a property.

The report gives the proportion of properties selling within four months of listing, for both December (30%) and March (33%). And – like the average asking price and total stock on the market – it does suggest a slight improvement in conditions in the first few months of 2012. One third of properties now find a buyer within four months. In Dublin, that figure is 40%.

As I’ve been saying on radio this morning, I wouldn’t be take this report and run off popping open the champagne in the certainty of the market having stabilised. Instead, it’s a step in the right direction. Recovery in the property market is about activity (not prices). There’s evidence from today’s report that conditions did improve in the first quarter of the year – but that could easily be undone by trends between April and June. In particular, without sufficient lending by the banks, it’s unlikely we’ll see any stabilisation and recovery in the property market.

The daft-myhome conundrum

For those paying attention, there’s an obvious clash between what this Daft Report is saying and what the alternative report, by Myhome.ie, is saying. Whereas the Daft Report shows these three indications of improved market conditions, the Myhome report reads like the Daft Report from January: they’ve seen the largest fall in their series yet.

I learnt recently that there is one large methodological difference between the two reports. While the underlying methodology, hedonic regressions, is the same (and is also used by the CSO and was previously used by the ESRI), Myhome use all properties listed on their site come late March, no matter how long those properties have been listed. Asking prices however reflect sellers expectations and in my own opinion it should only be expectations formed (i.e. properties listed) during the quarter that are counted.

The other difference is the sample size available to each website. Daft has approximately 50% more properties listed for sale than Myhome and this is particularly pronounced outside Dublin (in the capital, to the best of my knowledge, it is pretty much even).

Last week, I outlined some of the many reasons why the EU’s Fiscal Compact should have been sent back to the drawing board when first seen by European leaders and their economic advisers. The experience of Spain since then sums these up pretty well. Spain had been given a target deficit of 4.4% of GDP this year. But it turns out the deficit is going to be closer to 6% of GDP.

The Pain in Spain

And with good cause. Firstly, the Spanish government doesn’t control GDP. It barely controls its own spending, let alone its own receipts. So what happens GDP should not be enshrined in laws and constitutions. The Fiscal Compact should be about government spending relative to government receipts, and not relative to some arbitrary concept of national accounting. For example, if the Government makes up about 50% of the economy, an 8.5% deficit relative to GDP actually means that 17% of spending is unfunded by current receipts.

Secondly, the Spanish government fears the effects of actually getting the deficit down to 4.4%. Halving that 17% unfunded spending down to just 9% in one year would mean cutting roughly 10% of Government spending… in one year! And all this while an economy is on the verge of recession, defeating the purpose of fiscal policy as one of the remaining tools of economic stabilisation for economies within a currency union.

However, Ireland does not have the luxury of saying no to the EU’s Fiscal Compact. The reason why is simple: cash. Until someone comes up with an alternate plan for sovereign funding as Ireland closes its deficit, borrowing from our EU partners and the IMF at what are – relative to the markets – low interest rates is the only game in town.

Bear in mind that our borrowing requirements are substantial. We’ve roughly €120bn in debt that needs to be rolled over at various intervals (although some of this is owed to Irish citizens, for example in the form of Prize Bonds) while an optimistic scenario sees us borrowing a further €14bn this year, €12bn next year, €10bn the year after… and so on meaning our national debt will be something like €170bn before it is close to stabilisation.

If not EU, who?

The plan, of course, was to go back to the markets in a substantial way next year. The question is, though, with the sovereign debt markets as they are, who would lend to Ireland at anything close to the 3% medium-term growth rate we are hoping for? (When national debt is the roughly the same size as the entire economy, the quickest way of assessing sustainability of debt is to compare the interest rate with the growth rate. If the interest rate is higher than growth, debt repayments would ultimately dwarf all other spending.)

Not only that, any institution that would lend to Ireland would attach conditions that would be effectively identical to the Fiscal Compact: i.e. Ireland’s government would need to get its spending back into balance and fast. The only alternative would be to balance the books overnight – this would be an extremely painful overnight adjustment, with public servants and social welfare recipients experiencing a dramatic reduction in their income.

Compared to that, the EU Fiscal Compact is quite attractive. The “path of adjustment” outlined in the Compact gives Ireland a full two decades upon exiting the bailout programme in 2015 to reduce the debt from, say, 120% of GDP, to 60%. That’s right – only in 2035 will the full EU Fiscal Compact and all its silliness apply to Ireland.

So, as an economist, I think the EU Fiscal Compact should be completely rewritten, this time with an understanding of fiscal policy. But it will go ahead, with or without Ireland’s assent in a referendum – the referendum is really only about whether Ireland wants to opt in for further funding from 2013 if needed. So as an Irish citizen, it has to be a yes for the EU Fiscal Compact.

Over the last few days, there has been a lively debate on Ireland’s corporate tax affairs. It all started when Stephen Kinsella declared “Let’s say it out loud: Ireland is a tax haven”. Stephen pointed to this not to make the case that we should change our policy on the 12.5% rate – as he himself notes, “we need all the investment we can get”, but to highlight the threats associated with being dependent on tax motives for investment – in particular threats from the US political system, as it struggles with high unemployment and anger at big business.

Op-Ed Wars: It’s getting fiscal

The following day, and in the same newspaper, Brian Keegan of Chartered Accountants Ireland responded. Taking the OECD’s definition of how a region earns “tax haven” status, Brian went point by point through, outlining that Ireland has far more than nominal rates of tax, is very clear on tax issues, does share information with other jurisdictions and – at least according to the ECJ – does require a significant presence in the economy from taxpayers.

With a further response by Stephen, it’s now all kicked off on irisheconomy.ie. For me, the top comment has come from Kevin Denny: it’s probably not very useful to use a value-loaded term like “tax haven” because that gets people’s backs up and instead we should focus on the core point that Stephen was trying to make: it could well be the case that changes to tax codes, either domestically driven or more worryingly elsewhere (especially the US), could have a significant impact on Ireland’s investment performance.

Formally testing for the “elasticity of foreign direct investment with respect to the corporate tax infrastructure” is not an easy ask. In fact, while you might be able to measure the impact of the headline rate on FDI, there are a multitude of factors above and beyond the headline rate that comprise the corporate tax infrastructure – many of these are very difficult to measure.

So in the absence of that exercise, what can do we do? Well, a tax haven is only useful if companies know about it and are using it. So why don’t we ask just investors what they think of Ireland?

Why don’t we ask them?

Yesterday, a report I authored entitled “Investing in Ireland – A survey of foreign direct investors” was launched. The EIU report involved a survey of over 300 executives that had both responsibility for foreign direct investment decisions in their company and familiarity with Ireland. The survey was complemented by ten face-to-face interviews, with executives of companies that have significant operations here, such as Google, those with small operations here (such as Goldman Sachs) and those that could have chosen Ireland but didn’t (such as Kayak).

The survey asked respondents why they set up overseas, what they look for in potential investment locations, whether Government incentives matter (and it so which ones), and which locations (other than Ireland) are most attractive to them for FDI. It also asks them specifically about Ireland: what Ireland’s strengths and weaknesses are as a location for investment, if they have operations here why they came, if they are expanding why – and if they are not based here, why. The survey did not shirk the tax issue either: respondents were asked about the importance of the headline tax rate, the ability to transfer price and Ireland’s network of double taxation treaties.

There will of course always be quibbles about what exactly this sample represents but policymakers do not have the luxury of ignoring all surveys until the One True Survey comes along to answer all their questions. They need to act based on available information, knowing the strengths and weaknesses of that information. Like any good survey, a significant number of cohort questions were also asked of respondents so we do know a good deal about responding companies, including sector, size, number of countries and HQ country.

Ireland’s four pillars

So what do investors say about Ireland? Is it all about the tax? Well… no. There are four reasons Ireland is so successful attracting investment – tax is but one. The foundation of Ireland’s competitiveness is market access: the principal reason companies go international is not to cut costs, it is to access new markets. Ireland offers companies outside the EU access to the world’s largest market. When asked what Ireland’s top three competitive advantages were, by far and away the most popular one was access to EU (and EMEA) markets.

But Ireland has no more access to the EU markets than Birmingham, Barcelona or Bavaria. What else does Ireland have? Access to skill is a second pillar of investment in to Ireland. This can sound like patting ourselves on the back – as Paul Duffy, CEO of Pfizer Ireland, says, “The reason that Pfizer has expanded in Ireland so extensively is the country’s proven ability, from as early as the 1960s, to deliver. The people are reliable and can handle complexity.” But the facts remain: Ireland has a larger proportion of young people with higher education than most other EU countries.  And crucially, Ireland is open to skill from elsewhere in the EU: access to skills from across the EU was chosen by almost as many respondents as one of Ireland’s competitive advantages (23%) as local skills (26%).

Ireland's competitive advantages, according to investors

A third key pillar is the regulatory environment – as you can see from the graph above (taken from the report), both the ease of doing business and Ireland’s legal and fiscal stability were highlighted by between one quarter and one third of investors.

The fourth pillar is tax. But even here, we should be careful not be caught like a rabbit staring at the headlines, so to speak. The headline corporate tax rate is just one component of Ireland’s corporate tax infrastructure. Perhaps more of interest to firms is the effective rate of corporate tax (i.e. once all allowances and loopholes have been applied). And while Ireland has one of the lowest headline rates of corporate tax in the Eurozone, its effective rate (as per the World Bank Doing Business report) is in line with the Eurozone average (both median and mean).

Other components of the tax infrastructure also matter – the network of double taxation treaties matters, particularly to financial services firms (22% of FS firms mentioned it as one of Ireland’s top three competitive advantages). And the ability to transfer price matters too – it was the third most important fiscal incentive for respondents, after the headline rate and double taxation treaties.

Tax Haven? Yes with an if, no with a but

While Stephen is right to highlight the risks of changes in the international taxation environment, Ireland is not a tax haven in the true sense of the word. Tax is not the only reason companies are here – if they were after low taxes on profits, there are plenty of jurisdictions that will charge them zero.

Firms have significant operations in Ireland because of the bundle of factors Ireland offers. I’m sorry I can’t give a more dramatic answer but this is the truth. But in a way, the answer is already dramatic enough. If Ireland were to lose its attractiveness completely on any one of the four factors highlighted – market access, skills, regulatory regime or tax – its phenomenal competitiveness at attracting FDI would be under threat.

So if by “tax haven” you mean that Ireland could no longer continue to attract investment if it had an uncompetitive tax infrastructure, then that it is true. Ireland is also a skill haven, an ease of doing business haven and a market access haven.

PS. There’s lots more to the EIU report than just tax – Ireland’s cost competitiveness, for example, the threat posed by high marginal rates of income tax or recent financial regulation, and indeed the plans they have to create new jobs here. I’ll probably post again on this report but if you get the chance, give the report a read – it’s not long.

This year, I’m teaching first year undergraduates at Trinity. I’ve a gang of about 400 and they’re mostly students not interested in studying Economics after this course. My job is to try and make them economically literate as they head off into the world. Part of the course is about macroeconomics in their everyday life: how the jobs market works, how the housing market works, that kind of thing.

But the first part of the course is about giving them the grounding to understand the bulk of major headlines at the moment. Unemployment, negative equity, emigration, bailouts, quantitative easing, bondholders, recessions and business cycles… it is hard these days to be an educated citizen without a thorough grasp of what monetary and fiscal policy are and indeed how the modern banking system works.

Back to school for some

Surprisingly hard, it turns out, to be an educated policymaker or politician these days too. Leaders of twenty-five European countries have signed up to a fiscal compact that would, I hope, be soundly trashed by a II.1-standard student if I set this in the summer exam.

Any first year undergrads that have been paying attention to my lectures will know that there is a limited number of tools available to policymakers to smooth out the bumps (recessions) that modern economies face as living standards grow from one generation to the next. Trade policy – using tariffs or quotas to protect domestic producers (at the expense of domestic consumers) – was a classic response but is not an option for members of the World Trade Organisation.

The next most popular instrument has traditionally been monetary policy, in particular a Central Bank setting the interest rate in an economy. The lower the interest rate, the cheaper it is for firms and households to borrow – and thus economic activity (even if it’s just buying homes) should be stimulated. Members of a currency union, however, such as Wales within the UK, Florida within the US or Ireland within the Eurozone, don’t have this option either.

In the middle of a huge recession, it may seem odd that most economies (particularly if you view the US as a collection of cities and states at very different points in the business cycle) have no recourse to either trade policy or monetary policy. But there is clear justification for both: trade policy is all about protecting domestic producers at the expense of domestic consumers (and producers elsewhere). Having your own currency and interest rate exposes you to the vagaries of international exchange rate markets, meaning – as older Irish borrowers know all too well – high and volatile interest rates, which reduce investment.

The importance of fiscal policy

This leaves just one set of tools for policymakers to smooth the ups and downs that modern economies inevitably face: fiscal policy, the government’s taxing and spending decisions. Given that spending has to rise in bad times and fall (at least relatively) in the good times, the watchword is discretion. You need judgement to be exercised, based on context, when thinking about how to use fiscal policy.

Unfortunately, though, the Fiscal Compact has gone the opposite way. It is as though it has been designed by diehard fans of the recent fashion in monetary policy for rules and automatic mechanisms, people who think that what worked so well in one area (by ‘well’, I mean sort of well at least until the Great Recession came along) can be copied and pasted into another area.

Fair enough, you might say, but if the rules are good ones, then what’s the worry? Unfortunately, the rules are populist but economically illiterate. For example, the start of Article 3 of the Compact states the overall aim: “The budgetary position of the general government… shall be balanced or in surplus.” In brief, the EU Fiscal Compact takes the last remaining tool for stabilising the economy away from policymakers.

EU to member states: borrowing to better yourself is bad

This is the country-level equivalent of telling a student that they can’t borrow to go to college so that their future earnings will be higher – instead they have to live within their means. Because countries, unlike households, don’t age and die, there is nothing wrong about having a national debt and not paying it back. In fact, unless there’s an abundance of natural resources, only a silly country would ever attempt the pain of paying back the principal of national debt, rather than simply roll it over and keep on growing until the debt is small.

Countries shouldn’t be just allowed to borrow ad infinitum – provided they are investing in projects that boost growth, they should be practically required to borrow. If a government’s capital spending is consistently boosting the country’s output by 5% a year, the markets are not going to stop that government from borrowing 5% of GDP a year, every year. But now the EU Fiscal Compact will ban such spending.

As long as current spending is in balance and capital spending is based on the boost it gives to future output, markets will lend. The trouble is that government finances have not been organised along these lines. In that vacuum, financial markets have come up with their own measures of sustainability, in particular the “primary surplus”.

Who’s measuring what now?

The primary surplus is government’s balance, excluding interest repayments. It is economically meaningless, with only the veneer of sustainability… “but if we didn’t have all this debt, we’d be fine”. But it is mathematically compelling, because it turns the focus to comparing the interest rate on national debt (say 6% if Ireland returned to the markets) and the economy’s growth rate (say 3% in a benign scenario).

Quite how this tool of necessity on the part of financial analysts, due to dereliction of duty by governments, has become one of the measurement tools of choice by governments is beyond me. But that is the lesser of two evils, when it comes to how bad a job EU governments are doing at putting their finances on a sound footing.

The other key measurement of choice – written throughout the EU Fiscal Compact – is deficit relative to “potential output”. Nobody actually knows what potential output is: technically, it’s the level of GDP that would have happened if the economy were in balance… which of course it never is, so how on earth do we know what it is? This didn’t, of course, stop EU policymakers from putting it front line and centre in the Compact. From the same Article 3: “the [above] rule shall be deemed to be respected if the annual structural balance of the general government is at [no worse than] a structural deficit of 0.5 % of GDP at market prices.”

Output and potential output in Ireland 1980-2016, for different years of calculation

Potential output and the potential for error

Why might economists say this is crazy? To show this, let’s consider “potential output” in 2016 – shown in the graph above. As of 1995, real growth in Ireland had been an average of 3.4% a year since 1980 so an economist at the time might have thought this a reasonable basis on which to project potential output. By this calculation, output would have been €114bn in 2005 and €164bn in 2016 (the red line in the graph above; I’m setting aside inflation to show that this point holds even in constant prices).

Output was actually €161bn in 2005 (in today’s prices) so our economist would either have to conclude that Ireland was running well ahead of its sustainable potential or that his model was wrong. So let’s say he thinks his model is wrong and that he now knows Ireland’s potential output grows by 6% a year (which is what it had done on average between 1990 and 2005). He now confidently predicts that potential output in Ireland in 2016 will be €309bn (the green line), almost twice his initial projection for 2016.

Well, as of last September, the IMF expected output in 2016 to be €183bn (the blue line). Even a more level-headed economist, as of 2007, might have thought potential output would grow by 3.4% a year (i.e. back at pre-Celtic Tiger rates), in which case potential output would be €232bn in 2016 (the purple line). Either way, the margin for error is huge. We don’t ever actually see “potential output” (heck, even calculating GDP is dodgy enough) so why would we put it in our constitution?!

In a way, though, the whole potential output thing – while attracting a bit of attention – is a bit of a sideshow. There are two main issues with the Fiscal Compact. Firstly, it brings rules to an area where there should be discretion – fiscal policy is not monetary policy and flexibility is key. Yes, governments don’t have a good track record on spending but surely we should tackle the cause rather than the symptom. Secondly, and much more worryingly, it is bringing the wrong rules. By thinking deficits are a bad thing, it will actually prevent the investment that – in the long run – will boost living standards and repay the interest on the very borrowings the EU is worried about.

And yet, despite all this, Irish citizens should vote yes! I’ll explain why next week.

PS. Similar sentiments are expressed by Karl Whelan here. A more benign assessment of the impact of the EU Fiscal Compact is given by Philip Lane.

The imminent publication of the house price register, where from June this year all members of the public will be able to find out the transaction price of a particular property, can only be welcomed by those interested in restoring Ireland’s moribund property market to some sense of normality.

The recent economic history of Ireland’s property market is well known, not only in this country but the world over. From the 1990s until the mid-2000s, the world economy was one of many buoyant property markets. Since 2007, prices in many major markets, including large parts of Europe and the U.S., have fallen significantly. And in that story, Ireland sticks out, with the largest rise in house prices of any developed economy in the decade to 2007 – 300% if anyone needs reminding – and the largest fall in the five years since – over 50% as of late 2011.

Why Ireland sticks out

But why was Ireland’s bubble-crash cycle so vicious? While there is a long list of potential suspects, three factors that distinguish Ireland from most other countries must shoulder the lion’s share of the blame. One was opening the floodgates of Eurozone credit to an Irish banking system that had up to that point only ever been used to having to fight for every pound. A second factor was Ireland’s extraordinarily generous treatment of property as a form of wealth: Ireland was, as of 2005, the only modern economy where citizens neither paid an annual property tax nor capital gains if they sold their house at a profit. (Indeed, the situation is worse now, with the only substantial property market tax that existed in 2005, stamp duty, effectively abolished.)

The third factor – and perhaps the least excusable – was the poor quality of information available to those transacting in the property market. To see why this matters so much, we need to go back to how the property market works. The price paid for a property today reflects people’s expectations of what they think will happen property prices tomorrow, next year and over the coming generation. This makes our expectations of fundamental importance.

People’s expectations of house prices are what economists call adaptive: if they see prices having risen by 60% in the last five years, most assume that something similar will happen the next five years. And sure enough, if you look at the ESRI survey of consumer confidence from early 2007, most people thought that house prices would increase by as much between 2007 and 2012 as they had done between 2002 and 2007.

The importance of expectations

But of course we know that is not what happened. So part of ensuring that the bubble and crash we have just experienced never again happens involves not only fixing how banks themselves borrow – and how society taxes property – but also improving how people form their expectations of house prices. Think back to bubble-era Ireland. Then, we had a situation where the price of an off-plan apartment would be higher on a Monday than the previous Friday. Why? Because in the frenzy, nobody knew what anything was really selling for – and to avoid getting caught out, they effectively gazumped themselves.

The best tool to fight this type of situation is information and the house price register is the most obvious step forward. There will of course be those that think it is nothing but an annoying invasion of privacy. But they need to think of others. After all, buying a home is the largest transaction that most people will ever engage in – surely it is only reasonable that we give our young families as much information as possible before they take the plunge.

The house price register will do this. Members of the public will be able to go on to a map of Ireland, click on their area of interest and see all recent transactions, their addresses and their prices. In the early years, it seems other information – such as property type, building size or site size – won’t yet be available but given the huge amount of work being done in digitizing Land Registry records and local authority Development Plans, it’s only a matter of time before the “informational infrastructure” available to Irish people becomes even better.

Aside from perhaps the labour market, there is no more important market in any modern economy than housing. In Ireland, we (still) hold some €300bn in residential property alone. All types of real estate make up probably three quarters of our wealth, while housing makes up more of the country’s “basket of goods” than any other good or service. The links between housing and the broader economy have gone from being underappreciated by economists ten years ago to a hot topic of research now. In the Ireland of 2012, with widespread unemployment, negative equity and growing mortgage arrears, those links are all too real.

Make no mistake – the house price register will not be a panacea. But it is an important step in normalising Ireland’s property market and creating a healthier link between it and the rest of the economy.

–

This post originally appeared as an op-ed in the Irish Independent last week. It does not seem to be available online but its companion piece, by Michael Brennan, is available here.

Recently, reading the Irish Independent has been a bit of a rollercoaster for me – one day I’m practically doing the government’s job for it for free, the next I’m guilty of elder abuse. By way of context, in late January, I presented at the Dublin Economics Workshop Conference on Irish Economic Policy. Specifically, I presented on how a Site Value Tax might be introduced in this country, both on an interim basis and on a full-time basis – a podcast of the entire property market session is over on the irisheconomy.ie website.

My proposal – full report here – was relatively straightforward: use the best information we have currently (1.3 million sales and lettings ads posted on daft.ie between 2006 and 2011), and the best methods available for establishing the components of house prices (hedonic price regressions) to implement the best known form of taxation (Site Value Tax) on an interim basis, in an area where Ireland desperately needs new revenues: residential property. And when better information becomes available – in particular the Revenue Commissioners register of transactions – then that can be used for a full Site Value Tax. My map outlining relative land values in 4,500 districts across the country is reproduced below.

4,500 districts of Ireland put into one of ten land value bands, for the purposes of an interim SVT

SVT: the sales pitch

A Site Value Tax (SVT) is an annual tax that is paid on the value of the land that you own. If you own a four-bed semi-detached in suburban Dublin worth €400,000, you can think of that €400,000 as being the value of the building (say €300,000) added to the value of the land (say €100,000). Your tax bill would be something like 2% of the €100,000.

Why do I say SVT is the best known form of taxation? Ultimately, because it’s fair and efficient. It’s that rarest of taxes, popular with not only both left- and right-wings but also with environmentalists. Left-wingers like Site Value Tax because ultimately real estate is the single biggest form of wealth – and what left-winger worth their salt doesn’t like a wealth tax? Right-wingers like Site Value Tax because it does not distort economic outcomes: land can’t go anywhere, unlike pretty much every other input you can think of, so just because it’s taxed doesn’t mean that rents have to go up or that business has to move elsewhere. And environmentalists like Site Value Tax because it encourages the best use of land, which is a scarce resource. Why would you keep a site derelict if you’re getting taxed as much as the same the guy next door making that land work?

A Site Value Tax is particularly appealing when viewed in the context of local government. Think back to why any land you own is worth more than agricultural land. It’s because of a range of amenities to which your land offers access – from public services like education, health and public safety, through environmental amenities like urban green space, coastline or lakes, to more intangible services, such as access to thick labour or consumer markets. Unlike, say, the value associated with shares in a firm, no one person or group of people creates the value associated with land – society does and thus SVT is the return that society gets for creating the amenities we enjoy.

SVT: glitches and hitches

The Irish property-owner, however, may not be as impressed with such lofty talk. What about those who bought in the boom and who are now stuck in negative equity? What about those, such as elderly couples, who are land-rich but cash-poor? What about those who live on rural sites that might be ten, fifty or even a hundred times the size of those in urban homes?

A Site Value Tax fundamentalist would say that none of this matters. Those who bought during the boom are not going to un-buy because this tax is brought in and besides the SVT reflects current land values, not bubble-era values. They would argue that those who are land-rich but cash-poor should be encouraged to move on, as a country where every set of parents who refuse to downsize on retirement push their own children’s homes further out. And a country of large rural sites imposes greater costs on urban dwellers subsidising their scattered neighbours – thus a site value tax should – and would – reflect this, they would argue.

A Site Value Tax realist knows that these things matter. Hence I prepared a series of FAQs in the full report prepared for Smart Taxes and the Department of the Environment, available here. Bubble-era buyers, for example, could be given a graduated tax credit from introduction of SVT for a five-year period (similar to mortgage interest relief). After this, 2004-2008 buyers would be liable for the same amount of tax as their neighbours on similar plots.

Those with large plots of land but little income – in particular pensioners – could easily be accommodated with the use of lien on the property, where the tax bill is postponed until the property is ultimately sold. And rural dwellers will almost certainly pay less than their urban counterparts anyway, with such a large differential between urban land values and residential ones. Allowing rural landowners to decide once and for all which of their land is residential and which agricultural would also assuage fears that rural life would be irrevocably destroyed.

In truth, any lobby group can be accommodated – we just need to be clear that this is what we’re doing. We’re shifting the burden from one group on to the rest of society. We may have good reasons for doing this but we shouldn’t fall for emotive arguments that try and disguise that.

One lobby group I think we should pander to is people, as opposed to empty land. What do I mean by this? Suppose we have two adjacent 1-acre city centre site. One owner leaves theirs empty (Case A) while the other builds 100 apartments, each worth €200,000, and rents them out (Case B). In case A, the site is worth €5m and in case B the block is worth €20m, of which the site is worth €5m.

Under a full property value tax, the empty site has a liability of €25,000 while the apartment block pays €100,000. It seems very unfair, though, that the site being used productively, from society’s point of view, has to pay the burden of the tax. Under a 1% SVT, both sites would pay a tax of €50,000 – already the person leaving their site empty is being encouraged to use their site to generate a return.

Now, suppose there were a 2% site value tax but with a per-person “green space” tax credit of €250 (roughly 1% of an acre per person, at a nationwide average per-acre value of €25,000). If the 100 apartments housed 250 people, that would mean the apartment block receives tax credits of €62,500, off their bill of €100,000, while the empty site is hit with a full tax bill €100,000. This modified SVT would shift the burden of taxation on to zoned-but-undeveloped land.

SVT: making us rich?

How much could SVT raise? The tax I proposed worked off an assumption that the Goverment would like to emulate best practice in this area and generate about €2bn in residential property tax annually – this is where the €625 per household figure from the press came from. If applied to commercial property also, a full SVT which replaced commercial rates, stamp duties and the 80% windfall tax, would constitute about €1bn in new revenue streams.

The natural response of anyone to the suggestion of a new taxation averaging €625 a year is “No thanks” (or possibly worse). To argue this, though, is effectively an argument for higher income tax and higher VAT. This is because everyone agrees that Ireland needs to raise about €4.5bn in new tax revenues over the coming years (€4.65bn by 2015, according to the 2011 Medium-Term Fiscal Statement) and even if organic growth delivers, as the Department of Finance expects, €1.4bn, that’s €3.25bn needed through fresh taxation measures.

Ultimately, there are only three types of taxes: those on incomes (which hurt competitiveness), those on consumption (which are bad for equity) and those on wealth, including property. So those who argue out of hand against a property tax such as SVT are arguing for the €3.3bn in new revenue streams to come entirely from some combination of income taxes or consumption taxes, both of which hurt jobs. And with Ireland’s VAT rate the highest in the world outside the Nordic countries and Ireland’s income tax rates among the highest in the world, the scope in these areas is limited.

For me, the key point is that when a full property tax is proposed, it needs to be done as part of an array of alternatives. The Minister cannot simply say, in the context of needing to raise €2bn: “Here’s our idea for a property tax. Do you like it?” No matter how nice the tax is on paper, the answer is going to be overwhelmingly “NO!”. Any property tax needs to be proposed as one of two (or three) options: “We can either introduce this property tax, or else we will need to raise the lower rate of income tax from 20% to 25%. Both harm disposable incomes but only one harms the creation of jobs. Which one do you want?”

A bold postcript

Note that the €625 average figure above was an input of the research (we need this to raise €2bn), not an outcome. The tax could be introduced at any level. At €100 a household, it could merely replace the household charge – but that’s not going to fund too many local amenities.

Alternatively, and much more boldly, the introduction of a 10% SVT on residential and commercial property – which would raise perhaps close to €10bn – could be done in conjunction with a reduction in VAT and a reduction in income taxes. This would help close the deficit, boost Ireland’s competitiveness, improve the fairness of the tax system and encourage efficient use of land. What’s not to like?