Tax Breaks

Nat O'Connor: TASC has estimated that tax breaks ('tax expenditure' to use the technical term) on personal income tax and corporation tax will cost €7.4 billion in 2009 in lost revenue. Tax breaks benefit the better off, whereas social welfare cuts will increase the number of people at risk of poverty. TASC argues that the Minister for Finance should cut tax breaks. You can read TASC's full submission here.

In this blog post I want to explore our (the broad public's) complicity in our tax break regime and what we can do next to make it economically and socially beneficial.

The OECD's Economic Surveys: Ireland reports that in 2005 (which is the latest full data) tax expenditure on personal income tax in Ireland cost three times as much as the average of 22 other EU countries. Tax expenditures on corporation tax costs seven times as much. In total, in 2005, tax expenditure cost €10.7 billion (not including personal credits).

Some questions:
1. What's the problem?
2. How did this happen?
3. What do we do about it?

Some answers:
1. There are three problems. Firstly, economic inefficiency. Secondly, inequality. Thirdly, the resulting non-progressive tax system.

An example of economic inefficiency was shown by the Goodbody and Indecon reports on property- and area-based tax breaks published as annexes to Budget 2006. They showed considerable deadweight - that is, people benefiting from tax breaks for investments that probably would have happened even without the tax breaks. This inefficiency was accepted by Government and these tax breaks are being discontinued.

An example of inequality is that high earners have disproportionately benefitted from pension relief (see this recent post).

The non-progressive tax system results because better off households can use more tax breaks. There is probably an income/wealth threshold after which it is cost-effective to pay a tax advisor, which in turn opens up more possibilities to avoid tax. Hence, we have a theoretically progressive tax system, with a higher rate for higher earners, but the reality of income tax paid is more like a curve. Low earners pay little of their salaries in income tax, middle earners pay a higher proportion, but higher earners pay a lower proportion.

Both the inefficiency and the inequality stem - in part - from a lack of caps and limits being placed on tax breaks. Whether or not you think that tax breaks are a valid and useful tool for Governments to use to encourange economic activity, it seems that successive governments were inexpert in designing and implementing tax break schemes. They may not have been concerned about equality, but is there evidence to show that successive Ministers for Finance signed off on tax breaks that would deeply harm the economy in order to benefit a small number of wealthy people?

2. There are probably a number of suggestion for why tax breaks grew in number and cost. Paul Sweeney, for example, has suggested they were seen as "costless" by some ministers. They certainly dovetailed with a low tax ideology. Maybe in the past ministers found it easier to persuade their colleagues to grant tax breaks, rather than increase departmental budgets.

It has been suggested that tax breaks permitted State supports to enterprise that would have been more difficult or forbidden under EU rules.

Many specific tax breaks are a response to the demands of specific sectors, such as construction, farming, mining, fund management, etc.

Tax breaks were also introduced to achieve parity with tax concessions or spending in other sectors. So more tax breaks were created to even out markets that had been distorted by other tax breaks. One cannot escape the classic image of someone sawing off the ends of table legs with increasing fervour in order to correct a relatively minor original imbalance.

3. The remaining problem is that many households, on low and middle incomes, benefit from tax breaks. Although this is nothing like the extent to which high net worth individuals have benefitted, an immediate cut of tax breaks (such as mortgage interest tax relief) would represent hundreds of euro per month taken out of many households' net incomes. The prices people paid for their homes were in turn inflated by the distorting effect of mortgage interest tax relief in the housing market, so cutting the tax break immediately would be a double blow. Nevertheless, we really do need to make major cuts in tax breaks.

One immediate solution is for the Government to impose strict caps and limits on the full range of tax breaks - including the many tax relieving measures that the Commission on Taxation identifies as part of the benchmark tax system. Strict caps will means that low to middle income households will not suddenly face a few hundred euro less in their net incomes (which is significant). Higher income households will benefit less. Over the following few years, more and more tax breaks can be cut completely, to lessen the shock to any particular part of the economy (except tax advisors).

Tightening up on tax breaks should also be more efficient than increasing income tax, as the amount of tax actually paid is much more effected by breaks than rates.