Tax target shortfall linked to forecasting methods

The below-par performance of income tax, which has dogged the Government’s exchequer returns since the beginning of the year, has finally been unmasked as a modelling error.

The Department of Finance now believes its own tax forecasting model for the universal social charge (USC) may be behind the mysterious shortfall in income tax receipts.

Principal officer John Palmer said the "elasticities" applied to its USC forecasting model are likely to have overestimated the impact of wage growth on the tax and ultimately the projected return.

“Based on performance here to date, we’re about €80 million- €100 million behind the original target [for USC] and the expectation is that we’ll hold that position for the rest of the year,” he said.

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“So it’s just a case that as we get to understand each tax better, as we re-evaluate elasticities and performance, we amend our forecasting methods,” he said, noting the USC was a relatively new tax and had been changed several times in quick succession.

Subject of speculation

The disparity between the Government’s income tax revenue, which comprises mainly PAYE and USC, and the bumper level of job growth in the economy, which should, in theory, be boosting Government tax coffers, has been the subject of speculation for several months.

The most credible theory was that self-employed workers in the now booming-again construction sector may be holding off paying USC until later in the year, hence the lumpy nature of the returns to date.

And this may still hold some validity as the tax modelling explanation doesn’t explain the full extent of the shortfall, which was €214 million at the half-year point, according to the exchequer data.

Overall, the latest returns paint a healthier picture of the public finances with the Government’s tax take for the six months to June put at €23.4 billion, only 0.5 per cent or €110 million below profile. In May, the shortfall had been 1.4 per cent or €268 million.

With the gap between actual and targeted receipts tapering, the Government is now likely to hit its tax targets for the year, strengthening its hand in the upcoming budget.

Taoiseach Leo Varadkar and Minister for Finance Paschal Donohoe have signalled their intention to make tax reform and tax reduction a key priority for the new administration.

Room for manoeuvre

However, their room for manoeuvre in October’s budget remains limited because of the carry-over costs of Budget 2017 and the likely cost of the new public sector pay deal.

These elements have already gobbled up about €800-€900 million of the €1.2 billion fiscal space available for next year, leaving a paltry €300-€400 million for tax cuts and expenditure increases. Mr Varadkar hinted last week he might look at cutting expenditure elsewhere to fund tax cuts but that can involve difficult political choices.

The forgone tax revenue from the special VAT rate for the hospitality sector is estimated at over €600 million, but that sector has been lobbying hard to have it retained.

With the economy growing at a healthy rate and more people returning to work, which boosts tax revenue and reduces social welfare spending, the Government is more likely to rely on the natural buoyancy of the economy to pay for modest tax breaks.