ECONOMICS:We only have to look at our own recent history to determine the most appropriate tax burden for returning us to growth

THE NATIONAL Economic and Social Council (NESC) published an interesting report on the grave state of the nation this week. Next Steps in Addressing Ireland’s Five-Part Crisis: Combining Retrenchment with Reform represented a brave and thoughtful attempt (mainly by the council’s secretariat, I suspect) to construct a conceptual framework around which some form of national solidarity might be mobilised to get the economy out of the mess it’s in.

An important message that shines through in the report is that successfully addressing the crisis requires much more than a merely technocratic approach. The solutions are not simply a matter of applying the results of desiccated analysis. For the enterprise to work it will also require a vision of the kind of economy/society we’re trying to create, trust in the integrity and competence of the institutions involved, and a sense that the whole endeavour is infused with fairness. These are my words, by the way, not the NESC’s, but I believe they reflect the essence of the report.

Newspaper coverage of the report suggested the NESC’s view is that further tax increases will be required to resolve the public finance element of the crisis. Actually, the NESC doesn’t go quite that far. What it does say is that there is scope for the tax burden to increase without making us a “high-tax” State, which may not amount to the same thing.

This proposition, whatever its policy implications, is based on a comparison of Ireland’s tax/gross national product (GNP) ratio with the equivalent ratios for other EU member states. Such comparisons show that the Irish tax burden is significantly lighter than the EU average and, according to the NESC, indicate that the Irish ratio is among the lowest in the EU27.

International comparisons of this sort provide a useful point of reference for policymaking, but they need to be treated with circumspection. In the first instance, there is so much diversity across the EU (the tax/GDP ratio ranges from sub-30 per cent in Latvia, Lithuania and Slovakia to almost 50 per cent in Sweden and Denmark) that the EU average is not very meaningful. This raises the obvious question: with what subset of EU members does it make most sense to compare Ireland?

From an economic viewpoint, one obvious answer is those countries with which Ireland most closely competes for mobile factors of production, especially capital and skilled labour. I don’t believe any of the high-tax Scandinavian countries would make it on to such a list, but the UK certainly would, and its tax burden is considerably lower than the EU average and not that different from Ireland’s.

Looked at another way, one might ask what conclusions are to be drawn from the discovery that the tax burden in Ireland is significantly lower than the equivalent ratio in countries with much higher military spending, a higher death rate (because of a much higher proportion of elderly people), and a higher stock of outstanding government debt (necessitating a higher level of debt service).

Many of the relatively highly taxed mainland European countries fall into this category. The point is we should be capable of financing public services of comparable quality to such countries but at significantly lower cost in terms of the tax burden.

I suspect that less reliable guidance about the appropriate tax burden for a particular country is to be gleaned from international comparisons than from the country’s own recent history, particularly if that spans a period of outstanding economic success.

This brings me to the speech by the new Central Bank governor, Patrick Honohan, at the Economic and Social Research Institute’s Budget Perspectives conference on Tuesday.

Honohan reminded his audience that it was less than a decade since the Irish economy was on a strong sustainable growth path, and suggested that restoring the structure of the economy to that which had been obtained at the turn of the millennium provided a template for returning to healthy employment-generating growth. He also suggested that resolving the fiscal crisis could be achieved by returning to the ratios of tax and public spending to GNP that had prevailed around that time.

What would this entail for the tax burden? By my reckoning, the ratio of tax (including PRSI receipts) to GNP this year will be about 31.5 per cent. This compares with an average of 35 per cent from 1998 to 2000, the halcyon days of the export-driven, highly competitive Celtic Tiger, and seems to imply there is scope for increasing taxes from current levels.

However, two important upward adjustments have to be made to the 2009 figure. First, the full-year effects of the tax increases announced in the budgets of last October and April have not yet been felt; when they are, they will raise the tax burden by about 1 percentage point. Second, the tax/GNP ratio can be expected to increase automatically as the economy recovers. Quite how big this effect will be is uncertain, but it is hard to believe it will be much less than 2.5 percentage points. Taken together, these two effects should be enough to push the tax/GNP ratio back up to its level of a decade ago.

Strict application of the Honohan formula, therefore, would mean avoiding further tax increases and seeking to achieve the large fiscal adjustment that is required exclusively by means of expenditure cuts. No doubt it will invite vigorous rebuttal on that account.

However, the type of fiscal settings that Honohan is advocating clearly worked, in that they were associated with and helped to create vigorous growth and a sustainable pattern of economic activity. And that, at a time when vision and confidence are sorely needed, is an idea with the potential to concentrate minds in a positive way.

It’s a case of: we’ve seen the future and it works.

jim.oleary@nuim.ie