March 3rd Morning: The Recession Diaries

There is an almighty locomotive train of a consensus coming down the tracks at us: taxation. Many commentators are demanding that tax increases be substantial and immediate. Can this help resolve the crisis? The answer is: yes and no and, in some cases, it can make it worse. Taxation is, after all, an instrument; like the proverbial flame thrower, if we don’t how to use it or what we are using it for, we could do ourselves a serious injury.

Let’s start with a first principle: in the long term, taxation will have to rise. Even if there wasn't a recession it would have to rise: to boost our public services, social protection our physical and social infrastructure to a modern European benchmark.  Add in our structural deficit and paying off all this borrowing and, yes, tax increases are on the agenda. 

But if we react in an unthinking manner, we could end up deepening and extending the recession. And if we take the advice of the likes of Stephen Collins and Patrick Honohan, that’s exactly what will happen, with little fiscal benefit to show for. Let’s take an example (and here I borrow a concept discussed by Frederick Bastiat, courtesy of a link from Graham at the Irish Liberty Forum; ‘what is seen and what is unseen').

In the last budget, the Government introduced two measures: an income levy and an increase of half-a-percent in VAT, which were intended to raise €1.2 billion and €227 million respectively. That is what is seen. But what about ‘the unseen’, the effect these two measures are having on economic activity. That these are more difficult to measure doesn’t lessen their impact.

• First, the income levy took money off of people who might have spent (most?) of this, producing extra VAT. So the gain to the Exchequer is the income levy minus the spending taxes that would have occurred if the levy hadn’t been introduced.

• Second, the displaced spending is undoubtedly impacting on those sectors that are reliant on domestic demand. Less money in people’s pockets means less spending, less sales revenue, less profit (or more losses): what is the effect of less business taxes, employees short-timed, wages frozen or cut, people laid-off, even enterprises closing? How much less tax revenue and higher social welfare costs arise from the income levy? This has to be subtracted from the gross gain.

• Third, what is the ‘psychological’ effect of the levy, especially if people think this is the first among many? Do they start saving even more? What effect does this have on falling consumption and everything that flows from that? Once more, this should be subtracted from the gross gain in revenue.

• Fourth, while the VAT increase may not have had much impact on prices, given the deflation that is setting in, it will squeeze companies’ cash flow even further – and this coming at a time when this squeeze is not being ameliorated by credit extension from our broken banking system. This impact – if it is realised in wage and employment-cutting measures at the firm level – will once again have to be subtracted from the gross revenue gain.

Where does the Exchequer stand after a more sophisticated equation is applied, assuming we can measure it:

Net Revenue = Gross Revenue – displaced spending taxes – lower tax revenue / higher government spending arsing from lower consumption – the consequences of enterprises’ cash flow squeeze.

This doesn’t even take into account the secondary effects of reduced consumption. When x amount of workers are short-timed or laid-off as the result of the deflationary impact of higher tax increases, they set off another round of deflationary effects as their spending power and economic activity impacts on the economy again – like a ripple effect And down and down we go.

The cause and effect may be difficult to isolate amidst all the other noise of the economy; yet we experience it. To narrowly focus on the gross gain from a tax increase and ignore it’s impact on an economy in recession, is to betray a static view of the economy reduced to a ledger sheet. We leave the realm of economic analysis and enter that of the accountant's.

Now we can put calls for tax increases into some context. Stephen Collins claims that €1.6 billion can be raised from increasing income tax rates to 22 and 44 percent respectively. Patrick Honohan takes the back-of-the-envelope calculations to the extreme, arguing for increased rates, slashing the standard rate tax band (workers earning over €25,000 would enter the top rate of tax) with the exemption threshold cut by half. He claims this would gross the state €2.6 billion.

Would they raise that amount? No. The purported gains would wither away once it impacts on economic activity. Let’s take Collins’ proposals:

• For a single person on €28,000 – it would mean taking €560 out of their pocket – a 29 percent increase in their income tax liability.

• For a single person on the average industrial wage of €40,000 – it would mean taking €836 out of their pocket – a 16 percent increase in their tax liability.

That’s big wads of money for people who, at the end of the day, don’t earn a king’s ransom. What would happen? To the extent that these individuals can save, they may deduct some of that tax take from savings (that’s if they have enough to save). But even so there is no doubt that:

• Consumption will fall 
• Businesses reliant on domestic consumption will see sales fall
• As sales fall, so do wages and jobs

So, we might get a gross gain of €1.6 billion on paper, but in the real world it will be less, substantially less.  And at its most extreme and perverse, these increases may nearly cancel out any gains in the short term and actually widen the fiscal deficit in the long term where temporary unemployment becomes near chronic, or where valuable skills are lost. For in the middle of a recessionary fire, people like Collins and Honohan are calling for more fuel to be dumped on it.

What principles can we pull out of this discussion?

• Do not, while the economy is in a recession, increase tax on those groups that have a high propensity to spend. The trick here is to define those groups and we can only hope that we have the statistical information to assist us in that task.

• Raise taxes from unproductive assets and high income groups that have a higher propensity to save. Their loss – arising from a higher taxation – will have less of an impact on consumption.

• Increase general taxes and social insurance contributions once the economy has come out of the recession.

The rate of increase in the post-recession period must be consistent with increased consumption, wages and growth. The last thing we need is to come out of this damn thing and see ourselves right back in it because tax increases strangled growth at rebirth.

Let’s be clear: calls for tax increases, without regard for their economic impact, are recipes for keeping us in the ditch for a long-time to come. They should be rejected. They are short-sight, ledger-based and quite simply wrong.

It’s one thing to share pain. It’s quite another to willfully generate it, to the long-term detriment of all of us.

Comments

[Pablo2009]

Great post. One question, what about prices wouldn't they fall too? This is already happening in the property rental market.

[James]

The consensus that you are attacking is the idea that we imperatively need to take immediate action to reduce the deficit by raising taxes (and cutting spending). The foundation of this consensus in turns rests on two assumptions:

1) that we are in serious danger of being shut out of international capital markets if we don't convince those markets that fiscal retrenchment is underway (and that any IMF/EU rescue package would be far worse than the retrenchment we would perform ourselves)

2) that by cutting nominal wages even more than real wages we can deflate our way back to competitveness and growth (or at least mitigate the recession)

I know that you contest both these assumptions, which are technical and/or factual questions - not ones over values - either you're right or the consensus is.

However, the arguments you make in this post are relatively independent from these. It seems to me that whether or not you think that it is utterly inmperative that we immediately and substantially reduce the deficit, the arguments in this post (i.e. about the need to retrench in such a way that does the least immediate damage to our already dire economy) are valid.

One possible implication is that we could actually similtaneously reduce the deficit and give some (modest) stimulus to the economy by auditing every euro spent by the government for its "Keynesian multiplier".

For example, use revenue from increased taxes (or, yes, public sector pay cuts for the higher paid) to create employment (eg by expanding and accelerating the isulation programme).

If the consensus is right, then we really can't afford to go borrowing more money in order to provide stimulus. But that doesn't mean it's impossible for the government to do what Keynesianism is essentially about - seizing idle resources (money and labour) and putting them to work.

[D_D]

Thanks Michael again.

This consensus has, to a great extent, been cleverly spun out of the demand of those opposed to the cuts and the levies to increase tax instead. Tax on the rich that is. It was expressed in general terms of increased taxation but the intention was that the rich and not the low to middlle paid workers should pay for the crisis (the crisis the super rich and their acolytes caused in the first place). Even CORI made a modest proposal to up tax to the EU average and so cover all the deficit (or the €16 billion as it was then).

The spin said, 'sure we need to incease tax' and simultaneously began a campaign of repetition around the fact that a big proportion of workers paid no tax at all. So the target became those who paid no tax because they - such a big proportion - earned too little to pay tax! The original intention of the 'cuts no, tax yes' position, to take it from the shelters, the fugitives, the billionaires, the millionaires, was spun out.

It is now clear that 'fairness' is to be used for taxation as it was for the cuts. That is to make the ordinary people pay, including those not too well off, and to minimise the cuts and tax to business and the wealthy. Even the great Colm Rapple is saying that the 20% rate will go up to to 21% Why?

Three points on the new taxation focus:

This morning the RTE 'Morning Ireland' interviewer put it to David Begg (who did not dismiss it) that taxing the rich would get very little and that increased taxation lower down was needed.As if this was a given. The front page of today's 'Irish Times'reports that "Paddy Power announced that its online [gambling] operating profit grew 34% to €42.8 million last year.." That should be €40 million to the Exchequer and €2.8 million to Paddy Power. Are we in a Crisis or are we in a Crisis?

Garret Fitzgerald said it directly on Saturday in the 'Irish Times', and furnished a table of figures to illustrate, that there isn't a crisis of spending (to which cuts would correspond) but a crisis of revenue (to which tax increases would correspond).

Finally, would the drop in income tax in the past two months have any connection with the change in the online payment of PAYE and PRSI from a monthly to a quarterly basis? Many millions that would have been paid before in January and then February will not be paid until April. Or was this factored into yesterday's figures?

Finally, finally, in relation to the zero tax status of the lower paid. There is a history to this and it has a lot to do with substituting tax cuts (as distict from tax reform)for bigger pay rises in the boom years , by which the social partnership deals delivered take home increases without correspondingly bigger wage cost rises to employers. Opponents of social partnership, of which this was a 'win-win' component, warned that this was not sustainable for social provision, never mind a revenue crisis.

[Alec]

Great piece again, but at what point will the deficit become too large? Is the threat of IMF/EU rescue package the biggest threat to a left wing economic response?

Finally, what are economists like you doing to get your message out there, because unfortunately I ain't hearing it.

[Michael Taft]

James - in a post that I have put up today, I have tried to address the issue of dove-tailing the need for stimulus with the need for putting a ceiling on the defict, as a runaway deficit will squeeze out resources for a stimulus.

As to a 'multiplier' audit - that is a great idea and I will certainly give some more thought to that in upcoming posts. This is a crisis - all issues are on the table (including public sector pay). A multiplier audit combined with stress testing for social equity, could allow us to come at the problem with a different set of eyes. Needless to say, I wouldn't trust this Government to do it - they are blind.

D_D - a couple of points to reinforce the points you make. Fitzgerald's article did rightly refer to the fact that spending wasn't the problem and that there isn't a whole lot more to cut (especially with rising unemployment costs). However, his comment that the problem behind the fiscal deficit was low taxes begged a further question - why are taxes low? The reason for that was in the top line of his table - the drop in national wealth (a related issue is the fact that the deficit is based largely on structural tax problems - the over-reliance on property related taxes which have gone and won't come back, unlike other taxes that will come back once employment growth returns.

But most definitely yes, the core principle of wage agreements has been to limit wage increases (a subsidy to employers) in return for reductions in tax. This was always unsustainable over the long-term and was inevitably going to come undone. It is also a major contributor to our degraded physical infrastructure and poor social services. The complete ignoring of the 'social wage' will haunt us for a long time to come.

Alec - I can assure you, from discussions I have had with PR people on behalf of progressive organsiaions, there is almost a complete closed door when it comes to progressive opinions. I have never been a conspiracy theorist, but I could start subscribing to the newsletter. The Prime Time show I mentioned on bonds and borrowing, the Pat Kenny show when Moore McDowell was allowed to savage Fintan O'Toole, a number of radio programmes where conservatives outnumber progressives (if there is one) by two-to-one with a hostile presenter added-in.

I can assure you, from the people and organisations that I know, it isn't for want of trying. But it doesn't help, either, when some progressive groups send it mixed signals on the economic crisis - as if it all comes down to fairness. It doesn't. It comes down to policies that work and policies that don't. Personally, I don't know what more to say because I ain't hearing it either.

[Michael Taft]

Pablo2009 - thanks for the commnet. I think the deflationary effect - which operates differently in different markets - is more likley to be exacerbated by falling disposable income, thus forcing businesses to drive down their prices even further. Another contributing factor - which is stronger in Ireland than other countries - is the high level of household debt. Even if income wasn't falling, people would be trying, quite understandably, to pay off those debts. This has the same effect as general tax increases, since ther eis less income to spend. Now put tax increases with develeraging together and you really get a deflationary double whammy. That's why there is concern over how far deflation will go here in Ireland, especially as it is already the worst in Europe.

As to rents - which works at a different level since shelter is not discretionary - I suppose there is the phenonemon of over supply of rental units. This could be due to apartments, second houses available for rent. Also, emigration will contribute to this - especially the emigration of non-naitonals who imagine were disproportionately tenants. So put all that together and you have landlords competing with each other by reducing rents.

Where will this all end? Hard to know. But its not good. And I don't see anyone courageous enough to make a prediction.

[מכשירי שמיעה]

Great post says strict attention to the gross benefit of a tax increase, and ignore the effects of economic recession, it is a betrayal of a static view of the economy less general ledger sheet.