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.
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