CURRENT AFFAIRS
‘It’s just counter-intuitive to expect governments not to increase expenditure or reduce taxes if revenue rises, because of the pressure on them to do just that’
He believes that the fact that fiscal policy in Ireland has been con- sistently pro-cyclical, rather than counter-cyclical, has contributed to our current difficulties. “There is no singular reason why policy has been pro-cyclical, but bad forecasting and poor analysis lie behind many of the policy mis- takes,” says Durkan. “When the economy has grown above expectations and the pub-
A
lic finance position has improved, government has tended to regard the new situation as normal and increased expenditure and/or reduced taxes – leading inevitably to retrenchment when the econ- omy slows down. “Or, as in the Seventies, when fiscal policy was used to stimulate an economy in an upturn, leaving no room for manoeuvre in the downturn and creating a fiscal crisis,” he adds.
Tax reform Durkan suggests that a significant improvement could be made to fiscal policy by reducing the extent to which the budgetary situation improves when the economy grows above potential, by introducing other forms of taxation, like property taxation, and by reducing the elasticity of the income tax system through the reduction of mar- ginal tax rates relative to average tax rates. “What governments have tended to do in good times is to treat the
revenue that comes in as permanent, and then to increase expendi- ture and sometimes even to reduce taxes,” says Durkan. “Then when whatever it was that caused that initial stimulus in the economy stops, you can go from a 4 or 5% growth down to 1% and suddenly tax revenues weaken. The government is then lumbered with the expenditure that it has undertaken, and suddenly you have a fiscal problem, and you have to raise taxes again. This is what causes fis- cal policy to be pro-cyclical. “Business cycles tend to be very big, the duration of them is unclear and sometimes their depth is also unclear. What we need government to do is behave rationally, anticipate this business cycle and run through the middle of it and not get carried away when there’s more revenue. We just haven’t managed to do that,” says Durkan. “When you think about it it’s just counter-intuitive to expect governments not to increase expenditure or reduce taxes if revenue rises, because of the pressure on them to do just that.” He recalls such a case in the early part of the 2000s. “One year there was this enormous budget surplus and the Minister for Finance, the present Taoiseach, was actually criticised very heavily for not spending the money, whereas he was absolutely right not to spend it. If truth were known, he should have actually increased
Swe approach what is expected to be the toughest Irish budget in history, Joe Durkan reminds us that this crisis will eventually end, and says it is time lessons were learnt from past mistakes when it comes to fiscal policy in this country if we are to avoid future crises of this scale.
taxes to increase revenue even more at the time.” The answer, suggests Durkan, may be to “turn the whole thing on its head”, and establish a tax system that does not give rise to such huge increases in revenue when the economy booms. “One of the methods for doing this, in my view, is to have proper-
ty taxes. “Property prices tend to be a lot more stable than you might think,” he says. “The boom and the bubble have distorted it some- what, but, generally if you take that out, values tend to be relatively stable, so taxing that will give more certain revenue to government.” Durkan also proposes reducing the elasticity of the income tax system through the reduction of marginal tax rates relative to aver- age tax rates. “The marginal personal tax rate at the top end is very high, at
56%,” he says. “The average tax rate is probably too low in Ireland, but the marginal rate is too high. If you actually increase the average rate and reduce the marginal rate, you reduce what is called the elas- ticity of the tax revenue with respect to income. What that does is it means when the economy grows the government doesn’t get so much extra revenue, so therefore it’s not likely to spend.” Durkan admits this is a way of thinking that is new to himself.
“This is not the kind of thing I would have recommended before because I always thought governments will see what’s going on and then behave rationally. But I think now the pressure on govern- ments is so great they’re always going to do this. “The point is you need to distinguish between permanent increases and temporary and, if you think this revenue is temporary, well then you don’t spend it. It reduces the flexibility of the political system but it stops you making those big messes.” Not that Durkan believes governments should not spend more
money in important areas. He cites the example of education. “We know that in first level you really need to put resources in for chil- dren who are slow at learning for instance, and if you don’t put those resources in then they will suffer permanently. It’s well worth spend- ing that money, but you just raise taxes to finance it.”
Rainy day fund
According to Durkan a ‘rainy day’ fund would also mean govern- ment would have more flexibility for dealing with sudden shocks, as in the current crisis. “We’re a very small economy, so we are very open to external shocks – and we will get internal shocks as well, as we have at the moment – and when you get those shocks the effect on the budget seems to be extraordinary. You suddenly find everything falls apart very quickly. “You suddenly find yourself with a budget deficit of 10 or 15% or, as it was in the Eighties some 25% of GDP. You can’t have that, you can’t finance that in reality. You might do it for one year but long term you can’t do it. “What you need to do is to ensure that you have the resources so that, when the economy downturns, rather than having to borrow
UCD BUSINESS CONNECTIONS 15
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