The Importance Of Economic Growth by Jim Power
The Importance of Economic Growth To Generate the Tax Revenues Needed to Fund Public Expenditure.
by Jim Power
In terms of the economic and political ideological divide, the main area of disagreement in general revolves around the level of government involvement in the running of the economy and indeed of our lives in general. Obviously, the level of public expenditure and the amount of tax revenues collected are key indicators of just how much involvement government has.

Those of a right-wing ideological pre-disposition generally tend to advocate a low level of government interference in our lives and hence tend to advocate for lower taxes and lower levels of public expenditure. In contrast, those of a left-wing persuasion tend to advocate for high levels of public expenditure and high levels of taxation to pay for that expenditure. 

Economists are often accused of being obsessed with economy and of ignoring society. I tend to be of the view that without a well-functioning economy and strong sustainable levels of economic activity, the tax revenues to fund public expenditure and hence society will not be generated. Witness the level of tax buoyancy experienced in Ireland over the past couple of years.  Consequently, I believe that it is important to foster strong and sustainable economic growth to generate tax revenues, and then it is up to the political system to decide how those resources should be allocated. 

A guiding principle is that tax revenues should be used wisely, and the use of a cost-benefit analysis should be a key guiding principle on all types of expenditure. While it is not an exact science, it is important to seek to measure the monetary and non-monetary benefits that might flow from any expenditure or indeed taxation decision. The type of populist politics that is increasingly dominating political discourse in this country (we are not unique), renders it very difficult to apply sensible cost-benefit or evidence-based analysis. The popular narrative is that money should be thrown at every problem and the money will come from somewhere. Unfortunately, there is no such thing as a money tree. 

On September 27th the Government will present Budget 2023. The budget will be prepared and presented against a very difficult and uncertain background. The global economy is on a knife-edge and recessionary conditions are certainly possible and most likely probable over the coming months, particularly in the US and Euro Zone; central banks are increasing interest rates aggressively in an attempt to bring spiralling inflation under control, regardless of the consequences for economic growth; financial markets are very nervous and volatile; commodity prices are at elevated levels; and the global geo-political background does not inspire confidence. 

To date, the Irish economy has remained largely immune from the global threats, but logically this cannot persist. A slowdown in Irish economic activity looks highly likely over the coming months due to higher interest rates, high inflation, rising business costs, and the intense global difficulties and uncertainties that currently prevail. 

Notwithstanding all of the aforementioned pressures and uncertainties, many indicators of Irish economic activity are still performing strongly, but particularly the Exchequer finances, the labour market and external trade. 

In 2021, the Exchequer collected €68.4 billion in tax revenues, which was a record high. This buoyancy has continued in 2022. In the year to the end of July, the Exchequer ran a surplus of €5 billion, which compares to a deficit of €5.7 billion in the same period in 2021. The turnaround of €10.7 billion is due to ongoing strong growth in tax revenues and reduced current expenditure as the Covid-19 supports are being phased out. Overall tax revenues totalled €43.5 billion which is 23.5 per cent or €8.3 billion higher than the equivalent period in 2021. Corporation tax receipts in the first 7 months totalled €9 billion, which is €3.1 billion or 51.2 per cent higher than last year. Corporation taxes accounted for 20.7 per cent of tax revenues in the first 7 months of the year. However, there is justifiable concern about how sustainable this is in the longer-term.

Income tax came in at €16.7 billion, which is 17.1 per cent or €2.4 billion ahead of 2021. The strength of income tax reflects the very progressive nature of the Irish income tax system, and the high quality of employment that is being increasingly created in the economy. It is also indicative of a very buoyant labour market, where retention, recruitment and increased labour costs are now significant challenges for many employers. Income tax accounted for 38.5 per cent of total tax revenues in the first 7 months of the year. VAT receipts totalled €11.9 billion, which is up by 22.8 per cent or €2.2 billion on the same period in 2021. In total, Income tax, corporation tax and VAT accounted for 86.5 per cent of tax revenues in the first 7 months of the year. This goes to show that tinkering around with the other tax headings will not make a substantial economic difference. Income tax, corporation tax and VAT are really where the meaningful focus needs to be.

The Department of Finance laid out the parameters for Budget 2023 in the Summer Economic Statement in early July. The key elements are as follows:

  • Budget 2023 will be sold as a ‘Cost-of-Living Budget.
  • Budget 2023 will provide an overall package of €6.7 billion, which will comprise of additional public spending of €5.65 billion, and tax measures of €1.05 billion. The tax measures are likely to comprise of the significant indexation of tax credits and allowances. This seems like the most sensible approach to income tax. A further narrowing of the tax base should be avoided. One of the positive attributes of the USC when originally introduced over 12 years ago was that it broadened the tax base, but budgets in recent years have unwound some of those base-broadening benefits.
  • Last year, the Government adopted a medium-term budgetary strategy based on public expenditure growth of 5 per cent per annum over 2023 to 2025. Core spending on public services is now projected to increase by 6.5 per cent in 2023.
  • Government is also providing €4.5 billion extra non-core expenditure for temporary measures such as the Ukraine humanitarian supports, and some Covid-19 supports as needed.

The government is now set to ramp up spending significantly, but there are reasons to be concerned. Over the coming years, the pressure on public expenditure from climate change mitigation measures; ageing demographics; the impact of higher interest rates on debt servicing costs on what is a very high level of debt; Sláintecare and the digital transition will intensify.

Government is increasing expenditure on the basis of corporation tax revenue buoyancy, but in my view, a prudent approach would be to save up the possibly temporary corporation tax windfall in some form of ‘rainy day’ fund, but such farsighted strategy is not consistent with the political realities that prevail in Ireland today.

There tends to be a general view that the opportunity costs involved in tax changes can be very significant. In order words if monies are allocated to certain tax reductions, then there will inevitably be less money available to do other things. That is true to a point, but it is also important to consider the implications of not giving tax incentives to certain sectors. The SME sector at the moment is a case in point.

Many SMEs are just now starting to come back to something resembling normality after the Covid shock, but they are now being faced with strong headwinds. Interest rates are rising; consumer spending power is being undermined by escalating inflation; the global outlook is not promising; labour costs are rising; sourcing suitable labour is a huge challenge; and it seems inevitable that the Irish economic performance will come under some pressure over the coming months.

The question then revolves around the appropriateness of giving financial support to such SMEs and if so, in what form? It has to be recognised that many businesses have been seriously damaged by the pandemic but are now facing numerous other challenges. Changes to the taxation of those sectors under pressure would obviously have a monetary cost. However, this cost needs to be weighed up against the cost of not doing anything. The cost of not doing anything would include business failure; job losses, with a consequent loss of tax revenue and increased social welfare outlays; further damage to the streetscape of the countryside; and reduced consumer choice.

Changes to the VAT rate is one policy option. In Budget 2021, a reduced 9 per cent VAT rate was re-introduced for restaurant supplies, accommodation, cinemas, theatres, museums, historic houses, open farms, amusement parks, and hairdressing, as well as certain printed matter such as brochures, leaflets, programmes and catalogues. This measure was intended to help sectors that had been very badly affected by the Pandemic get back to a normal trading environment.

The reduced VAT rate was applicable from 1st November 2020 to 31st December 2021 at an estimated cost of €401 million. In Budget 2022, the measure was extended to 31st August 2022 at a further estimated cost of €251 million. In May 2022, the measure was further extended to 28th February 2023, at an estimated further cost of €250 million. It is envisaged that the 13.5 per cent rate will apply to all affected sectors on 1st March 2023.

Given that hotel costs have spiralled in recent months, with the average cost of accommodation up by 19.9 per cent in the year to June, the granting of further VAT relief to this sector would be politically difficult in the current environment. On the other hand, the restaurant sector is facing many struggles, but the annual rate of inflation in the sector was running at just 5.4 per cent in June, compared to an average rate of inflation of 9.1 per cent. Given the challenges and pressures currently being experienced by the restaurant sector, the Restaurants Association of Ireland is looking for the 9 per cent VAT rate to be extended for at least a further 2 years for the restaurant sector. The question now is if it is possible to have a split rate of VAT for different components of the broad sector? It should be explored.

Any tax measures introduced in the budget should be directed at helping businesses survive a challenging environment and protecting the real incomes of households to the greatest extent possible. It should not be forgotten that economic activity generates tax revenues and anything that helps business activity will result in increased tax revenue. Furthermore, the incentivisation effects of taxation should not be forgotten. It strikes me that the Government will have to use tax incentives to a greater extent to move the private car fleet towards its EV climate target ambitions.

Headshot of Aine Collins
Jim Power

Jim Power is one of Ireland’s leading and best-known economic analysts. Jim has a wealth of experience in delivering insightful economic analysis, forecasts and commentary to both Irish and international audiences. He writes regularly for national newspapers and is a regular contributor to radio and TV debates and discussions.