The direct and indirect tax debate

The Nevin Institute’s report has sparked another debate about the country’s taxation system for individuals

By Sean Whelan, Economics Correspondent

The Nevin Economic Research Institute seems to have kicked over a hornets nest with its latest version of a working paper claiming that top and bottom income deciles pay about the same proportion of their income in tax.

The premise is that while income tax is very progressive in Ireland, indirect taxes such as VAT tend are regressive. 

Using data from the CSO’s Household Budget Survey economist Micheal Collins says the combined effect of direct and indirect taxes results in three income deciles – 1, 9 and 10 – paying above average levels of tax.  Because decile 1 is the lowest income group, NERIs research suggests the total tax system is regressive.

The implication is that reducing or otherwise modifying indirect taxes such as VAT and/or excise would disproportionately help raise incomes or purchasing power for households at the bottom end of the distribution.

That may well be correct – most economic opinion here and abroad views indirect tax as broadly regressive.

But is it regressive to the extent NERI claims? Or is the amount of tax attributed to this decile an outlier that gives the NERI chart its distinctive “U” shape (actually more of a Nike Swoosh-shape)?  And if its an outlier, does it stand up?

One correspondent wondered if net contribution to exchequer would be a more meaningful figure to take account of social welfare payments.

And then there is the suggestion that the average household direct tax charge is 13.6% and the average household indirect tax burden is 10.36%, giving a total tax charge of 23.95%.  It certainly doesn’t feel that way.

Earlier versions of the findings attracted criticism (not all of it temperate) about the assumptions used to arrive at the direct tax figure in particular.  Brendan Burgess of AskAboutMoney posted the following:

The Nevin Economic Research Institute has launched their Quarterly Economic Observer

Their key point is:

“Currently the top 10% of households (above €109,000 gross income per year) have an average effective tax rate of between 22.5% and 27.5%” 

Anyone lucky enough to be earning €109,000 per year must be shocked to see that they are paying only 22.5% in tax. 

So how does the Nevin Institute come up with this figure? It takes a lot of statistical wizardry to show that the top earners in this country pay an effective tax rate of 22.5%. 

Trick no.1 Talk about households, not individuals. 

So a household is all of the people living together in one household. So this includes: 

• a single person living on their own, earning €109,000
• A couple where each earns €55,000
• three nurses sharing a house who earn €37,000 each

Trick no.2 Redefine gross income 

Add in the following: 

• Employers’ PRSI
• Child benefit

As a result, a couple have to earn only €45,000 each to be assigned a gross income of €109,000 which catapults them into the top 10% of households. 

Trick no 3 – Double count pension contributions as income 

• Add the employers’ pension contribution to gross income
• Don’t allow the employees’ contributions as a deduction
• But when the person draws down the pension in retirement, show it as gross income.

Pension contributions whether contributed by the employer or the employee are deferred income and should only be taken into account once – when the person receives the pension income. 

A comparison of the true effective tax rate with NERI’s calculation 

Trick no. 4 Ignore the Revenue’s own data on effective tax rates 

The Revenue Statistical Report for 2011, gives the data for income tax for 2010. (Extract attached to this post) 

For single people earning between €100k and €150k 

As tax credits, have been reduced, it’s likely that the effective tax rate has risen marginally.

So the effective total tax rate for 2013 for a single person earning between €100k and €150k is 

Trick no. 5 Don’t specify how you would raise the “effective tax rate from 22.5% to 24%” 

For example, don’t suggest any of the following which are implied by the way the figures are presented:

• The married tax credit should be abolished. Married couples should be treated as if they were a single person, in the same way as we present our data.
• All people living in a house together should be taxed as one person i.e.they should have only one set of tax credits between them.
• The tax relief on employees’ pension contributions should be abolished but pensions in retirement should continue to be taxed.
• The tax relief on employers’ pension contributions should be abolished also.

• Employees should be taxed on the PRSI paid by their employers, and any resulting benefits such as Jobseekers Benefit or Maternity Benefit should continue to be taxed as well.
• Child Benefit should be taxed.

Seamus Coffey of University College Cork economics department posted the following response to the original working paper, finding the total tax system is progressive.  He also has a chart including state transfers as a proportion of income:

•  NERI looked at the combined effective rate of direct and indirect taxes on Irish households along the income distribution.  The headline results are summarised in this chart.
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• From the fourth decile up the results indicate that the Irish tax system is progressive.  The first three deciles run counter than this though with the first decile notable in particular because it has the second highest reported effective tax rate.
• The lowest contributions are in the third and fourth deciles and we have previously looked at the composition of the households in those deciles (albeit using the SILC rather than HBS as used by the NERI study).
• So what can we say about these estimated tax burdens.  The following table gives the estimated nominal amounts paid by each decile.
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• The estimated average tax burden is €12,900 per household.  According to the Census taken in April 2011 there were 1.7 million households in the country.  Thus the total amount of tax included in the effective tax rates is €12,900 x 1.7 million = €21.9 billion (of which €12.5 billion is “direct” and €9.4 billion is “indirect”).  That is a lot of tax but it is around half of the total tax actually collected in 2010.  The 2010 tax take is summarised in this table.
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• Of course, the incidence of taxation is incredibly difficult to determine.  Direct taxes are deducted from income but even that is not enough to isolate the economic incidence of the tax.  Do employers need to pay a higher wage to attract workers from a abroad in locations with high income taxes.  This is an issue in various soccer leagues.  Determining the exact incidence of indirect taxes is almost impossible.
• If a household buys something for €123 that includes VAT at 23% then the amount of VAT in the price is obviously €23.  However, this doesn’t mean the purchaser paid the full amount of VAT.  It depends on what the price would be in the absence of the VAT.
• If the VAT was eliminated the price might fall to, say, €110.  It is incorrect to say the household has paid €23 VAT when the price absent a VAT would be €110.  In this case the retailer, or some other element along the production chain, has absorbed part of the VAT.
• The NERI report covers €5.7 billion of VAT (€3,360 x 1.7 million) as opposed to the €9.9 billion actually paid but it is not stated why this gap is present.  It could, in part, be because of VAT paid by businesses not fully passed on in the price.  Of course, this will be reflected in lower profits and dividends from the business so the burden of the taxation will ultimately be borne by households as is the case for all taxes.  Some of those households may be outside the country as with Corporation Tax with around 75% of the total paid by foreign-owned companies.
• There will be many small businesses who would regard the rates, excise duties and other taxes which they might not be able to pass on through prices as coming out of their income.  Of course, there will also be many cases where rates, duties and other taxes are put into the price but are not explicitly listed.  However, in the sense that these may affect all households equally it may not alter the overall results.  Then again they may not.
• Returning to the household level it is worth looking at the income and expenditure figures for each decile.  The tax rates shown in the first chart above are as a percentage of gross income while the dominance of indirect taxes for the lower deciles means that the amount of tax paid is, in the main, a function of expenditure.  This table from the report summarises these.
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• One of the notable features is that average expenditure of households in the lowest decile is almost two times greater than their disposable income.  This is also true for the second, third and fourth deciles though not to the same extent.This is not an unusual feature of household surveys and the following is noted by the CSO in their publication of the 2009/10 Household Budget Survey:
• There are many reasons why expenditure may exceed income in lower income decile households and this is a common experience internationally in income and expenditure surveys. Households with recently unemployed household members may draw on savings to maintain their expenditures. Self-employed consumers may experience business losses that result in low incomes, but are able to maintain expenditure by borrowing or relying on savings.  Third level students may get by on loans or savings from summer employment, retirees may rely on savings and investments. In addition, across all deciles there may be an  under-reporting of certain categories of income (e.g. shadow economy employment income).
• On the income measure in the HBS the CSO note that:
• The HBS [.] calculates income on the basis of the “current income level” of the individual without adjustment for employment activity over the year in question.
• The HSB is a weekly survey rather than an annual one with respondents reporting their income and expenditure over a two-week period.  Is it appropriate to calculate an effective tax rate using expenditure now when the income may have been earned previously.
• In the 2009 SILC the average disposable income of households in the lowest income decile (as measured over a year) was €11,000, around 12% higher than the equivalent figure in the HBS.  For the top decile the SILC has a figure of €118,300 versus €119,500 in the HBS, a difference of 1%.  The HBS may not the optimum instrument to measure income but it is good at what it is designed to measure: expenditure.  Here are the expenditures, estimated indirect tax burdens and effective tax burdens as a percentage of expenditure by decile.
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• Although VAT has some progressive features with most necessities zero rated it can be seen that the proportion of expenditure accounted for by indirection taxation is inversely related to expenditure.  The greater the level of expenditure the lower is the proportion taken in indirect taxes.  This is likely due to consumption patterns, particularly in relation to high excise duty goods, and also the disconnect between some indirect taxes and expenditure such as the television license, credit/debit card levies and annual motor tax to a certain extent.
• Although there may be difficulties measuring it there can be little doubt that indirect taxation in Ireland is regressive.  Whether it is sufficiently regressive to offset the very high progressiveness in direct taxation is less clear cut.  Finally, the CSO also give a breakdown of the income by direct income and state transfers for each decile which can be used to infer that Ireland’s overall tax and transfer system is progressive.

As is so often the case, the headline findings are abstracted from an abstract that masks some pretty difficult data wrestling. The data in question is that CSO Household budget survey.

The most recent version was published in 2012, and is based on fieldwork carried out in 2009/2010.

Obviously a lot of changes have been made to the tax code since then, especially in Budgets 2011 and 2012.

But the CSO only do this survey every five years (that seems set to change to an annual survey after 2017).  The author notes that while it is the only comprehensive source of household expenditure data, it is “far from a perfect measure”.

The paper does try to address two of the post survey changes to indirect tax  – the rise in VAT from 21% to 23% in Budget 2012 (which it finds to be regressive) and the cut in VAT to 9% for tourism and hospitality related sectors (which it finds to be progressive).

Micheal Collins says his aim with the paper is to stimulate debate on the impact of indirect taxes.  He says the debate on tax is too focussed on the rates of income tax and USC.

That may be true, but trying to make indirect taxation a greater part of the political tax debate will, one suspects, take a good few years -  and a lot more data.