Tuesday, March 3, 2009

The Latest Exchequer Figures: can Biffo turn Gruffalo?

Gruffalo is a marvelously hideous and not-so-bright character in my son's favorite books. Today's Exchequer figures and the talk about the need for higher taxes and courageous Government policies remind me of this imaginary animal.

The preliminary Exchequer receipts show that we are on track to deliver on my forecast from February 8 (here) that estimated a tax revenue this year between €33.3bn (moderate case) and €34.5bn (benign scenario). Ulster Bank's Pat McArdle - an excellent economist with good knowledge of the budgetary nitty-gritty - agrees (his forecast produced today is €34bn). Of course, to remind you, DofF official forecast revenue is €37.7bn. Ya wish, baby!

It feels good (even in these sad circumstances) to be the first to deliver a correct prediction. The post - linked above - and the precedent ones (Update I and the original post) were bang on the money. The mini-budget is now inevitable by the end of March - spot on my prediction for tax increases before April made in December issue of Business&Finance and here.

Ulster Bank note (full credit to Pat McArdle) shows the rate of DofF's descent into forecasters' hell:

Forecast date: 6 Dec 2006 - €56.3 billion

Forecast date: 5 Dec 2007 - €51.8 billion

Forecast date: 14 Oct 2008 - €42.8 billion

Forecast date: 9 Jan 2009 - €37.0 billion

Current figures: Ulster Bank - €34.0 billion, my - €33.3-34.5 billion

As of today, we are some €22-23bn ahead of DofF-forecast for the shortfall. This, as McArdle rightly points out (I produced the same figure back in February) is approximately what we have to find to plug the hole in the side of our public spending Titanic.

Think about it: the hole is almost 70% of the entire revenue projected for this year. Can we plug the hole with a Gruffalian (draconian) 50% income tax increase?

Here is the breakdown of the revenue figures (again from Ulster Bank note):

I've said time and again that the Laffer Curve and tax minimization will imply that the revenue will fall as taxes rise or at the very least it will not rise in 1-to-1 relationship to tax rates increases. We have evidence of this. VAT receipts have fallen at more than 4 times the rate of fall in national income and in line with retail sales. Income tax receipts are down at ca 1.5 times of income contraction (and this is before self-assessment returns come in).

And as far as tax minimization goes - many of those on both high and low incomes are sole traders or business proprietors. These categories of workers do not pay income tax on a regular basis, bunching much of their payments into October. They do pay more regular VAT and this smooths quarterly VAT returns. Comes October, they will do everything legally possible to make sure Biffo-the-Gruffalo, Bromidic-Brian and Mary-the-Lottery-Winner don't get their paws on hard earned cash. In addition, the sole-traders on lower earnings will never be brought into the tax net, no matter how much the Government widens it, because they will 'adjust' their income to just below any feasible new threshold.

I did some crude maths on the two effects and here are my estimates.

First the assumptions. I assume that both Laffer Curve and Tax Minimization effects will reduce 1% increase in the rate of:

  • Income tax to a 0.68% increase in underlying revenue (with Laffer effect reducing tax rate increase contribution by 20% and a Tax Minimization effect reducing it by further 15%),

  • Corporate tax to a 0.6% increase in underlying revenue and
  • Excise taxes to a 0.4% increase in underlying revenue.
Now, note I am not assuming that the Laffer effect will result in a fall off in revenue, but that it will only undermine the rate of revenue expansion. I then computed two scenarios:

Scenario 1: 'Biffo gets upset' - increasing excise tax rates by 20%, income tax rates by 25% and corporate tax rate by 10% across all possible bands. Under this scenario, gross annual revenue rises to €33.5bn assuming January-February slaughter of the Exchequer continues. To assure that budgetary deficit does not exceed DofF estimate of 9.5% of GDP, promised by Biffo to Brussels in January, and allowing for a 5% decline in GDP, Brian-Brian-and-Mary must come up with €6bn in fresh public sector cuts on top of the above tax increases and the pensions levy!

Scenario 2: 'Biffo goes Gruffalo' - increasing excise tax rates by 25%, income tax rates by 50% and corporate tax rate by 25% across all possible bands. The Gruffalo-Biffolo must come up with €3.1bn in fresh public sector cuts!

And that's before any second order effects of tax increases (dynamic Laffer Curve) and no spillover from higher taxes into weaker economy.

Pat McArdle estimates the required additional cuts to be around €4bn this year. Ok, close enough... An impossible task for Mr Cowen's gang of public sector appeaseniks.


Jon Ihle said...

So what you're saying is that there is no tax solution to the calamity in the public finances.

TrueEconomics said...

Jon, you are absolutely right. There is no solution to the budgetary overspend via increasing the tax rates. The structural problem of over-dependency on tax revenue from highly focused sources - the problem of revenue volatility and dependency on transactions taxes - can be resolved in the long run by a structural reform. This will require shifting tax burden from indirect taxation and transactions taxes to income and corporate tax. But this is a different issue from the one we are facing at this moment in time. The problem of revenue shortfall relative to expenditure commitments cannot be solved via revenue raising exercise. Hiking taxes to pay for unproductive expenditures - e.g entire FAS budget, 90% of all quangoes, extremely complicated and overstaffed administrative and management frameworks in HSE, Dof Helath, DofF, CBFSAI, DofTransport, DofSocial Welfare, Foreign Affairs, Defense, you name it - is not only insufficient - it is counterproductive. One simply has to cut public spending. 10-15% across the entire budget is a good starting point.

Anonymous said...

Thanks, I have no knowledge of economics but this confirms my gut feeling.

Anonymous said...

Constantine, I just heard that Germany is considering leaving the euro.

I think that screws us. What do you think?

TrueEconomics said...

Tim, sorry for a delay with posting your comment. I will reply to it in a separate post. Many thanks for commenting.