Sunday, October 4, 2015

4/10/2015: Budget 2016 and beyond: some priorities...

This is a summary of my speech at the local constituency meeting in Sandymount organised by Renua Ireland (October 1, 2015). Please note: I was invited to speak in a personal capacity as an independent, politically non-affiliated speaker, so all thoughts, arguments, errors and omissions in the below are mine.

Where we are?

1) Recovery in official figures:

  • GDP is up 6.9% y/y in 1H 2015.
  • GNP is up 6.6%
  • Some 60% of GDP growth in 1H 2015 was accounted for by Fixed Capital Formation - much of which is driven by assets sales to and by vulture funds, plus by reclassified R&D spending booked by MNCs into Ireland via our ‘knowledge development box’. 
  • But the aggregate data is dodgy. Our GDP is 19 percent ahead of our GNP and it is 25% over Domestic Demand, over 2000-2007 the latter gap averaged ‘only’ 10 percent.

2) Recovery in somewhat more real figures:

  • Personal expenditure is up 3.27% y/y in 1H 2015. 2Q 2015 was sixth consecutive quarter of positive y/y growth. But it is still down 9.9% on pre-crisis peak. Nonetheless, the numbers coming out on this side of National Accounts are positive.
  • Government expenditure on current goods and services was up 3.54% y/y in 1H 2015. But down 10.6% on pre-crisis peak. There is timing issue involved here, but for now, Government spending is rising faster than personal consumption.
  • Fixed Capital Formation rose 22% y/y in 1H 2015, but is still down 12.3% on peak.

By all measures of domestic economy, we are in an official recovery since 3Q 2013. And the rate of growth is relatively robust

  • Final Domestic Demand is up 7.7% in 1H 2015 on a yearly basis, although overall activity as measured by Domestic Demand is down 7.9% on pre-crisis peak. 
  • But, crucially, over the last 4 quarters, personal expenditure per capita was up only 1.62% on average (y/y per quarter) against total domestic demand rising 4.3%. Which shows the role played by Fixed Capital Formation (including Nama, vulture funds, R&D reclassifications and MNCs activities) in driving up domestic demand. 

Ditto for Unemployment figures:

  • Official unemployment rate (QNHS-based) has fallen from 16.3% in Q3 2011 to 10.3% in 2Q 2015. Which is a robust decline and undoubtedly good news. Other good news is that much of new jobs creation was in stronger quality category of full time employment. 
  • Still, current rate of unemployment is close to 1Q 2009 and is almost double 5.9% rate recorded in 2Q 2008, more than double 4.9% rate in 2Q 2007.

However, these figures mask several sub-trends that are worrying.

  • Per CSO own report: % of unemployed persons plus  others who want a job, plus part-time underemployed persons, plus those who want a job, who are not available and not seeking for reasons other than being in education or training stands at 18.3%.
  • Factoring in those in State Training Programmes (e.g. JobBridge) raises actual unemployment rate to 21.9%, comparable to 2Q 2009.
  • Adding in net emigration as reported through 1Q 2015 raises broadest measure of potential unemployment to 29.5 percent - a figure that puts our relative labour market performance back to 1Q 2011 levels. In other words, it took us twice longer to go from cyclical unemployment high back to 1Q 2011 levels than to go from 1Q 2011 to cyclical unemployment high. Road to recovery is, for now, twice longer than the road travelled through the collapse.
  • Worse: labour force participation rate has been averaging 59.8% in 1H 2015 down from 59.9% in 1H 2014. Both are still well below pre-crisis (2000-2007) average of 61.2%.

Top line: 

  • Our GDP - at the aggregate - is now above the pre-crisis peak levels. 
  • But our GDP per capita is still 0.8% below pre-crisis levels and our domestic demand per capita is 13.3% down on pre-crisis peak. Our personal consumption per capita is down 8% on pre-crisis peak. 
  • Much has been achieved, the Government deserves quite a bit of credit for facilitating these achievements, if only in a 'safe pair of hands' way, yet more remains to be delivered, still and this requires more than just a 'safe pair of hands'.

What are the risks to a sustained recovery and how do we deal with these?  We should focus not short-term risks, but on bigger themes:

  1. Global secular stagnation and demographic challenges
  2. Global interest rates (cost of debt) normalisation
  3. Our legacy debt problems and related issues of longer-term savings and investments
  4. Domestic imbalances on production side: MNCs v domestic economic activity
  5. Domestic imbalances on wealth distribution side (inequality, poverty, persistent and concentrated underinvestment in human capital, homelessness, debt distress, and cultural/systemic/institutional barriers to deployment of human capital).

  • All of these factors are cross-linked. The realisation of which at the top of Irish political elite is lacking.
  • All require a joined-up thinking to deal with.  A practice of which at the top of Irish political elite is lacking too.
  • Addressing them requires a new longer-term agenda or strategy for growth and development of the Irish economy. Which we have no institutional framework for preparing, let alone enacting.

In this environment, lacking big ideas, Budget 2016 or indeed any budgetary framework won’t be enough, no matter how good the intentions and execution can be. Neither will be piece-meal approach to development of public investment, as exemplified by what we know from the bits and pieces of the Capital Investment programme for 2016-2021 announced this week.

So what needs to be done to begin addressing these bottlenecks in leadership?

Let’s start from the big picture - policy formation and implementation mechanism. We need deep reforms of how we do business when it comes to policy formation.

Key principles here should be:

  1. Cross-party engagement
  2. Bringing in divergent voices from the outside (given lack of political culture to do so, this should be mandated for all public boards, agencies and policy formation bodies).
  3. Bringing in robust measures to stress-test all and any proposals.
  4. Doing away with token talking shops of policy formation: all the Diaspora Meet-ups, all National Forums and Working Groups that are dominated by vested interests, the Fiscal Council (which has neither teeth, nor independence in its composition), etc etc.
  5. Replacing the above fora with a functional National Task Force composed of both independent and vested interests-linked people with requisite expertise divided by key sectors of the economy: Domestic Economy, Internationally Trading Economy, Public Sector & Government, Households and Quality of Life. Each sectoral group should be tasked with generating & collating ideas for development of the broader sectors on the basis of counterbalancing measures applied to one sub-sector against other sub-sectors. Each group uses seconded public service assistance to cost/price proposals. All group proposals are to be published, publicly vetted and reviewed subsequently by the umbrella body based on the same principles of transparency, professionalism, factual analysis and contrarian view stress-testing. 

At the deployment level, we need to reform public sector systems and local authorities. This should at the very least involve:

  1. Dramatically reducing the number of local authorities, to eliminate extreme levels of non-coordination and empire-building in individual decisions;
  2. Empowering local authorities to create meaningful institutions for developing economic and social policies at a local level by providing them with full control over taxation in property sector and giving them a right to impose local prices for water delivery as well as supply water (Irish Water should be changed to a state-wide entity in charge / ownership of water infrastructure, while actual water provision should be decentralised to local authorities who can supply water into the distribution network on a competitive basis. Such system already works in electricity and gas distribution and can provide better services to consumers at lower cost, while giving local authorities more independent revenues to undertake provision of their own supports and services).
  3. Bringing in functional mechanisms to promote and reward managed risk-taking and informed decision-making in the public sector, as well as to support those who reach above the mean in terms of effort and output. Merit, not tenure, should guide public sector careers progressions. Whilst this objective is not easy to achieve, I am certain that a combination of best practices and good policy thinking can result in a significant (though probably imperfect) improvement on status quo.
  4. Bringing in functional measures to create a climate and culture of accountability. Not for mistakes made (and properly managed) in attempting leadership, but for lack of initiative, failure to carry out required work, any harm done by negligence and inaction.
  5. We need to reform the system of ministerial advisors and oversight over departments, state boards and bodies. Again, here, the key is to bring in professionalism and remove cronyism, instill culture of debate, independence and entrepreneurialism (measured and managed taking of risks).

Let’s go on to specifics of policy objectives.

Ireland is a demographically young country trading in global markets in higher value-added goods and services. This means we are a country based on human capital. And this also means we face global competition for human capital.

What is human capital? A sum total of skills, formal and informal education, aptitude to work, attitudes to risk, ability to manage risks and uncertainty, creativity, capacity to innovate and to adapt to innovation. It also includes health, emotional and psychological well-being, cultural capital, and so on.

So what do we need to do to shift our economic model firmly in the direction of relying on human capital?

The core principles of human capital-intensive economy are:

  • The need to attract human capital from outside
  • The need to retain human capital that is already present in the economy
  • The need to create new human capital within the economy, and
  • The need to enable human capital to add value in the economy.

I have a catchy name for this system: CARE.

Primarily, in the short term, we have to rebalance our tax system. This is something that can be started with the budget, but will require more effort than just altering tax rates.

We need to shift burden of taxation away from taxing individual returns on human capital - in other words, we need to cut tax burden on income from skilled labour and entrepreneurship, but also from other forms of human capital. Incidentally, because human capital is a very broad concept, human capital-intensive value added is being created across the entire economy: public and private, lower income and higher income and so on activities. Human capital economy is not about rich v poor, and it is not about unemployed v employed. Every person in any occupation should be encouraged to invest in their own human capital in whatever form suits them, and every person in every occupation should benefit from reaping the returns on such investments.

To do so, we have to shift some of the current taxation burden away from income tax arising from investing own effort and talents into work, and onto something else.

Best target for such a shifting of burden is to shift it onto those assets that have the least productive use (in terms of value added) in the economy and that, simultaneously, cannot be moved offshore. Such assets are land and fixed capital - buildings and distribution networks.

It is worth noting that in sectors where land plays significant role in overall production, such as agriculture, human capital matters too, and land occupies still lower importance in production chain than we tend to think. Agriculture producing commoditized goods (e.g. generic grains or milk) still accrues value added via types of production, quality of supply, etc. Which are non-land outputs. Beyond that, agriculture also involves increasingly higher value added production – e.g. specialist grains, processing of milk, production of organic and/or artisan and/or specialist types of dairy products, etc. A land tax does not mean a tax on agriculture, but a tax on those activities in all sectors, including agriculture, that use land less efficiently.

Budget 2016 can start on this path by eliminating two or three upper marginal rates under the USC. Or better yet, eliminating USC altogether. And introducing a land or site value tax.

We also need to eliminate all penalties on taxation of self-employed and, unless we bring in symmetric access to benefits, we need to stop charging self-employed for services they have no access to.

We also need to create a system of taxation that recognises that self-employed face high volatility of income year-on-year. A system of 3 year average minimum taxation can be developed to address this, providing self-employed with a limited, but meaningful temporary credit for taxes paid in the case their income dips below, say, 75% threshold for previous 3 year average. These credits can be recouped in subsequent years when their income exceeds, say 110 percent threshold. Numbers here are illustrative and can be estimated more precisely, but it is the principle that matters. As economy becomes more and more linked to the ‘Gig Economy’ principles of work, the volatility of incomes and asynchronicity of tax liabilities will wreck more and more havoc in the households’ ability to fund basic purchases and investments, savings and debt repayments.

But, real reforms will require simultaneously bringing in some sort of income transfer system that guarantees high quality of life for those in needs of social transfers, while not relying on excessively penalising those who invest in their own skills and labour. So longer term reforms should involve introduction  of basic income. This will, accidentally, retain progressivity of taxation under flat rate income tax. And it will assure that those who are well-off can not benefit from social transfers.

Parallel with this, we need to close all targeted incentive schemes within our tax codes. The state should get out of business of picking and choosing future ‘winners’ or ‘champions’ of Irish economy and get into business of administering payment for & provision of core public services.

We also need to stimulate enterprise formation and entrepreneurship. These are two different but adjoining concepts.

  • So we need to reform tax codes to allow entrepreneurs who exit their recent ventures to reinvest in new ventures. In other words, we need to recognise the reality of modern entrepreneurship: it takes more than one or two years to find and develop a suitable target for new investment, so tax exemption for reinvested proceeds of business sale should be stretched out to cover 3 years. A reduced rate of CGT for reinvestment over 3 years window can help here.
  • We need to empower entrepreneurs to incentivise their employees and key partners/advisers. Which means we should switch taxation of equity shares granted to employees and key contributors to new business from immediate tax liability on shares issuance to taxation at the point of shares disposal. When income arises, tax should arise. Until no income accrues, no tax should be levied.
  • We need to steer more funding toward risk capital or equity, away from preferentially-treated debt. Which means we should have symmetric tax applying to both capital gains on equity and gains realised from holding debt instruments (bonds), including Government bonds. There is no financial or ethical justification for exempting Government bonds from taxation net.
  • VAT threshold in Ireland is imposing too high of a burden on sole traders and self-employed. We should move this threshold to the levels found in the UK. Instead of EUR37,500, VAT should be levied from around EUR90,000. 

We also need to significantly reform our corporation tax policies. 

The headline rate is fine. But the loopholes are glaring and are damaging to our competitiveness through several channels:

  1. Tax loopholes are costing us in international markets by creating a perception that Ireland is a corporate tax haven
  2. Tax loopholes are funding the creation of a labour market that is severely skewed in favour of MNCs, inducing higher costs on SMEs and indigenous enterprise
  3. Tax loopholes are steering economic activity into non-productive areas where we have little chances to capture international comparative advantage (STEM areas of R&D, whilst our human capital base is better suited to develop sales, marketing, copyright and soft-innovation expertise).

One key loophole that has been introduced recently is the so-called ‘Knowledge Development Box’ that suits primarily (and almost exclusively) a narrow segment of MNCs, while providing no benefit for domestic enterprises. Another key loophole is treatment of foreign revenues domiciled into Ireland.

Shut them down.

The issue of reforming taxation system also goes to the heart of the ongoing debate about wealth inequality.

Except, contrary to what many (especially in the media) think, this debate is a bit more complex than our papers’ and TV programmes allow.

Economists Bill Gale, Peter R. Orszag and Melissa Kearney at the Brookings Institution recently showed that even a big increase in the marginal tax rate for top earners would have shockingly little effect on after-tax inequality in the U.S.

This covered such scenarios as raising the top individual income tax rate to 50 percent from its current level of 39.6 percent. Take the Gini coefficient is an index that ranges from 0, if everyone has the same earnings, to 1, if a single person has all the earnings and everyone else has none. When the authors calculated the Gini coefficient for after-tax income before and after the simulated tax change, they found that under the current tax schedule, the after-tax Gini coefficient is 0.574; raising the top marginal tax rate to 50 percent would reduce that only to 0.571. This difference is smaller than the effect of enlarging the share of the population with a college degree. Income inequality doesn’t change materially even if the revenue raised from a high-income tax increase is redistributed to households in the bottom income quintile, or if high earners are assumed to respond to the higher tax rate by reducing their work effort and taxable income.

For Ireland, the same measure would probably be even less productive in reducing income inequality. Why?  Because of our residency basis of taxation as opposed to the American citizenship-based system. And because our top earners (excluding public sector employed ones) are more mobile internationally than their U.S. counterparts.

Instead, in my view, reducing wealth inequality requires increasing wealth (not spending) of households that are currently below the top 20 percent of earners. This can only be done by simultaneously:

  • Increasing their after-tax incomes (to create savings surplus) by having lower tax burden at the upper margin of earnings, and
  • Increasing their investments in productive capital (not property) - e.g. business equity and entrepreneurship via incentives and behavioural nudging (for example, auto enrolment into pensions etc).

Now, let’s talk about capital investment side. 

I have some signifcant reservations about the new proposed capital investment 2016-2021 framework. Here they are.

1) ‘Something for everyone’ spatial development plan is an investment model followed by Irish banks in pre-2008 period: hosing cash wide in hope of striking a random pot of gold. Instead, what is needed is an in-depth, costed and scrutinised assessment of potential returns on investment. Project by project. And a tie-in of investment plans to a broader regional development scheme.

2) To give you an example: is our public capital priority to provide yet another link to Dublin airport? Or should it be to provide direct, quality train access to Ireland’s third largest city - Limerick?.. I don’t know. But I see nothing in the new framework analysing this. Should new priority development involve improving infrastructure links in parts of Ireland - e.g. Kerry to Limerick-Galway-Shannon links - or to sustaining & expanding public subsidies for transport provision? The point of investment is not to ‘give something to everyone’ but to prioritise areas where ROI is highest (social, economic, financial).

3) Prioritising investment must be based on factual analysis & scrutiny - both of which are lacking in the proposed framework. Examples of the contrary approach are Poolbeg Incinerator & Irish Water. Again, I see no change in the new plan on past modus operandi.

4) Any investment plan, based on prior experiences, should explicitly commit to capping a maximum percentage of total allocated expenditure going to auxiliary activities, such as consultancy fees, planning etc. Given the horrific track record of our public sector in securing value for money in capital investment structuring, eliminating waste should be a priority.

5) Why are new PPP rules going to be announced in 2017 when investment plan covers 2016-2021? Much of the projects will be allocated in 2016-2017, with expenditures happening later, but committed to under the old rules. If current PPP frameworks is not fit for purpose, how can we commit multi-annual programme to run under it. If current PPP framework does fit its purpose, why is it necessary to revise it in 2017?

6) Current cap spend is ~E3.5-3.7bn/pa. New plan E4.5bn/pa. So over 6 years the entire net new funding is just about enough to cover Dublin Airport link.

Truth is, Ireland needs to stop talking about State investments and State-run investment funds as a panacea for our economic problems. We need more productive, better managed private investment, more productive, better managed, better funded and more empowered public services, and more productive and better managed domestic private sectors.

There is much more that can and needs to be done within the context of structural reforms in Ireland, and within the context of the Budget 2016. My presentation today was neither designed to address all important aspects of both, nor has achieved a comprehensive coverage of all issues we face. This is not to say that the omitted considerations (for example relating to improving access for those in need to basic public services, improving the quality of all public services and so on) are less important than considerations I discussed above. No speech or presentation can aim to be comprehensive or perfectly complete.

The key point, therefore, of what I was focusing on today, is the need for dramatic, deep reforms of our policy formation and deployment systems and the need for new policies aimed to put Ireland onto the track toward human capital-intensive growth. So far, sadly, both of these objectives are missing from the Government and the main parties’ analysis.

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