Income Tax: An Appraisal of the Irish Situation
Suzanne O'Neill (Senior Freshman)
In recent years, government budgets have been subjected to
three competing forces: fiscal rectitude, fiscal reform and increasing
unemployment. The clamour for fiscal rectitude has given way to
calls for reform that will also contribute to solving the unemployment
problem. In this paper, Suzanne O'Neill examines the impact of
the latest round of direct taxation reforms, questioning whether
they will have the desired effect of increasing the number of
individuals entering salaried employment.
'Ultimately taxes will be chosen on the foundation of
how well they are consistent with other objectives of government
policy' Charles Allan
Introduction
The 1995 budget will be remembered most notably for its treatment
of income taxation and more specifically for its treatment of
the stated central objective of rewarding work. Thus this paper
seeks not only to examine the post-budget income taxation system,
but also to question any effects on work effort and behaviour
that these changes would induce. Therefore I propose to outline
initially three considerations which one must be aware of when
discussing taxation in general, followed by a practical breakdown
of how one moves from gross to disposable income, incorporating
this year's budget changes. I will conclude with a discussion
as to whether an increase in the numbers participating in salaried
work will materialise.
Taxation: Some General Issues
It is worth knowing firstly that taxation is the principal means
of transferring resources to the government. These resources are
used to provide essential services in the economy, such as health
and education, and also to provide some basic needs to members
of the community deemed to be unable to provide for themselves.
Taxation is the direct and inevitable consequence of government
expenditure, the level of which is determined by public demand.
Therefore while it is the community who decide the level of taxation,
albeit indirectly, it is the government who must implement the
structure of taxation that will satisfy revenue needs.
Secondly, since the focus of this essay is on the taxation of
income, it is essential to note that PAYE-related ('pay as
you earn') social insurance, health and employment levies
all fall under the umbrella of income taxation. Thus the practice
of fiscal illusion, where one concentrates solely on income tax
rates, is seen to understate the actual amount of tax deducted
at source from an individual's salary.
Thirldly, it is important to note that not all individuals are
liable for tax under the same schedule. The self-employed are
assessed differently from those employed in the private or public
sectors. Furhtermore, public sector workers are liable for pay-related
social insurance (PRSI) at a lower rate than any other group of
employees.
Income Tax in Practice
Not all of a person's income is liable for tax due to the presence
of allowances, relieves, exclusions and exemptions in the Irish
system. Tax-free allowances are administered uniformly, regardless
of one's gross income, and currently stand at £2,500 for
a single person. The system provides additional allowances for
widows and single parents. In the determination of taxable income
one has traditionally been allowed to deduct relieves from gross
income, thereby reducing taxable income. One has been allowed
to offset certain expenditure against tax liability. Two types
of relieves exist: business and non-business. Although the conflict
that this topic raises between the self-employed and the PAYE
sector has provided many hours of entertaining debate, a more
serious issue is the appropriateness of their existence in a progressive
and equitable income tax system. Certain relieves, such as mortgage
interest relief and voluntary health insurance relief, are balanced
in favour of the more affluent in our society. With regard to
exclusions, certain types and sources of income such as imputed
income and investment returns are not liable for taxation. Finally
income from state-run gambling institutions, social welfare payments
and artists' incomes have traditionally been exempted from tax
altogether. Having derived one's taxable income, this is then
subject to a progressive system of tax rates. At present the tax
rate for the initial £8,900 earned is 27% with a higher 48%
rate levied on income above this threshold. On top of this PRSI
and various government levies add to the income tax actually paid
by the individual.
The 1995 budget saw the government increasing personal allowances
and increasing the threshold income above which the higher income
tax rate applies. The rationale for this is to increase an employee's
take-home pay. PAYE allowances were left unaltered. In contrast
to its generous nature in other areas, Mr. Quinn chose to gain
revenue by reducing mortgage interest relief, voluntary health
insurance relief and abolishing covenants. In addition the government
introduced an exemption on PRSI payments on the first £50
for the private sector and £10 for the public sector, earned
per week. PRSI allowances were also reduced.
The combination of these changes according to the Minister for
Finance, reward work. In order to assess further the significance
of these income taxation changes, an analysis of the effect of
direct taxation on work behaviour is needed.
Work Effort and Behaviour
It is widely accepted that the higher the marginal rates of income
taxation, the greater the disincentive to work and the greater
the incentive to avoid and evade tax. However, one must distinguish
between the influences of income taxation on (i) those currently
in paid employment and (ii) on the choice of ones occupation and
work pattern.
(i) Theory dictates that as the rate of income taxation increases
two effects occur; an income and a substitution effect. In principal,
a higher tax rate reduces take-home pay and in order for an employee
to maintain his original level of income, he/she must work additional
hours. The substitution effect operates on the basis that the
amount one earns for an extra hour of labour is declining as the
marginal tax rate increases, thus one substitutes towards leisure
and away from labour. This is as a result of the decreasing opportunity
cost of leisure as measured by ones declining take home pay per
hour of labour. However, it is in reality very difficult to assess
the actual magnitude of either the income or substitution effects
thereby making it difficult to identify a predictable outcome
resulting from a change in direct taxation rates. Hence, the favourable
income tax changes in the 1995 budget, due to changes in allowances
and relieves rather than the tax rates per se, may or may not
have an effect on work behaviour. The problem lies largely with
ones ability to work overtime. By working the normal week in a
given industry, one may benefit from increased income, however
should working additional hours push an employees income above
the 27% threshold value then that employee may not be better off
when the financial and opportunity costs in terms of leisure are
considered.
(ii) The income taxation system has a clearer impact on the choice
of occupation and work pattern. Certain groups of individuals
may not enter paid employment if they consider that the taxation
system would leave them financially worse off. Individuals in
this category include married women and in many cases the unemployed,
who find themselves caught in unemployment traps. High and indefinite
social welfare payments coupled with the perception of punitive
income taxation, may encourage some of the community to evade
taxation altogether by working in the black economy. The taxation
system may also act as a disincentive to new enterprises and the
self employed who often find their burden of income taxation coupled
with employers pay related social insurance contributions, too
great to maintain viable businesses. income taxation also has
the ability to affect where people work, leading to emigration
of highly skilled and motivated entrepreneurs. The 1995 budget
with the increase in childrens allowances should provide additional
incentive for mothers and unemployed fathers to enter paid employment.
The reduction in employer's PRSI contributions also provided a
welcome indication of support for native Irish entrepreneurship.
Conclusion
As one noted at the outset of this paper, taxation will always
have to be paid to satisfy public demand for government expenditure.
However in recent budgets, one has witnessed the realisation that
the collection of revenue must not be to the detriment of other
government objectives. Thus one has concluded that the lessening
of the direct taxation burden in the 1995 budget, especially for
those earning below the average industrial wage, will on balance
increase the incentives and thus the number of individuals entering
paid employment or providing additional such employment.
Bibliography
Books
Allan, C. : Theory of Taxation, Penguin, Harmondsworth, 1991.
O'Hagan, J.W. : The Economy of Ireland, (6th edn.),IMI, Dublin, 1991.