Income tax is an emotive issue in every country, and Ireland is no exception. It involves states using coercion to appropriate a fraction of people's earnings in order to finance government spending. This implies a huge responsibility on taxing authorities to carry out the operation in a manner that is fair, or at least acceptable to the majority of taxpayers. The purpose of this essay is to examine whether or not the Irish income tax system is a good system. Thus, the issue of fairness is crucial and will be the central theme.
Adam Smith's canons of taxation of 1776 provide certain criteria by which a tax system can be assessed, and this essay discusses them. In doing so it will examine definitional problems associated with the term 'good tax system' and ask whether such a system is possible in practice. Turning to the income tax system in Ireland, this essay will look at issues such as the size of the tax base and proposed reforms. It will conclude that the system is flawed and resistant to change. Far from being fair, the best the government can hope for is that the tax regime is accepted.
Smith's canons of taxation can be considered under the headings of equity, efficiency, and ease and cost of administration. The principle of equity raises the most fundamental problems in terms of the vagueness and contestability of the concept of fairness. According to Smith, horizontal equity and vertical equity respectively require the equal treatment of similar incomes and an appropriate degree of inequality in the treatment of different incomes.
The most obvious problem arises in interpreting and applying the latter. An appropriate degree of inequality can have very subjective interpretations. However, even the seemingly innocuous concept of horizontal equity is not uncontested. For instance, as Allen points out, one could plausibly hold the view that equity is best served by 'making tax payment proportional to the degree of benefit derived from government expenditure'. In this case a person's income is not considered directly relevant and horizontal and vertical equity are of no consideration.
Although there is an attractive simplicity to this notion, its unpopularity would doubtless make it unworkable, but it does serve to highlight the ambiguities surrounding the concept of fairness. According to Ruane and O'Toole, equity suggests a progressive tax structure, which considers an individual's ability to pay and applies higher rates of tax to higher incomes and this is generally accepted.
In Ireland, the system of taxation nominally embodies the principle of progressivity, although it can be more accurately described as a crude approximation of the concept. Income is taxed at two incremental rates, but only after a series of allowances, exemptions, reliefs and exclusions, which greatly reduce the sum of taxable income in the economy, have been applied. The aggregate of taxable income is termed the tax base and its size determines which tax rates must be applied to raise a given amount of revenue required by the government.
Consequently, given an inability or unwillingness to reduce the size of public spending, any measure which serves to narrow the tax base will necessarily impose a burden of higher rates on taxpayers, and conversely, a reduction in tax rates will necessitate a wider tax base. Using this analysis, we can see how concessions which apply only to some taxpayers must be subsidised by all other taxpayers. This insight makes the need for justification on the grounds of fairness all the more urgent.
As well as automatic personal allowances, which apply to all, an individual can further limit the amount of tax he or she pays by, amongst other things, contributing to a private pension or health insurance. Such concessions can be justified on the grounds of promoting desirable behaviour or generally furthering government goals with regard to efficiency and equality. Much harder to justify, however, are tax reliefs, for example, for buying apartments in designated areas or investing in the film industry.
If the tax system were truly progressive, all tax-payers could derive similar benefit from sheltering some of their income in this manner and so benefit to the amount at which that extra income would have been taxed - that is, the individual's marginal tax rate. In Ireland, it is argued with strong justification that the higher one's marginal rate, the greater the relative benefits from concessions. Thus, the degree of fiscal privilege afforded by the system is positively correlated to the individual's income.
Earning a high income very often gives an individual a degree of discretion over how and when they earn their money, as well as access to professional advice on how to minimise tax liabilities. According to the Revenue Commissioners' estimation, 17% of people with incomes over £250,000 pay tax at an effective rate of 20% or less. The adverse effect of these factors can be seen in the narrowness of the tax base, and in particular, the high marginal rates of taxation which apply to it.
Irish income tax rates of 24% and 46% are not particularly high in comparison with other European countries. For instance, the corresponding upper rates in the UK and Denmark are 40% and 60% respectively. The problem in Ireland is that the higher rate applies at relatively low levels of income. Before last December's budget, a single person in Ireland with basic allowances started paying tax at the upper rate once their income exceeded a mere £9,900. The corresponding figures for the UK and Denmark are £29,000 and £24,779.
Although the recent budget took two percentage points off both tax rates, the accompanying increase in personal allowances (extra £250 for a single person) and widening of the standard rate band (extra £100 for a single person) were slight and did little to ameliorate the situation outlined above. In fact, 38.2% of tax-payers will pay tax at the top rate in the coming tax year, an increase of 1.2% over the current year. In any case, it should be noted that some increase in allowances and bands is necessary just to compensate for the effects of inflation.
The issue of tax reform encapsulates the controversies surrounding income tax more than any other. In the 1980s, the trend in Britain and the US was towards cutting tax rates, and the current government in Ireland is committed to doing the same. In 1981 President Reagan cut the top personal rate from 70% to 50%. Proponents of such cuts draw theoretical justification from the Laffer curve, which explains that discretion over tax payments at very high income levels means tax revenue can rise after rates are cut.
However, more considered analyses of tax systems look beyond such rudimentary measures. In 1980, the Commission on Taxation was established here in response to widespread disquiet in the PAYE sector. It proposed a wide range of reforms which would have changed the Irish tax system beyond recognition. The Commission advised that all exclusions and concessions be abolished and a single rate of tax be applied to a broad definition of income.
Under the Irish tax code, only money earned from work is defined as income and taxed accordingly. Money earned from other sources such as gambling or capital gains, although it confers the benefactor with the same spending power as income, is either taxed under a different heading or not at all. So, two individuals with identical command over society's scarce resources may be required to make different contributions to the state because of the source of their spending power. The reduction of the capital gains tax rate from 40% to 20% in the budget, which means such income is now taxed at a rate lower than income tax, must be seen as a further step away from the concept of a broad definition of income.
Implementation of the Commission's proposals would surely have benefited the majority of tax-payers by widening the tax base, but would have been unpopular with those who benefit most from the current system. The fact that they were never seriously acted upon raises questions about the political will to pursue equity in the Irish tax system. The two tax amnesties in recent years raise further questions in this regard. While the amnesties certainly contributed to exchequer revenues in the short run, they may have a greater long run cost in terms of undermining the confidence of ordinary tax-payers in the system.
Given the gap between the principles which should govern a good tax system and the features of the Irish tax regime identified above, how can such a system persist? The answer is one of interpretation. If we choose to define 'good tax system' as meaning one that is absolutely fair then we must be guided by the equity principle at all times. If however, we view a good system as one that is workable and provides government with the resources it needs, then we can settle for one that is accepted by the majority of tax-payers without unrest or widespread evasion. Unfortunately, successive governments in Ireland appear to have settled for the latter.
Allen, C. (1971) The Theory of Taxation, Penguin: Harmondsworth.
O'Hagan, J. (ed.) (1995) The Economy of Ireland, Gill & Macmillan: Dublin.
Sunday Business Post (9 November 1997)
Sunday Business Post (14 December 1997)