Tuesday, April 7, 2009

Laffer Laughs Last

The Minister for Finance is, as Sir Humphrey might say, being 'very brave'. He has gambled on achieving most of his budget ambitions through tax increases, with rather less from expenditure cuts. Given his experiences with VAT (an increase in the standard rate in December followed by a calamitous fall in revenues the following months), he is being very brave indeed. Perhaps that is why he has opted to secure 73% of his tax increases through additional taxes on incomes (income levy + health levy + PRSI increases) rather than spending.

Nevertheless, his bravery is foolhardy. The families that will be hurt the most by this budget - working couples in their thirties and forties with dependent children, mortgages and insurance policies - will be confronted with a nasty reality: it isn't worth their while financially for both spouses to keep on working for sharply reduced net household incomes. So they won't.

We are embarking on a real world test of the Laffer Curve hypothesis: that above a certain level of taxation, employees withdraw their labour causing a collapse in government revenues from income taxes. Nor is the Laffer Curve some throwback idea from the 1980s: recent experiments in behavioural economics show the existence of a behavioural Laffer curve.

One consequence of the more flexible and fluid, predominantly private sector labour market that we now have in Ireland is just that: individuals and households are flexible - they make adjustments to the new circumstances that face them. Including decisions about whether to work, and for how long. I'm guessing Irish working couples will look at their paychecks this month and next and act accordingly.

Ireland is unique among OECD countries in responding to the global economic crisis through a policy of tax increases. Indeed, we appear to have a government that is living in a world more familiar to Sir Humphrey than to that in which most of us live. They are gambling the nation's future on the hope of a shortlived recession that will see us growing again in twenty months time. If they are wrong, and the Minister for Finance has to go to the IMF next autumn for the money to pay teachers' and nurses' salaries, then the decisions made today will seem not so much brave as reckless.

I suspect Laffer will have the last laugh.

4 comments:

  1. Interesting perspective and I am sure that for many working couples the costs of running an extra car, reduced childcare assistance and generally higher taxation may indeed make one of the jobs more marginal. Though if one spouse exits the market, woudn't their marginal salary prove very attractive for example to a single person on the unemployment register thereby negating the Laffer effect? Indeed the tax take to the Government might increase if this person does not require any childcare/child benefit transfers.

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  3. Add to this the effective scrapping of the childcare supplement and taxing and means testing of children's allowance and you are really making the two income scenario less viable. Many couples would rather look after their own children and the economic case to do otherwise has to be convincing. This budget will be enough to push us over the Laffer hump and down the other side for sure.

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