I thank the Chairman for the invitation to the ESRI to appear before the committee. I am joined by my colleague, Dr. Karina Doorley. We work in the area of taxation, welfare and pensions research at the ESRI. We are happy to provide our views on indexing the tax and welfare system and will focus on the rationale for indexation, how such a system could be created and the economic sustainability of such a system.
I will first speak to the rationale for indexation. Indexation, or changing the monetary parameters of the tax and welfare system in line with price or earnings changes, is often suggested as a useful policy tool, both nationally and internationally. Currently, the Irish tax and benefit system is not automatically indexed. Instead, discretionary changes to tax and welfare parameters are announced, usually at budget time. Historically, these changes have, on average, kept pace with earnings growth, although on a year-to-year basis, there can be some deviation.
The absence of a rule for increasing welfare payments, tax credits and bands in line with inflation or earnings growth has implications for household purchasing power, the Exchequer, poverty and income inequality. If we consider a year in which price growth is 2% and earnings growth, which is usually higher, is 4%, and if all tax and welfare parameters are frozen, the purchasing power of those receiving welfare falls and income taxpayers face paying more of their income in taxes, a position known as fiscal drag. The Exchequer experiences an increase in income in real terms due to this fiscal drag. People may also lose eligibility to cash and non-cash benefits, such as medical cards, housing and childcare subsidies and student grants, due to earnings growth. Income inequality tends to increase as the incomes of those dependent on welfare falls relative to workers.
If tax and welfare parameters increase in line with price growth, the purchasing power of those receiving welfare is constant, Exchequer revenue from income tax still increases in real terms, as tax credits and bands fail to keep pace with wage growth, and income inequality increases, albeit by less than in the case of no indexation. Only by indexing tax and welfare parameters in line with wage growth do welfare recipients and workers see their income grow at the same rate. This wage indexation scenario is distributionally neutral in that it keeps at-risk of poverty rates and income inequality constant.
The creation and operation of an indexation system first requires the identification of a benchmark, or a desirable or adequate level of welfare benefits. Once the benchmark has been reached, further increases can continue to be linked to the benchmark or to a price or earnings index. Previous expert groups have suggested benchmarks for the Irish welfare system. The report of the social welfare benchmarking and indexation group from 2001 suggested that if indexation were to be adopted, the lowest welfare rates should be increased to 27% of gross average industrial earnings. in 2010, the national pensions framework suggested that the State pension should be benchmarked at just over a third of average weekly earnings to prevent elderly poverty, with the road map for pensions reform suggesting a similar benchmark.
In terms of which index to use, ESRI research argues that the natural index for indirect taxation is prices to ensure that taxes set at a fixed rate per unit of a commodity, such as excise duties and the carbon tax, remain constant in real terms. However, indexation based on earnings growth may be more suitable for income tax and welfare parameters if the aim of indexation is to avoid poverty or inequality increases.
Internationally, there are many examples of indexation systems in operation. There are few examples of automatic and unified earnings indexation, such as in Denmark, and the most common practice remains adjustment linked to prices. When uprating is linked to earnings, this is often limited to pension benefits. Indexation of tax bands and credits is much less common in Europe but more commonly seen in the US and Canada.
While typically wages rise by more than prices, they can both be subject to cyclical variations and at times if wage growth falls behind price growth, then indexation with respect to real wages would imply falls in real incomes for welfare recipients. If welfare payments are protected during downturns, they must be increased by less than the full extent of growth in upturns to avoid what is known as a ratcheting effect whereby social welfare rates grow faster than either incomes or inflation in the long term.
Regarding budgetary sustainability, it is important to bear in mind that automatic indexation removes some discretion available to Government each year and can reduce the scope for more targeted measures for groups considered to be at greater risk of poverty or deprivation. It can also limit the Government’s ability to respond to economic shocks. ESRI research by Callan et al, estimated the net cost of indexing the tax and welfare system in 2020. In that year indexation would have cost between €462 million for price indexation or €1.3 billion for wage indexation. That was between 10% and 29% of the available fiscal space that year.
In summary, indexation, or a lack thereof, has implications for poverty and inequality. While price indexation of the tax and welfare system would ensure that inflation does not erode purchasing power, it would still result in an increase in poverty rates and inequality. Indexation in line with earnings growth would avoid these increases but generally comes at a higher cost for the Exchequer. Both indexation options reduce budgetary flexibility. The decision to index the tax-welfare system is, therefore, ultimately a political one but could be assisted by using a microsimulation model, such as the ESRI’s SWITCH model. That has been used in the past in advance to estimate the cost of indexation options each year and to assess their financial feasibility.
