Here is a presentation titled “The Lender of Last Resort in the Euro Area: Where Do We Stand?” which I gave in March at a workshop on financial stability at University College Cork.
The Eurosystem’s often-misunderstood TARGET2 balances have again become a topic featured in op-eds and bank briefing documents. I’m posting this a bit late but here is a briefing paper I did on these balances that was submitted to the European Parliament in November 2017. For those interested in a longer explanation of how the mechanics of how these balances come about, my 2013 paper covers a lot of different issues.
The past week has been the most fraught yet in the Brexit negotiations. The EU and UK have not agreed on how the “Irish backstop” proposed in December should operate. The UK government and the DUP are unhappy that the EU believes the “backstop” arrangement should only apply to Northern Ireland. The EU backstop would essentially keep Northern Ireland (but explicitly not the rest of the UK) in the EU customs union and single market unless other arrangements are agreed that would also rule out the need for a hard Irish border.
In Westminster and Northern Ireland, there is a lot of concern about the EU’s proposal, with many viewing it as implying a “border in the Irish sea” and Theresa May arguing that it would “threaten the constitutional integrity of the UK” and that “no UK prime minster could ever agree to it”. In Northern Ireland, unionists have argued this approach is inconsistent with UK’s commitment in the December agreement that there would be “unfettered access for Northern Ireland’s businesses to the whole of the United Kingdom internal market”. Arlene Foster has repeatedly insisted that this arrangement would be “catastrophic” for the Northern Ireland economy and, in a notable upping of the ante, said on Friday that the EU’s approach would amount to Northern Ireland being “annexed” from the UK.
I believe these concerns are fundamentally misplaced. Rather than being threatened economically, Northern Ireland would gain from the implementation of the EU’s backstop. To understand why, let’s look at how the backstop would work in practice.
Let’s start with the most obvious objection to the EU’s backstop: the idea that a “sea border” would make it harder for Northern Irish firms to sell into Great Britain. The DUP’s Arlene Foster has emphasised this repeatedly in recent months. Consider, for example, this statement from Foster in March
“What was there, in the [EU draft agreement] legal text, is around creating a border down the Irish Sea,” she said.
“And of course that’s not something we in Northern Ireland could allow from a constitutional point of view, but also in terms of economics, it would be catastrophic to have a border down the Irish Sea.”
“56% of our goods from Northern Ireland go to Great Britain, so it is incredibly important that that border does not exist.
This probably sounds like a reasonable concern but it is without foundation. Firms in Northern Ireland will remain within the UK, so there will not be and cannot legally be customs checks for goods produced in Northern Ireland when travelling to the rest of the UK. In addition, the UK itself promised in the December agreement that unfettered access would be maintained for Northern Irish firms and that “no new regulatory barriers” would affect these firms. Together, these points mean Northern Irish firms will have unfettered access to the rest of the UK under the EU backstop.
If you’re surprised by this and perhaps think I’m making it up, you might not know the UK civil service has already worked out how this backstop would work and they have said there would be unfettered access for Northern Ireland firms for the rest of the UK market. The document describing how this would work was part of a series of UK civil service documents leaked to politicians in the European Parliament and was discussed in various press stories in May.
This “customs channel” proposal implies no land border checks on the island of Ireland but some checks at the small number of ports in Northern Ireland that transport goods to Great Britain. Goods would either go through a “green channel” with no checks or a “red channel” which has checks. Crucially, goods from firms in Northern Ireland would go through the green channel. Goods coming from the Republic of Ireland to the Great Britain via Northern Ireland’s ports would probably have to go through the red channel if the UK required customs or regulatory checks on goods from the EU.
Viewed this way, the “border in the Irish sea” terminology is misleading because it will not affect firms from Northern Ireland. A better terminology would be “enforcing the land border at Northern Ireland’s ports.” With a small number of ports in Northern Ireland, all of whom are already checking shipping documentation of some sort, the implications for trade frictions for Irish firms would be far less severe than the alternative of enforcing customs and regulatory checks on a meandering 310 mile border with about 200 different crossing points.
Over time, various issues would need to be sorted out about how this arrangement would evolve. These issues are not trivial but they would be would not be too difficult to work out between the EU and UK. A few examples.
- Most likely, Northern Ireland would be given a “special economic zone” status, so that the free movement of goods from its firms to both the rest of the UK and EU is agreed and accepted internationally by all members of the WTO.
- Assurances may be required that the UK will discourage tariff-hopping via “name plate” firms setting up in Northern Ireland just to label products as a way to avoid tariffs that the UK may charge on EU goods (though these tariffs should be minimal if the EU and UK agree a sensible free trade deal).
- Some goods moving from Great Britain to Northern Ireland may need to be checked to make sure they meet EU regulatory requirements. Goods that are heading on towards the Republic of Ireland would also need to have EU customs procedures applied.
- The UK has promised there would be no new regulatory barriers affecting Northern Irish firms accessing the market in Great Britain. If the UK starts passing new product regulations that deviate from the EU’s, any new regulatory bill passing parliament could include a clause stating that Northern Ireland’s products (produced according to EU rules) are also allowed to be sold throughout the UK, i.e. that there is a form of regulatory equivalence. Ultimately, it is up to the UK government to honour its promise to allow Northern Irish firms unfettered access to markets in Great Britain and there should be little difficulty in implementing this.
Economic Impact on Northern Ireland
So the EU backstop isn’t going to turn Northern Ireland into an economic dystopia. It is far more likely to have a positive economic effect. Northern Ireland would become the only place where firms could export freely to both the EU and the UK. One could easily imagine Northern Ireland obtaining new foreign direct investment because of this unique selling point. Business leaders in other regions of the UK (for example Scotland) would view this kind of special status as a great opportunity if they could attain it but the EU has made clear that this can only apply to Northern Ireland.
Northern Ireland’s agriculture and food sector is also likely to do better under this regime than under any alternative approach. If the UK decides to pursue trade deals that allow cheap food from outside the EU into the UK, then Northern Irish farmers would have to compete with these imports in the Great Britain market (most likely in an environment with less generous state-funded agricultural subsidies). However, regulatory alignment with the EU would mean produce like chlorinated chicken and hormone-injected beef could not be sold in Northern Ireland, providing some protection for local producers. Northern Irish farmers would still also have full access to the European Union market without facing tariffs or quotas, which would provide some opportunity to diversify their sales.
Most importantly, the EU’s backstop keeps the land border open and allows the all-island Irish economy to continue to operate freely. Contrary to Boris Johnson’s uninformed sneering, the reality is that more firms in Northern Ireland sell goods to the Republic than to Great Britain and integrated all-Ireland supply chains are of huge importance to many firms, North and South. Northern Ireland would keep this important element of its economy, without losing anything.
Constitutional Integrity? Annexation?
But what about the constitutional integrity of the United Kingdom which is supposedly a great concern to Theresa May? Well the UK’s constitutional integrity is a complicated thing, not least because it doesn’t actually have a constitution.
The reality is the UK has a patchwork of different governance arrangement across its regions. Northern Ireland, in particular, already differs sharply from the rest of the UK in lots of ways, including its form of government, rules on gay marriage and abortion and the plethora of ways in which the Good Friday agreement has introduced North-South co-operation. In truth, the DUP’s desire for Northern Ireland to have a different corporate tax rate from the rest of the UK is probably a more substantive difference in economic policy than anything new that would emerge from the proposed backstop.
Is this Northern Ireland getting annexed by the EU or Republic? Clearly not. Northern Ireland would still send MPs to Westminster. Its people would still pay UK tax, hold British passports (if they wish), have access to the NHS and the UK social welfare system, and be subject to UK laws in most areas. The people of Northern Ireland would probably barely notice their new status. By contrast, they would certainly notice the return of a hard border, which is the most likely alternative option if the EU’s backstop offer is rejected.
The Politics: Still Time (Just About) for a Broader Discussion
It now looks like nothing will be settled between the UK and EU until the Autumn. This still leaves some time for an informed debate in Northern Ireland and Westminster about the consequences of the EU backstop proposal. For a number of reasons, this debate has not taken place so far and there is a general lack of understanding about how the EU backstop would work. These reasons include:
- Northern Ireland does not have an assembly operating. The assembly would certainly have held extensive committee meetings to discuss the various options and this would have helped to debunk the scaremongering about the so-called “border in the sea”.
- Many in the UK government probably know the EU backstop would work well for Northern Ireland. Under other circumstances, they could give assurances to everyone in region that the backstop would work well for them – it is not the EU’s job to explain how unfettered access to the UK market could be maintained. However, the Conservatives are reliant on a hard-line unionist party for their majority at Westminster and do not want to upset the party keeping them in power by asking them to consider a proposal they are so uncomfortable with.
- The last UK general election meant the DUP and Sinn Fein were the only parties in Nothern Ireland with MPs and Sinn Fein do not attend parliament. This has left the Westminster debate without nationalist or non-sectarian voices (such as the Alliance Party) who could have argued for the EU’s backstop. It is also seems likely that the current DUP leadership has handled these issues in a more aggressive manner than, for example, Peter Robinson would have (see for example Robinson’s speech last week imploring leaders on both sides of the community to compromise to get the Assembly up and running again.)
- Finally, the Irish government appears to have outsourced most of the communication on Brexit to Michel Barnier (who has a lot on his hands) rather than working hard to publicly explain the benefits of the EU backstop to all sides of Northern Ireland’s community.
Northern Ireland may not have a functioning assembly but the MLAs that were elected last year must surely understand they have a political responsibility for what happens next. Even if the assembly does not formally convene again this year, it must be possible for the MLAs to meet to debate the options and perhaps hold a “consultative vote” on the EU backstop. The DUP do not speak for all of Northern Ireland (they received 29% of the vote in the 2017 assembly elections) and they should not be the only party with an influence on the final outcome. Even if it had little legal standing, a vote by a majority of assembly members registering approval for a form of the EU backstop would have a profound political impact.
A final word on the long-term political implications. The DUP clearly believe that Northern Ireland remaining in the EU’s customs union and single market is a step towards a united Ireland. I doubt if this outcome would actually change perceptions of a united Ireland by much since it would mainly involve a continuation of the status quo for most people in Northern Ireland. Indeed, a special economic zone status within the UK but with full access to the EU could be popular even with some nationalists. However, the alternative outcome – the return of a hard land border with Northern Ireland firms having poorer access to the EU – may convince many nationalists that they are better off to re-join the EU via unification. With a border poll sufficient to trigger unification, a rejection of the backstop may turn out to be a crucial stop on the road towards (rather than away from) a united Ireland.
Seventeen months on from the Brexit vote, the UK government has largely avoided setting out clear and realistic positions on key issues. Their stance on almost everything continues be a form of cake-and-eat-it.
Nowhere is this more clear than on the question of the Irish border. The UK’s position is that there will be no hard Irish border even though they plan to take the UK out of the EU’s single market and customs union. When pressed on this, they use the phrases “flexible and imaginative” and “technologies” but don’t put forward much by way of specifics. (If you think I’m exaggerating, read this).
In the absence of anything concrete from the UK government, the EU has put forward its own flexible and imaginative suggestion that Northern Ireland could remain part of the EU’s single market and customs union. This proposal has been received negatively by the Conservative Party and the DUP. As best I can tell, there has been little public discussion of the objections that have been put forward, so here I want to discuss the economic arguments for and against the EU’s proposal and to propose that Northern Ireland be allowed vote on it.
The Economic Arguments
If Northern Ireland were to remain part of the EU’s single market and customs union, then this would allow free movement of goods between the North and South of Ireland. However, once the UK leaves the EU’s single market and customs union, then there would need to be some form of checks on goods leaving Northern Ireland for Great Britain as well as those goods coming in the other direction. The extent of these checks would depend, over time, on the extent to which the UK departs from its current EU-consistent policies on tariffs and regulations.
One economic argument against this proposal is that Great Britain is a more important market for Northern Irish firms than the Republic of Ireland and the rest of the EU. Figures show that in 2015, Northern Ireland had €14.4 billion in final sales to Great Britain while final sales to Ireland were €2.9 billion and sales to the rest of Europe were €2.1 billion. In this sense, surely it makes sense from an economic perspective for Northern Ireland to rule out any trade barriers with Great Britain?
There are two counter-arguments to this position. The first is that the final sales figures under-state the significance of cross-border economic linkages to Northern Ireland. The second is that the inconvenience to firms of NI\GB trade costs will likely be much smaller than the costs associated with an Irish border for goods.
Importance of the All-Ireland Economy
The trade figures just described come from an appendix to the UK government’s position paper on Northern Ireland and Brexit. However, the paper also acknowledges that
the sale of finished products to Great Britain relies upon cross-border trade in raw materials and components within integrated supply chains meaning trade with both Great Britain and Ireland are vital to Northern Ireland’s economy.
And that cross-border trade is a crucial part of the Northern Irish economy:
Over 5,000 businesses in Northern Ireland exported goods to Ireland in 2015, one and a half times as many as sold goods to Great Britain.
So cross-border trade clearly plays a very significant role in Northern Ireland’s economy. In addition to these substantial linkages, there are also a wide range of all-Ireland bodies devoted to supporting all-Ireland economic linkages in areas such as agriculture, the environment, energy and so on. Northern Ireland leaving the EU’s single market would likely undermine the economic benefits that have been achieved in these areas.
A Seamless Irish Border?
Once the UK leaves the EU’s customs area and agrees new trade deals with third-party countries, then the EU will require an Irish customs border to protect the integrity of its customs union. There is no point, by the way, in presenting this as a “big undemocratic EU bullies little Ireland” story: There is no way Irish farmers will allow the UK to pursue cheap food deals with the US or Brazil and then have these products imported to the Republic without customs checks.
Brexiteers are currently saying the EU will be “to blame” for the subsequent border checks but the border will only be there because of the UK’s decision to leave the EU. Moreover, despite silly talk from various British politicians about the UK “not being bothered” to enforce a customs border in Ireland, the UK will be under legal obligations to do so via its WTO commitments.
So if Northern Ireland leaves the single market, the customs union and European Economic Association (EEA), there will be border-related checks on goods: Customs checks, rules-of-origin checks, regulatory compliance checks. Will the much-discussed technological solutions make all of this seamless? No
Some in the British press have pointed to the Sweden-Norway border as an example of how well an Irish border could work. For example, this BBC report starts with stories about average wait times of eight minutes and plans for a future frictionless border. Only later in the story do we find “there is still plenty of paper to be processed, first with the customs agents, then at the customs office” and that the eight-minute figure might have been over-hyped. “A Swedish trucker grumbles to me that it can take an hour and a half, and he is unimpressed with the level of customer service.”
For lots of reasons, an Irish customs border will be more complicated. For starters, unlike Norway, the UK will be leaving the EEA, meaning extra layers of trade and regulatory checks will be required that do not exist on the Norway-Sweden border. Another important difference is the political sensitivities of border checks in Northern Ireland and the possibility that formal checkpoints could be a target for terrorist organisations.
The complexities of the physical Irish border are also daunting. Currently, there are an estimated 1.85 million cars crossing the border each month through about 200 crossing points as well as 208,000 light vans and 177,000 lorries. And the nature of the border they are crossing? Here’s Fintan O’Toole
It meanders for 310 miles, and it is not a natural boundary. It was never planned as a logical dividing line, still less as the outer edge of a vast twenty-seven-state union. It is simply composed of the squiggly boundaries of the six Irish counties that had, or could be adjusted to contain, Protestant majorities in 1921. And it cannot be securely policed. We know this because during the Troubles it was heavily militarized, studded with giant army watchtowers, overseen by helicopters, and saturated with troops—and it still proved to be highly porous. It is an impossible frontier.
Trade Costs Associated with an Irish Border
Even if physical customs borders managed to be relatively seamless, Northern Ireland leaving the customs union would still damage many of the businesses that rely on integrated cross-border supply systems. To give one example, consider the example of dairy businesses in which milk from Northern Ireland is moved over the border for processing, then perhaps moved back to the North for further processing and then perhaps sold in the Republic. When Michael Lux, a German customs expert and former European Commission employee was asked about these kinds of businesses by a House of Commons committee, he responded
“I am always saying to companies, “You need at least two people doing the customs business, if you do it yourself, because one of them may be ill or on holiday and then you will have nobody to do it.” Alternatively, you can use a service provider that is a logistics company. Depending on the complexity, they will charge you between €20 and €80 per declaration; so the cost will increase enormously just due to the fact that, each time you are doing something that involves a crossing of the border, it creates a cost. That will be part of the cost of the milk and, later, of the cheese, and I cannot imagine that anybody will continue these practices. It would just be too costly.”
Manufacturers in Northern Ireland are gradually learning how costly it would be for them to leave the customs union. Stephen Kelly, Chief Executive of Manufacturing Northern Ireland, told a Commons committee:
I have some evidence here for the Committee today, on just what that country-of-origin certification and the paperwork around that would actually mean in terms of cost to an individual business. Between the development and the time required to produce those certificates, plus the letters of credit from banks that are required to export alongside, the total is £478 per shipment. That is roughly the same price as shipping a container from Northern Ireland to GB or two-thirds of the price of shipping a full container from south-east Asia to Northern Ireland ….
the dangers that are staring our members directly in the face right now is a £478 charge every time they transfer anything across a border, and that is just the paperwork element of it, never mind any tariff elements
To summarise, even a sophisticated “light touch” implementation of an Irish customs border would involve delays and costs that would have a highly negative effect on businesses that have relied on integrated North-South supply chains.
Trade Costs Associated with Northern Ireland Remaining in the Customs Union
What about the alternative? Wouldn’t trade costs associated with Northern Irish firms moving goods to Great Britain also be a big problem? This is clearly not an ideal scenario but there are a number of mitigating points.
The first is that this is a much simpler “border” to monitor. Almost all of Northern Ireland’s trade with Great Britain is shipped via freight and two-thirds of this is shipped via Belfast port (see page 10 here). Goods are shipped already require various pieces of paperwork to be filled out, so it may be possible to add customs and regulatory forms to these and, yes, to use technology to ensure that all of the trucks arriving at Belfast port are ready to board with minimal delays. It would certainly be a lot easier than monitoring the famously-complicated Irish border.
A second is that it may be possible for the EU and UK to agree to designate Northern Ireland as a special economic zone that would allow streamlined procedures to make moving goods to Great Britain as cheap as possible. This could include exemptions from various regulatory or rule-of-origin checks for the vast majority of Northern Irish firms and a guarantee from the UK government that there would be no fees charged for any documentation required. I would guess the Irish government would be willing to share in the costs of administering the checks required in moving goods from Northern Ireland to Great Britain.
This outcome—remaining in the customs union and single market but with simple low-cost procedures for moving goods into the UK—could make Northern Ireland a highly attractive option for international firms. It would allow them to get direct access to EU markets while also getting lower-cost access to the British market. Designed in a flexible and imaginative way, Northern Ireland could potentially prosper as a result of its special status.
Movement of People
One complication when discussing Brexit is that when borders get discussed, most people immediately think about passport control and delays in travel for people moving through airports. Thus, the idea of Northern Ireland remaining in the EU customs union gets represented as a “border in the Irish sea” and people imagine that Northern Irish residents will have to go through passport control to get into Great Britain. In fact, Northern Ireland remaining part of the customs union and single market would likely have no implications for border controls for people. It would simply affect the movement of goods.
Both the Irish and British government seem committed to maintaining the “common travel area” which would allow Irish and British people to move freely between the two countries as well as maintaining other rights such as the right to work. I don’t believe anyone is suggesting Irish border controls to monitor people coming from the EU going to Belfast to then enter the UK.
Indeed, the whole focus on border controls as a way of keeping EU citizens out of the UK is misplaced. Unless the UK is planning to eliminate tourism from the EU, there will presumably be a bilateral agreement between the UK and EU on a light-touch visa-free system allowing tourist visits of sixty to ninety days. The UK will have to decide how to deal with those who overstay these visas but absent the right to work legally in the UK, I doubt if this is going to be a major problem. And there would really be little point in coming to Ireland to travel to Belfast to enter the UK with plans of working illegally since you could just go directly.
So let’s leave aside issues relating to passport controls: If Northern Ireland remains in the EU customs union and single market, its people will be able to move freely back and forth to “the mainland”.
So that’s the economics of it. Neither of the options on the table are ideal and none will match the current level of market access enjoyed by firms in either the North or South of Ireland. But, on balance, a plan to keep Northern Ireland as part of the EU’s single market and customs union probably has more economic benefits for Northern Ireland than costs.
The politics are infinitely more complicated. The largest party in Northern Ireland, the Democratic Unionist Party (DUP) define themselves by their commitment to maintaining Northern Ireland as part of the UK and they resist anything that looks like it is loosening these links. Hence, the reaction of DUP’s leader to the EU’s proposal as “reckless” and all about the Irish government “getting the best deal for themselves”. Similarly, the Conservative Party seem dumbfounded at this idea, with the Secretary of State for Northern Ireland, James Brokenshire commenting “I find it difficult to imagine how Northern Ireland could somehow remain in while the rest of the country leaves. I find it impossible.”
DUP opposition to the EU proposal has also not been helped by implications that the proposal is part of an Irish plan to somehow fast-track reunification. I think this is misplaced. The current Varadkar\Coveney Irish leadership team strikes me as perhaps the least republican in Irish history. And one can believe this is the best proposal available without being in any way focused on a united Ireland. Personally, I would vote against a united Ireland if it was put to a referendum in the Republic and would worry greatly about the economic, political and security capacity of the Republic to successfully absorb Northern Ireland.
So even if worries about “a border in the Irish sea” (which sounds like every unionist’s nightmare) could be clarified and the economic costs of a hard Irish border explained, it is likely that most DUP supporters will accept the economic costs of the new Irish border rather than accept anything that looks like a step towards integration with the Republic. And to be fair, unionists may wonder what their status as UK residents actually means if they started to depart from the regulatory framework of a post-Brexit UK (e.g. if Northern Ireland didn’t get to be part of the Brexiteer vision of the UK as the Singapore of Europe).
The reality, however, is that Northern Ireland already differs sharply from the UK in lots of ways, including its form of government, rules on gay marriage and abortion and the plethora of ways in which the Good Friday agreement has introduced North-South co-operation. The proposal to stay in the customs union could be considered just an additional recognition that Northern Ireland is a very specific place with a special status and its impact may likely be far less obvious than the re-introduction of border controls on the island.
Also, DUP opposition to the EU proposal is not, on its own, reason to assume it should not be considered. The DUP only received 28 percent of the vote in the recent Assembly elections, with the anti-Brexit Ulster Unionist Party receiving 12 percent and the anti-Brexit anti-hard-border Nationalist parties receiving 40 percent. Indeed, many young people in Northern Ireland are moving past the simplistic Nationalist\Unionist identities and may consider voting for whichever option they believe will be good for their economic security.
A Proposal: Let Northern Ireland Decide
Northern Ireland voted against Brexit by a fairly comfortable 56 to 44 margin but that was a vote for all of the UK to remain in the EU. We don’t know how Northern Ireland would vote on a proposal to remain in the EU’s customs union and single market while the rest of the UK does not. But I believe the people of the North deserve the opportunity to make this decision.
A future Northern Ireland economic model dictated by either London or Brussels could prove to be a long-standing source of resentment to large numbers of people in the North. In contrast, a future economic model decided by a referendum would continue the approach of requiring democratic consent for major decisions that was established with the Good Friday agreement.
So my recommendation to the Irish government is as follows: Agree to allow the Brexit talks to move to Phase 2 in return for a commitment from the UK to hold referendum in Northern Ireland by May 2018 on the EU’s proposal for it to remain part of the single market and customs union.
This proposal gives both the UK and Irish government a way out of what currently seems to be an impasse: Ireland can claim to have found a route to maintain the all-Ireland economy, while the UK government can get on with what it really cares about (trade talks) without actually taking the decision to keep Northern Ireland in the single market and customs union.
Is it feasible for the UK government to implement this proposal given its parliamentary reliance on the DUP? I think so. The DUP will doubtless object to a referendum but a British parliamentary majority for the proposal should be easy to obtain with the support of the Labour Party. After they’ve decided whether to bring the UK government down (thereby losing all the money Theresa May promised them and potentially letting Jeremy Corbyn take over) the DUP can then campaign again to get Northern Ireland out of the single market and customs union. If people of Northern Ireland decided to agree with them, then everyone in Ireland would need to prepare for the border that would be the consequence.
Today, I participated in a panel titled “Brexit: Six Months Later” at the American Economics Association meetings in Chicago (a bracing -17 degrees Celsius as I walked to the talk from my hotel room this morning!). The panel featured Jonathan Portes and Andrew Lillico and was chaired by Olivier Blanchard. My slides are here.
Video of the event is here.
A Labour Party that was in favour of remaining in the EU should keep this position, despite the referendum result. Thoughts here.
Flat tax systems, featuring a single rate and the elimination of tax breaks, have a lot to be said for them. They allow for the reduction of marginal tax rates and thus increase incentives for employment and discourage tax avoidance. And despite misconceptions related to the “flat tax” terminology, these systems can be made as progressive as you like via the introduction of a tax credit or tax-exempt allowance. In addition, many of the tax breaks that are eliminated are designed to benefit the wealthy. I’ve written about this before, highlighting that it is possible to combine a flax tax system with progressivity.
Given the potential benefits of a flat tax system, I’m glad that RENUA, one of Ireland’s new political parties, has proposed a such a system (see here and here) as it may lead to a constructive debate about what we want from our income tax system.
As with most economic policy proposals, however, the devil is in the details, and an examination of the evidence suggests some of RENUA’s claims about its flat tax proposal are over-egged and that the headline rate proposed would radically increase inequality.
RENUA are proposing a 23% flat tax rate, supplemented by a basic income policy in which people are guaranteed an income of €8000. The first problem with the proposal is that it is likely to raise far less revenue than the current system. RENUA’s statement discusses this as follows
Our conservative projections across the income bracket show that this rate of tax will generate approximately 75%-80% of the existing income tax head of taxation. As people will retain 77% of their current income and of any additional income they earn on top of this, secondary factors and multiplier effects will generate more than the remaining 20% of the current rate of collection.
Anyone who follows fiscal policy debates in the US will probably be aware that this kind of “dynamic scoring” of tax proposals is a famously thorny issue (a “can of worms” according to Harvard’s Greg Mankiw). However, in examining this literature (see this presentation for example) it is clear that a 20% boost to revenue collection is well above the usual range of estimates for what can be expected from tax reforms.
Overall, I think the best approach when introducing proposals of this type is to show how they can raise the same amount of revenue as the current system under current economic conditions and then to argue that there will also be a positive but uncertain boost from supply-side effects.
Impact on Inequality
To understand the impact of flat tax proposals, it is necessary to have a fully-worked example that shows how households in every part of the income distribution will be affected and how the taxes raised add up to match the revenue of the existing system. As far as I know, RENUA have not provided these calculations but I have put together a spreadsheet using data from the Revenue Commissioners to illustrate two different types of flat tax system. My conclusion is that any system that features a 23 percent tax rate and raises the same revenue as the current income tax and USC combined will be sharply regressive in its impact on income distribution.
To do these calculations, I used income distribution statistics from the Revenue Commissioners. The figures show numbers of tax payers in various income bands, the total amount of income they earned and the amount of tax they paid. Specifically, I use the table that shows the combined amounts of income tax and USC paid by various groups.These are in the tab labelled “Basic Data”. The figures I use are from 2011 and are from the 2012 “Statistical Report”, a publication that the Revenue appear to have discontinued. While it would be nice to have more recent data, the figures are sufficient to model the effect of tax reforms in a realistic manner.
See below for a summary of the tax paid by various groups in 2011. I have aggregated data on single-earner and double-earner married people as well as various classes of single people to keep the figures as simple as possible.
A couple of aspects of these calculations are worth emphasising. First, Ireland’s income tax system is extremely progressive with very low average tax rates for people at the lower end of the income distribution. Single people earning under €20,000 and married couples earning under €30,000 both are taxed at a rate less than 5 percent.
Second, the figures show that the richest are shielding large amounts of money from income taxation. For example, the richest group of married people (those earning over 275,000) earn an average of just over €500,000 per year but pay an average income tax rate of only 39 percent. Given how much of their income is supposed to be taxed at a marginal tax rate of about 50 percent, this suggests a significant amount of shielding of otherwise taxable income.
The spreadsheet describes two different variants on the flat tax. The first variant has a single tax rate as well as tax-free exemption on the first portion of income earned. The second variant has a single tax rate and a specified tax credit that is available to all. I have assumed that married couples get a double tax exemption or double tax credit depending on which system is examined. The spreadsheet allows the user to enter their chosen tax rate as well as their preferred tax exemption or tax credit. It then shows the resultant tax rates for various groups and compares them with the current system (or more precisely the 2011 system, which was very similar). Finally, it calculates the total amount of tax revenue raised by the current and reformed systems.
For both the tax exemption and tax credit system, I have entered 23 percent as the flat tax rate and then adjusted the other aspect of the tax system so that the total amount of money raised more or less matches the current system. For the tax exemption system, the size of the tax exemption that allows the reformed system to raise the approximately same amount of revenue was €5,000. The table below shows the details. It is very small but (at least on my computer) clicking on it makes it bigger. The tax rates for those at the bottom end (apart from those earning under €10,000) would be significantly higher and tax rates for those at the high end would be significantly lower.
This table (from the the tab “Specific Examples”) reports the scale of income losses and gains to various groups.
The proportional gains at the top and losses at the bottom are very large. A move to a tax system of this sort would greatly raise post-tax income inequality.
Of course, the RENUA proposal is a bit more like the “tax credit” variant due to the guaranteed income of €8,000. In my calculation, the tax credit that allows a 23 percent rate to raise the same amount of revenue as the current system is only €1,140. It is possible, however, that this is somewhat consistent with RENUA’s plan because most of the money for their proposed guaranteed income would presumably come from the existing social welfare system. In any case, the tax rates from this tax credit system are basically the same as those from the exemption system.
A Fairer Flat Tax?
This doesn’t mean that flat taxes have to be innately unfair. For example, you can use the spreadsheet to show that a flat rate of 40% with a tax exempt allowance of €17,500 would raise as much as the current system and still be highly progressive. However, there will always be winners and losers from tax reform. A system of this sort would see married people with joint incomes under €50,000 register gains but they would take these gains from single people earning between €25,000 and €40,000.
So no tax system is perfect or will be favoured by everyone. What this example does show, however, is that it is possible to have flat tax rate that is a lot lower than the current top marginal rate without having a significant increase in inequality. A system of this sort would likely have some positive effects in reducing tax evasion and could have some of the positive supply-side effects described by RENUA. However, the idea that we can have a headline tax rate of 23% without greatly raising inequality does not hold water.
I gave a presentation today on the outlook for the Irish economy at the annual conference of the Regional Science Association International (British and Irish Section). The presentation was considerably more upbeat than many I have done in recent years but still discusses a number of important medium-term risks to the economy. Slides are here in PowerPoint form and here in PDF.
Schäuble is working hard to undermine the deal that attempts to keep Greece in the euro area. And his key argument is pure fiction.
Here is a piece I wrote for Huffington Post on the implications of the Greek No vote.