Higher VAT is not about Northern Ireland, it’s about the Republic

Yesterday and today, Ireland’s Budget for 2012 is being announced. Very little will be a surprise, given that various Ministers have been leaking the long-list of proposed cuts over the past two months or so. It’s just a question of what made the short-list this year, and what will be postponed for future years.

We already know, through the Taoiseach’s State of the Nation address that, on the taxation side, there will be no change to the income taxation system but instead, VAT will increase. In fact, we knew this already as Ireland’s budgetary plans were, per the terms of the EU-IMF loan, sent to those lending to us so they could be kept abreast of their borrower. Unfortunately, Ireland operates under a bizarre system of national budgeting, where the Minister of Finance is supposed to pull rabbits out of hats on Budget Day to the oohs and aahs of the media (and perhaps the public). So the Irish public was none too impressed to learn many of the details of the Budget via the German parliament.

Traffic jams to Newry?

The increase in VAT rates, likely to be two percentage points, led to a rush of people decrying that this would be like 2009 all over again, with traffic jams on the way to Newry, as Irish consumers exploit arbitrage opportunities between Northern Ireland and the Republic. Clearly, if such a stampede were to happen again, more retail jobs would be at risk.

However, what impact will the VAT rate actually have on cross-border differentials? It turns out that this sort of thinking flatters the government, in terms of the power if has over these things.  The graph below takes a hypothetical basket of goods that cost €100 in late 2007 and the same, i.e. £70, in the North. By late 2008, the value of sterling had collapsed, with the euro now worth 97p, rather than the 70p it was a year earlier. That – and the VAT cut from 17.5% to 15% – meant that the Northern Ireland basket now cost just €72, whereas the Irish basket – thanks to inflation – cost €104.

With about €20 in fuel and tolls for a return trip to Newry from Dublin, you could make your money back on a weekly shop. Since then, though, sterling has strengthened somewhat, with the euro now worth about 85p. Meanwhile, VAT in the UK has risen from 15% to 20%. And whereas prices in Ireland are now only about 1% higher than four years ago, prices in the UK are over 15% higher.

The basket of goods that cost €100 both North and South in 2007 would now, after VAT increases to 23%, cost about €104 in the Republic – and about €98 in the North. Whereas you could make your fuel and tolls back with the weekly shop up North in early 2009, now you’d need to spend €400 just to break even. If inflation continues at 5% in the UK and 3% in Ireland, the gap on this basket will narrow by the next of next year from €6 to €4. To put it another way, to make a saving of €100 from a cross-border shop, you’ll need to spend €2,600, rather than just the €300 needed in 2008.

Competitiveness and cost of living

The risk to the economy from the VAT increase is not about people scooting up North and making a saving. It’s about destroying consumption, not diverting it, in two ways: firstly, it pushes up the cost of living, already a concern in relation to attracting investment into Ireland. More pressingly, it is effectively a tax that falls most heavily on poorer households.

This paper by Eimear Leahy, Sean Lyons and Richard Tol, of the ESRI, outlines the percentage of disposable income paid in VAT by different income groups. Whereas VAT is like a tax of 6% on the disposable income of the richest households (who will be doing tax efficient things like saving in their pension and owning their own home), the poorest households feel VAT as a 16% tax on their disposable income. But with Ireland’s marginal rates of income tax already so high in an international comparison, something has to be done, right?

The government thinks it’s in a bit of a bind. How do you increase taxation revenues, as it must, without affecting either Ireland’s cost of living or its competitiveness, as VAT and income tax inevitably do? Thus it has chosen what it regards as the lesser of two evils: raise VAT, not income tax.

The obvious “third way” in all this is to tax land. It’s immobile, so it’s not going to go anywhere in response to a tax increase, nor will people’s decisions be distorted as a result. I’m hoping the €100 household charge, which is of course incredibly regressive, is only a measure to take the sting of moving from a country with no property tax to one, like every other developed country, that does have one.

The more and more land – residential, commercial or agricultural – is taxed, the less income and consumption have to be taxed. Given that Ireland needs more tax revenues, it’s obvious which choice is best.