Ireland—Selected Issues
Author: International Monetary Fund
Publication Date:
29 Sep 1997
eISBN:
9781451818697
ISBN:
9781451818697
Language:
English
Keywords:
ISCR; CR; Ireland; deficit; GDP; spending; exemption limit; net Earnings; supplement net; low income; average earnings; Wages; Marginal effective tax rate
Download PDF (2.2 MB)

This Selected Issues paper analyzes budgetary developments in Ireland during the 1990s. The paper highlights that Irish fiscal policy has been central to the social consensus on macroeconomic policies. The economic buoyancy has reinforced this cycle by facilitating the tax cuts and increases in social spending that have been instrumental to the social consensus on policies, while also helping to keep deficits low. The paper also discusses the participation of Ireland in the European Monetary Union.

Abstract

This Selected Issues paper analyzes budgetary developments in Ireland during the 1990s. The paper highlights that Irish fiscal policy has been central to the social consensus on macroeconomic policies. The economic buoyancy has reinforced this cycle by facilitating the tax cuts and increases in social spending that have been instrumental to the social consensus on policies, while also helping to keep deficits low. The paper also discusses the participation of Ireland in the European Monetary Union.

III. THE TAX AND SOCIAL WELFARE SYSTEMS AND INCENTIVES TO WORK20

People who are unemployed and in poverty must be given hope, opportunities and adequate supports. We have to build a bridge between the unemployed and excluded into the world of work 21

A. Introduction

64. This chapter examines the effects of the social welfare and tax systems on the incentives to work faced by unemployed and low-income workers in Ireland. The issues are those faced by many OECD countries: payroll contributions and income taxes raise labor costs relative to take-home pay, adversely affecting employment opportunities and incentives. Welfare benefits may also weaken work incentives, particularly for low-paid workers. In Ireland and elsewhere, these disincentives to work have been reflected in a persistence of long-term unemployment that represents a waste of productive resources and imposes additional burdens for the budget through higher welfare spending and reduced tax revenue. While Ireland’s unemployment rate declined significantly from almost 16 percent in 1993 to 11 percent in 1996, long-term unemployment still accounts for about 7 percent of the labor force.

65. In recent years employment policies in Ireland have focused on steps to improve incentives to work and promote entrepreneurship. In this context, an Expert Working Group on the “Integration of the Tax and Social Welfare Systems” was established to review the disincentives to work induced by the lack of coordination between the social welfare and tax systems. The report of this group, issued in 1996, placed particular emphasis on disincentives to work created by a high marginal effective tax rate faced by low-paid workers and a declining gap between their earnings and social welfare benefits received by unemployed. The Report also pointed to the tax wedge as a factor depressing labor demand and supply.22

66. The Report concluded that, although the government had taken certain measures to improve incentives to work, unemployment and poverty traps still existed, affecting more than 4 percent of the labor force, and creating significant disincentive to work for unemployed and low-paid workers. The Report recommended addressing the poverty trap through reduction of the marginal effective tax rate for low-paid workers, and emphasized the particular importance of reforming the system of child benefits for reducing the unemployment trap. More profound changes, such as an introduction of the universal basic income, or basic income for children, aimed at reduction of the unemployment trap, were not recommended by the Expert Group due to their costliness. Other options for improving incentives to work, such as strengthening the insurance principle, gradually reducing unemployment benefit, limiting eligibility for unemployment assistance over time, etc., were beyond the scope of the Report. This chapter presents salient features of the social welfare and income tax systems in Ireland and analyzes the Report’s recommendations.

B. The Social Welfare System

67. Social welfare in Ireland incorporates old-age benefits, sickness and maternity care, unemployment benefits and assistance, family allowances, and health care (Table 1). Eligibility for the social insurance benefits, such as old-age, disability and survivors’ pensions, sickness, maternity and unemployment benefits, is limited to insured individuals.23 All residents are eligible for health care, which is free for those on low incomes but contributory for the rest of the population.24 Family allowances are universal for residents with one or more children.

Table 1.

Social Welfare System in Ireland

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Source: Social Security Programs Throughout the World-1995, Research Report #64, SSA publication No. 13-11805, July 1995, pp. 170-72.

Additional contributions at 2.25 percent of earnings not applicable to medical card holder or recipient of survivor’s pension and certain social assistance allowances.

The maximum level of the unemployment assistance is the same as of unemployment benefit—IR£67.50 a week. Eligibility for dependent supplements does not differ between unemployment assistance and benefit: IR£40 for adult dependent and IR£13.20 a week for dependent children.

The level of the family income supplement net of PRSI and levies is equal to 60 percent of the difference between family income and applicable income threshold, depending on the number of children.

68. Income support for the unemployed consists of the insurance-based unemployment benefit, paid for 15 months and limited to insured persons, and means-tested unemployment assistance for those who remain unemployed for longer than 15 months, or are not eligible for insurance-based unemployment benefit. Eligibility for the unemployment assistance is not limited in time. Basic unemployment benefits are supplemented by adult and child dependent allowances, housing costs supplements, and medical cards.25 The distinction between the insurance-based unemployment benefit and unemployment assistance was virtually erased in July 1994, when the pay-related component of unemployment benefit was eliminated and long-term unemployment assistance was raised to the level of the insurance-based benefit. Benefits under both schemes are in principle conditional on job search and the willingness to accept a job offer. However, these requirements were not strictly enforced and according to a 1996 Central Statistics Office survey one fourth of those registered as unemployed had withdrawn from the labor force, while another 11 percent were working full time.

69. In order to reduce the unemployment trap created by the withdrawal of child and adult dependent allowances upon taking a job, a family income supplement for low-paid workers was introduced in 1984 with the objective of boosting incentives for taking jobs.26 However, because the supplement was progressively withdrawn when an individual’s wage increased, it increased the marginal effective tax rate and reduced incentives to look for a higher paid job.27 The Expert Group concluded that the family income supplement induced a poverty trap at an annual income between IR£7,000 and IR£ 11,000, i.e., SO to 80 percent of average earnings.

70. Disincentives to work arise primarily from the withdrawal of the social welfare benefits as an unemployed person takes up a job, or as a result of an increase in earnings of a low-paid worker in excess of the qualifying threshold (Appendix II). The authorities have taken a number of social welfare measures in recent years in order to improve incentives to work for the unemployed and low-paid workers:

  • beginning from 1996 individuals unemployed for at least one year can retain their medical cards for three years and retain a child dependent allowance for 13 weeks after taking employment;

  • the 1996 and 1997 budgets raised the income threshold to qualify for a Family Income Supplement and beginning from 1997 the benefit is calculated on a net of PRSI, health and employment levies’ basis;

  • in recent years (1995-97) the increase of child dependent allowance was frozen while universal child benefit was increased.

C Tax Reform

71. Since the late 1980s successive governments have pursued a policy of tax reform aimed at improving the incentives to create and seek employment. These measures have led to the reduction in the standard rate of income tax from 35 percent to 26 percent, a cut in the top rate from 58 percent to 48 percent, a doubling in the width of the standard tax band, and the narrowing of the average tax wedge from 43 percent of total employer labor cost in 1987-88 to 35 percent in 1997. These reforms are part of a long-term strategy for reform aimed at favoring incentives to work, tackling the poverty trap, reducing the tax wedge, and promoting job creation. The reforms, targeted at lower paid workers and new job entrants, aim at widening the standard tax band so that only high income earners are taxed above the standard rate, maintaining real increases in personal allowances, reducing tax expenditures associated with mortgage interest and health insurance relief, and improving tax collection and enforcement.

72. The tax reform measures implemented in the 1996-97 budgets focused on increasing disposable income and reducing the cost of employment creation, particularly at low income levels. In order to promote job creation, the income threshold for the reduced rate (9.5 percent) of employer PRSI was increased to Ir£13,500 in 1997, the standard corporation tax rate reduced from 38 percent in 1996 to 36 percent in 1997, tax breaks for start up firms were expanded, and the capital gains tax was changed to facilitate the transfer of assets and family businesses. The incentives to seek employment are likely to improve as a result of an increase in general income exemption limits (by 2.6 percent in 1997), that is well below the increase in personal income tax allowances (9.4 percent) (see section E below); widening the standard income tax band (by 5.3 percent); cutting the standard income tax rate by 1 percentage point to 26 percent; and a reduction of the PRSI employee full contribution rate by 1 percent, which is expected to affect more than 70 percent of PRSI contributors.

D. Evolution of the Replacement Ratio

73. Changes in tax and social welfare systems were not closely coordinated during the 1980s: the government was increasing social welfare benefits in real terms, while taxing relatively low incomes at high marginal rates. These two factors reduced the gap between the level of income support available to the unemployed and net income from work, driving the replacement ratio up in the 1980s-early 1990s.

74. As indicated by Table 2 and Chart 1 below, unemployment assistance in 1985-90 was growing at much higher rates than net income, which boosted the replacement ratio. As Chart 2 indicates, the replacement ratio for a single-earner two-child family on average earnings peaked in the early 1990s at over 60 percent. The replacement ratios for low-income families rose to particularly high levels, approaching 90 percent, and in some instances exceeded 100 percent for large families.

Table 2.

Cumulative Real Change in the Value of Net Earnings and Unemployment Assistance, 1980-94

(1977=100)

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Source: Report of the Expert Group on the Integration of the Tax and Social Welfare Systems, p. 18.

Unemployment assistance.

CHART 1.
CHART 1.

IRELAND: NET EARNINGS AND UNEMPLOYMENT ASSISTANCE 1/

(Real change, 1977=100)

Citation: IMF Staff Country Reports 1997, 077; 10.5089/9781451818697.002.A003

Source: Integrating Tax and Social Welfare, Expert Working Group Report, June 1996.1/ Net earnings of average manufacturing wage.
CHART 2.
CHART 2.

IRELAND: REPLACEMENT RATIOS

(In percent)

Citation: IMF Staff Country Reports 1997, 077; 10.5089/9781451818697.002.A003

Source: Integrating Tax and Social Welfare. Expert Working Group Report, June 1996.

75. As shown in Table 3 below, categories of the labor force facing high replacement ratios tend to have high unemployment rates. In the late 1980s, the 5 percent of the labor force facing replacement ratios between 80 and 100 percent and above had an unemployment rate over 50 percent. The tabulation also shows that replacement ratios tended to be significantly higher for married people, particularly with children, pointing to the potential impact of child and dependent benefits as factors reducing incentives to work. It is also likely that high unemployment rates for single parents with children arise from relatively limited job opportunities, as well as the opportunity cost of unemployment being lowered by potential costs of child care.

Table 3.

Replacement Ratios and Unemployment Rates in 1987

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Source: OECD Economic Surveys, Ireland 1995, p. 45.

76. Policy changes in recent years have generally served to reduce the replacement ratios from the peaks reached in the early 1990s (Chart 3). The 1995 budget initiated a process of shifting the basis for dependency allowances from employment to income status: in 1995-97 the dependency allowance was frozen while child benefit was gradually increasing. In the 1997 budget, however, social welfare benefits were increased by 4-5 percent, compared with private sector pay increases of 2½ percent specified under the current wage agreement.

CHART 3.
CHART 3.

IRELAND: REPLACEMENT RATIOS AND TAX WEDGES

(In percent)

Citation: IMF Staff Country Reports 1997, 077; 10.5089/9781451818697.002.A003

Source: Data provided by the Irish authorities.1/ Unemployment assistance for a single-earner couple with two children as a percent of the average manufacturing wage.2/ The difference between total labor cost and the employee’s take home poy as a percent of total labor cost.

E. Marginal Tax Rates and the Tax Wedge

77. Ireland is marked by very high marginal tax rates at low income levels. As pointed out by the OECD,28 a single person in 1995 entered the top income tax bracket at an annual income 10 percent below the level of average earnings. Such workers faced an aggregate marginal tax rate, including payroll taxes, of 55.8 percent.29

78. High marginal tax rates on low to moderate incomes also result from the system of tax exemption limits, marginal tax relief and child additions. Exemption limits are income thresholds below which the taxpayer pays no income tax, and child additions increase this limit for every dependent child. Marginal relief is designed to avert a sharp increase in tax liability (if computed by applying the standard rate to income net of allowances) as income passes the exemption limits. The system of marginal relief ensures that only income in excess of the relevant exemption limit is taxed at a maximum rate of 40 percent.30 The marginal relief is withdrawn when the standard 26 percent rate results in a lower tax bill. The 40 percent marginal relief faced by low-income workers significantly reduces their work incentives since they would be exposed to an aggregate marginal tax rate of 47.8 percent.31

79. Although the tax wedge in Ireland is slightly below the OECD average and substantially lower than in some continental European countries, it is still an impediment for job creation and strengthening the incentives to work.32 According to the Department of Enterprise and Employment the growth of the tax wedge was responsible for about 30 percent of the reduction in manufacturing employment in the early 1980s.33 It was estimated that a 1 percent increase in the tax wedge reduces employment by 0.2 percent. The tax wedge has been gradually reduced in recent years: the tax wedge for a single earner declined from about 43 percent in 1988 to about 36 percent in 1996, for the single earner with two children it changed from 34 to 30 percent over the same period, reflecting the decline in tax rates.34

F. Recommendations of the Report

Benefits

80. Since disincentives to work arise primarily from the withdrawal of benefits when a person moves into employment, the Report, in its suggestions, intended either to smooth the effects of benefit withdrawal, or to eliminate these effects by making the benefits universal. So the options for reforming the system of social welfare benefits, considered by the Report, implicitly called for softening the eligibility requirements and in most cases elimination of means-testing, thus making the benefits less targeted.

81. The Report examined a number of options for reforming the system of child and dependent allowances (Table 4). These included introduction of the individual basic income, basic income for children, integrated child benefit, child benefit supplement, in work benefit and partial basic income. The individual basic income is a universal benefit which, if implemented, would have replaced the social welfare benefit. All the other potential benefits were intended to smooth the effect of benefit withdrawal during the transition from unemployment into employment. The potential gains from reducing the effects of benefit withdrawal are mixed, since the changes would affect both the demand and supply side of the labor market. The Expert Group did not recommend introduction of an individual basic income, partial basic income and basic income for children in the short or medium term on the grounds of their high budgetary cost.

Table 4.

Ireland: Summary of the Benefit Reform Options Considered by the Report

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Taxation

82. In order to improve incentives to work, the Report recommended to phase out the system of marginal relief by progressively increasing personal tax allowances to the level of the personal exemption limits; to equalize the rate of employees’ PRSI contributions across all income levels; and to allow people taking low-paid full-time jobs to retain housing cost supplements, withdrawing them gradually during the transitional period. In line with the first of these proposals, the 1997 budget raised personal allowances by significantly more than the exemption limits (see section C). The 1997 budget also reduced the full employee PRSI contribution rate by 1 percent.

83. Although the Report considered potential reforms on a revenue neutral basis, high rates of economic growth and buoyant revenues were implicitly assumed:35 “Over the last number of years the government devoted of the order of IR£200 million per year to real improvements (i.e., over and above indexation) in income tax and social welfare payments. It seems possible, therefore, that resources of this order could be available for implementation of further reform.”36 This assumption affected the options for reforms, considered by the Report, most of which are likely to incur additional costs.37 However, there is a number of the policy options such as reinforcing the insurance principle and enforcing eligibility requirements, which could improve incentives for a job search without incurring significant additional costs.

APPENDIX I Definitions of the Terms Used in the Report of the Expert Group

Marginal effective tax rate (METR) is the combined rate at which social welfare benefits are withdrawn and taxes and social security contributions are increased as earnings rise.

Marginal tax rate is the change in taxes paid with respect to a change in income.

Poverty trap is a situation in which an increase in gross income results in little or no increase in net income, due to high effective marginal tax rates.

Replacement ratio is the ratio of the net income of the unemployed to their net income when previously employed.

Tax wedge is the tax induced difference between the employer’s labor costs and the take-home pay of employee.

Unemployment trap is a lack of incentives to work resulting from the net income at work being approximately the same, or even less than, the net income out of work.

APPENDIX III

Social Welfare Benefits and Disincentives to Work

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Source: Based on the Report of the Expert Working Group on the Integration of the Tax and Welfare Systems, Dublin, 1996.

STATISTICAL APPENDIX

Table A1.

Ireland: National Accounts

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Sources: Central Statistics Office, National Income and Expenditure; and data provided by the Irish authorities.

Contribution to GDP growth.

Contribution to GNP growth.

Table A2.

Ireland: Distribution of National Income

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Sources: Central Statistics Office, National Income and Expenditure; and data provided by the Irish authorities.

Including employers’ social insurance contributions.

Deflated by personal consumption deflator.

Table A3.

Ireland: Gross Capital Formation

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Sources: Central Statistics Office, National Income and Expenditure; and data provided by the Irish authorities.

Preliminary.

Table A4.

Ireland: Sectoral Origin of Gross National Product

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Source: Central Statistics Office, National Income and Expenditure.
Table A5.

Ireland: Industrial Production

(Annual volume changes in percent)

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Source: Central Statistics Office, Industrial Production Index.

Quarterly data are seasonally adjusted.

Includes manufacturing, mining, quarrying, and turf production.

Includes transportable goods, electricity, gas, and water.

Table A6.

Ireland: Summary of Balance of Payments

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Sources: Central Statistics Office; and data provided by Irish authorities.

Including adjustments for balance of payments purposes.

Computed on a transactions basis, i.e., change in total reserves less valuation changes and allocations of SDRs. Minus (-) equals net increase in reserves.

Table A7.

Ireland: Merchandise Trade 1/

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Sources: Central Statistics Office, Statistical Bulletin; and data provided by the Irish authorities.

Data on customs basis; not adjusted for balance of payments purposes.

Table A8.

Ireland: Exports by Sector of Origin 1/

(In percent)

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Sources: Central Statistics Office, Statistical Bulletin; IMF, World Economic Outlook, and data provided by the Irish authorities.

Data on a customs basis.

Including the value of EC intervention stocks sent for storage abroad, which is excluded from merchandise exports for balance of payments purposes.

From 1993, includes Intrastat Survey Estimates which are not classified by main use.

Comprises SITC divisions 09, 54,75,76, and 87.

Table A9.

Ireland: Foreign Trade Shares

(At current prices)

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Source: IMF, Direction of Trade Statistics.
Table A10.

Ireland: Imports Classified by End Use

(Percentage distribution)

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Source: Central Statistics Office, Statistical Bulletin.

From 1993, includes Intrastat Survey Estimates which are not classified by main use.

Table A11.

Ireland: Services and Transfers

(In millions of Irish pounds)

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Sources: Central Statistics Office, Statistical Bulletin; and Statistical Release on Balance of International Payments; Central Bank of Ireland, Quarterly Bulletin; and data provided by the Irish authorities.

Including passenger fare receipts from nonresidents.

Excluding passenger fare receipts from nonresidents.

Including associated interest flows.

Including semi-state and bank interest flows.