Lisa O'Carroll's Ireland business blog

What's left to tax in Ireland? Savings

Ireland already taxes interest on savings at 27%. With little room for raising income tax, could savings tax be hiked by the Irish government as it bids to close a budget deficit, asks guest blogger, economist Stephen Kinsella?

After some pressure, the government has publicly committed to neither raising income taxes or cutting social welfare in the next budget in December. It has also committed to no further cuts to public sector pay and pensions.

But there is no doubt there will be pain, because the budget deficit — the difference between the government's spending and income — will be €15bn (£13.5bn) if the cost-cutting measures from the last budget are fully implemented.

So where is the room for manoeuvre?

At the moment, the government spends roughly a third of its income on wages and pensions, a third on social welfare payments, and a third on everything else. Given that the "everything else" is getting squeezed, it seems it has already closed off all its options.

There is one thing it could do however – could increasing taxes on savings be under consideration? That would get around the government promise of not increasing income tax and could generate a tidy income from the estimated €100bn on deposit in Irish banks.

Would such a move hold up to scrutiny? Would it work or backfire, depressing consumption in the economy even further?

The paradox of thrift

"Savings equal investment" is the classic textbook analysis that every sorry economics undergraduate has to plough through. When the rate of savings goes up, that means people are consuming less today, in order to consume more tomorrow.

The act of stuffing the money into a bank rather than buying a big screen TV tends to depress consumption today and increase it tomorrow, especially if there is no functioning credit distribution mechanism to translate savings into investment, as is the case in Ireland.

Savings go up for all kinds of reasons.

Sometimes the real interest rate on deposits is high enough to ensure people would like to keep some of their money in interest-bearing deposits rather than blowing it all in a shop.

At other times, people will save as a precaution, to provide a buffer between themselves and hard times. Different countries have different approaches to saving.

For instance, Chinese savings rates have been as much as 20 times higher than US savings rates in the past decade, depending on the year you look at, of course …

John Maynard Keynes wrote about the "paradox of thrift" and for the purpose of this exercise I want to look at savings in three different countries, Estonia, Germany and Ireland.

The paradox of thrift is a fallacy of consumption, wherein each person in an economy, suddenly deciding to begin saving 20% of their incomes, will depress national income by 20%, even though they are helping themselves (and the economy) in the long run. Keynes's point was that too much saving at the wrong point in the business cycle can be a bad thing.

Let's think about the second order effects of savings increases. If everyone saves more, demand for goods and services drops, which leads to increased unemployment as firms lay people off. This in turn leads to further decreases in demand and increases in uncertainty and precautionary saving.

Then there's the European dimension. I've already pointed out that countries have different attitudes to saving and the effect of saving has an impact on other countries in the EU.

German savings flat while Estonia and Ireland soar

So if German citizens save more today, Irish people don't see demand for their goods and services – food, pharmaceuticals, etc in Germany. The converse is also true, Ireland saves and spends less on BMWs and Mercedes. More attention needs to be paid to savings rates in the EU, especially by region. Too often we worry about inflation and unemployment—and these are important, of course—while neglecting other economic indicators, like the savings rate.

Savings in Germany Ireland Estonia

The chart above shows the household net saving ratio from 2005 to 2012. We can clearly see Germany maintaining its level of savings throughout the period, with Ireland and Estonia experiencing dramatic changes in savings behaviour as a result of the economic downturn.

Estonia in particular experienced a large change in its net saving ratio from -11% in 2005, meaning Estonia hoovered up the savings of other nations to consume, to +5.4 in 2012. Ireland saved only 0.03% in 2007, only to watch that ratio shoot up to 14.4% by 2012.

So Irish people have cash in the bank, or are paying down debt at a fast rate, as are Estonians. German behaviour hasn't changed much at all. This is important because cash-strapped governments are looking to tax holdings of wealth to balance their budgets.

Ireland already taxes savings with a tax on interest of 27% (was 25%) for payments made annually or more frequently and 30% for longer term deposits.

If the government can't force us to release our savings, maybe it'll do the job for us.

Could an increase in taxes on savings be on the cards? I certainly think so, given the large amount of savings projected to be here in 2012.

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