Income Tax: An Appraisal of the Irish Situation

Suzanne O'Neill (Senior Freshman)

In recent years, government budgets have been subjected to three competing forces: fiscal rectitude, fiscal reform and increasing unemployment. The clamour for fiscal rectitude has given way to calls for reform that will also contribute to solving the unemployment problem. In this paper, Suzanne O'Neill examines the impact of the latest round of direct taxation reforms, questioning whether they will have the desired effect of increasing the number of individuals entering salaried employment.

'Ultimately taxes will be chosen on the foundation of how well they are consistent with other objectives of government policy' Charles Allan


The 1995 budget will be remembered most notably for its treatment of income taxation and more specifically for its treatment of the stated central objective of rewarding work. Thus this paper seeks not only to examine the post-budget income taxation system, but also to question any effects on work effort and behaviour that these changes would induce. Therefore I propose to outline initially three considerations which one must be aware of when discussing taxation in general, followed by a practical breakdown of how one moves from gross to disposable income, incorporating this year's budget changes. I will conclude with a discussion as to whether an increase in the numbers participating in salaried work will materialise.

Taxation: Some General Issues

It is worth knowing firstly that taxation is the principal means of transferring resources to the government. These resources are used to provide essential services in the economy, such as health and education, and also to provide some basic needs to members of the community deemed to be unable to provide for themselves. Taxation is the direct and inevitable consequence of government expenditure, the level of which is determined by public demand. Therefore while it is the community who decide the level of taxation, albeit indirectly, it is the government who must implement the structure of taxation that will satisfy revenue needs.

Secondly, since the focus of this essay is on the taxation of income, it is essential to note that PAYE-related ('pay as you earn') social insurance, health and employment levies all fall under the umbrella of income taxation. Thus the practice of fiscal illusion, where one concentrates solely on income tax rates, is seen to understate the actual amount of tax deducted at source from an individual's salary.

Thirldly, it is important to note that not all individuals are liable for tax under the same schedule. The self-employed are assessed differently from those employed in the private or public sectors. Furhtermore, public sector workers are liable for pay-related social insurance (PRSI) at a lower rate than any other group of employees.

Income Tax in Practice

Not all of a person's income is liable for tax due to the presence of allowances, relieves, exclusions and exemptions in the Irish system. Tax-free allowances are administered uniformly, regardless of one's gross income, and currently stand at £2,500 for a single person. The system provides additional allowances for widows and single parents. In the determination of taxable income one has traditionally been allowed to deduct relieves from gross income, thereby reducing taxable income. One has been allowed to offset certain expenditure against tax liability. Two types of relieves exist: business and non-business. Although the conflict that this topic raises between the self-employed and the PAYE sector has provided many hours of entertaining debate, a more serious issue is the appropriateness of their existence in a progressive and equitable income tax system. Certain relieves, such as mortgage interest relief and voluntary health insurance relief, are balanced in favour of the more affluent in our society. With regard to exclusions, certain types and sources of income such as imputed income and investment returns are not liable for taxation. Finally income from state-run gambling institutions, social welfare payments and artists' incomes have traditionally been exempted from tax altogether. Having derived one's taxable income, this is then subject to a progressive system of tax rates. At present the tax rate for the initial £8,900 earned is 27% with a higher 48% rate levied on income above this threshold. On top of this PRSI and various government levies add to the income tax actually paid by the individual.

The 1995 budget saw the government increasing personal allowances and increasing the threshold income above which the higher income tax rate applies. The rationale for this is to increase an employee's take-home pay. PAYE allowances were left unaltered. In contrast to its generous nature in other areas, Mr. Quinn chose to gain revenue by reducing mortgage interest relief, voluntary health insurance relief and abolishing covenants. In addition the government introduced an exemption on PRSI payments on the first £50 for the private sector and £10 for the public sector, earned per week. PRSI allowances were also reduced.

The combination of these changes according to the Minister for Finance, reward work. In order to assess further the significance of these income taxation changes, an analysis of the effect of direct taxation on work behaviour is needed.

Work Effort and Behaviour

It is widely accepted that the higher the marginal rates of income taxation, the greater the disincentive to work and the greater the incentive to avoid and evade tax. However, one must distinguish between the influences of income taxation on (i) those currently in paid employment and (ii) on the choice of ones occupation and work pattern.

(i) Theory dictates that as the rate of income taxation increases two effects occur; an income and a substitution effect. In principal, a higher tax rate reduces take-home pay and in order for an employee to maintain his original level of income, he/she must work additional hours. The substitution effect operates on the basis that the amount one earns for an extra hour of labour is declining as the marginal tax rate increases, thus one substitutes towards leisure and away from labour. This is as a result of the decreasing opportunity cost of leisure as measured by ones declining take home pay per hour of labour. However, it is in reality very difficult to assess the actual magnitude of either the income or substitution effects thereby making it difficult to identify a predictable outcome resulting from a change in direct taxation rates. Hence, the favourable income tax changes in the 1995 budget, due to changes in allowances and relieves rather than the tax rates per se, may or may not have an effect on work behaviour. The problem lies largely with ones ability to work overtime. By working the normal week in a given industry, one may benefit from increased income, however should working additional hours push an employees income above the 27% threshold value then that employee may not be better off when the financial and opportunity costs in terms of leisure are considered.

(ii) The income taxation system has a clearer impact on the choice of occupation and work pattern. Certain groups of individuals may not enter paid employment if they consider that the taxation system would leave them financially worse off. Individuals in this category include married women and in many cases the unemployed, who find themselves caught in unemployment traps. High and indefinite social welfare payments coupled with the perception of punitive income taxation, may encourage some of the community to evade taxation altogether by working in the black economy. The taxation system may also act as a disincentive to new enterprises and the self employed who often find their burden of income taxation coupled with employers pay related social insurance contributions, too great to maintain viable businesses. income taxation also has the ability to affect where people work, leading to emigration of highly skilled and motivated entrepreneurs. The 1995 budget with the increase in childrens allowances should provide additional incentive for mothers and unemployed fathers to enter paid employment. The reduction in employer's PRSI contributions also provided a welcome indication of support for native Irish entrepreneurship.


As one noted at the outset of this paper, taxation will always have to be paid to satisfy public demand for government expenditure. However in recent budgets, one has witnessed the realisation that the collection of revenue must not be to the detriment of other government objectives. Thus one has concluded that the lessening of the direct taxation burden in the 1995 budget, especially for those earning below the average industrial wage, will on balance increase the incentives and thus the number of individuals entering paid employment or providing additional such employment.



Allan, C. : Theory of Taxation, Penguin, Harmondsworth, 1991.

O'Hagan, J.W. : The Economy of Ireland, (6th edn.),IMI, Dublin, 1991.