Budget 2007:Rise in tax threshold may not match inflation rate, writes Marc Coleman, Economics Editor

In the Middle Ages, the kings of Europe took to the practice of shaving the edges off gold coins before they were put into circulation amongst an unsuspecting public. When gathered together and melted down, they managed to net quite a tidy sum. As Europe modernised, the kings became prime ministers and gold coins became paper currency, but in matters of public finance, some things don't change. Simply the latest manifestation of an old wheeze, stealth taxation nets the Exchequer a very tidy sum.

Strictly speaking, there is no such thing as a stealth tax. All new taxes or changes to existing taxes require a level of Dáil scrutiny that rules out "stealth" in the truest sense of the word. But when tax thresholds don't keep pace with inflation and other increases, the government of the day reaps a generous reward.

To see how generous, consider the threshold for payment of income tax.

Taking the threshold for a single earner as a proxy for the average taxpayer, this was €28,000 in 2002, the year in which the Government was elected. Average industrial earnings have risen by about 25 per cent since 2002. To keep pace with that growth, that threshold should have risen to €35,000.

On this morning of the Government's last Budget, it stands at €32,000. And even, as is likely, Minister for Finance Brian Cowen closes this gap today, the Government has benefited from the delay in doing so.

Until last year, despite a 20 per cent increase in industrial earnings between 2002 and 2005, the single-earner threshold rose by just 5 per cent and by a rough approximation, some 15 per cent of earners drifted into the higher tax band over this period.

How much did the Government gain from this? Last year and with an election looming nearer, the Government started to close this gap, raising the most significant thresholds by 7 to 9 per cent.

Together with slightly larger increases in a range of other relevant employee tax credits, this cost the Exchequer €887 million.

With earnings growth running at about 4.5 per cent a year, that budget undid the negative effects of about two years of non-indexation. This implies that - at a conservative estimate, the Government rakes in about €400 million a year when it doesn't index income tax thresholds.

As the Government has been careful to ensure that exemption limits - amounts of income below which no tax is paid - have been increased significantly, by 30 per cent over the period, the burden of this has fallen mostly on unwitting entrants to the higher tax rate.

And that's just the beginning. Stealth tax works most effectively for government where inflation is strongest and nowhere has this been the case than in the property market.

For those other than first-time buyers of newly-built properties, eg the majority of purchasers, stamp duty rates have not been indexed at all in the last five years. This is in spite of a 58 per cent increase in the average price of a house nationally between June 2002 when the Government took office and June of this year.

In the first six months of 2002, the Government received €349 million from residential payers of stamp duty. In the first six months of this year, the equivalent figure was €560 million, 60 per cent higher than in 2002 and almost exactly the same increase as the rise in average house prices.

But at least neither income tax nor stamp duty were ever subject to indexation (meaning that what indexation occurred was done at the discretion of Mr Cowen on Budget day). In the case of capital gains tax, indexation was once obligatory but was abolished.

In the 2003 budget, the then minister for finance, Charlie McCreevy, reversed the rate reduction by abolishing indexation relief for any period after December 31st, 2002.

By preventing investors from setting some of their gain against inflation, the abolition of indexation has lead to a slow upward creep in the real rate of capital gains tax.

Consider, for example, an asset with a value of €475,000 in 2002, just below the threshold for relief during that year. Now consider that the asset increased by the rate of house price inflation, some 60 per cent, to reach a value of €760,000. Over the same period, indexation for general price increases would have increased the threshold to €542,295.

The balancing amount, €217,075 would have been taxed at 20 per cent, yielding a liability of €43,415. In a world of non-indexation, tax is paid on a balance of €283,750 incurring a liability of €56,750, over €13,000 more than if this tax were indexed.

The longer assets are held, the more this problem is magnified, producing an insidious effect on investor behaviour: Instead of encouraging long-term investments in productive capital, this regime favours quick "speculative" gains, a fact that might explain a lot of the speculative pressure driving up house prices in recent years.

Brian Cowen today is almost certain to announce an increase in the threshold for the standard rate of income tax, as well as the plethora of credits and exemptions applied when calculating income tax. Labour party leader Pat Rabbitte has promised that if Labour are in government, he will ensure that income tax bands at least will be fully indexed over the lifetime of government.

Fine Gael have not promised full indexation, but have said that if they are in government, the minister for finance would be required to explain to the Dáil why he has not indexed income tax bands.

This is as far as most politicians are likely to go. Despite being greatly in the taxpayers' interest, indexation is not in the interests of politicians.

Like the power that the kings of old had to shave gold coins, the ability to increase taxation without appearing to do so is just too alluring.