It is not possible for Ireland to enjoy Nordic levels of public service provision at Estonian tax rates, writes Paul Tansey.

The national tax rate - all taxes as a percentage of national income - has been rising steadily since 2003. Based on the Government's own budget estimates, the national tax rate this year will be more than three percentage points higher than when it took office in 2002.

In 2007, tax revenues are budgeted to reach 37.4 per cent of gross national product (GNP). In 2002, the Government's tax take amounted to 34.2 per cent of GNP. Thus, over the past five years, the national tax rate has risen by more than three percentage points.

These calculations are corroborated by data published recently by Eurostat, the statistical arm of the European Commission. The Eurostat data show total Irish tax revenues rising from 29.8 per cent of gross domestic product (GDP) in 2002 to 32.2 per cent of GDP in 2005, the latest year for which it publishes figures.

The upward trajectory in Irish taxation is illustrated in Table 1. As shown, the Government's total tax take increased by €24 billion between 2002 and 2007, an advance of two-thirds. Over the same period, GNP at current prices expanded by just over one half. In consequence, the overall proportion of national income taken in taxation has risen.

Not only has the national tax take risen, but its composition has shifted substantially over the past five years. As shown in Table 2, taxes on expenditure are now the principal source of Government revenue. Taxes on expenditure include value added tax (VAT), excise duties and stamp duties. These are nice little earners for the Exchequer since, at unchanged tax rates, increased consumer demand volumes and rising prices effortlessly send additional revenues spilling into the Government's coffers.

On the basis of the budget estimates for 2007, the yield from taxes on expenditure this year will be some €11 billion, or 70 per cent higher than the amount collected in 2002.

The revenues gathered from taxes on income - including corporate income - have risen much more slowly than the yield from taxes on expenditure over the past five years. While more than 250,000 people have been added to the national payroll since 2002, revenue from taxes on income and wealth has increased by just 47.8 per cent, less than the 52.0 per cent increase in nominal GNP between 2002 and 2007.

The relatively subdued growth in income tax revenue reflects reductions in effective income tax rates, particularly for employees on lower earnings.

As a result of this relatively tardy growth, the share of income taxes in total taxation has retreated by almost five percentage points. In 2002, income taxes contributed 39.5 per cent of all tax revenues collected. By 2007, this share is scheduled to decline to 35.1 per cent of the total.

Receipts from capital taxes have increased almost fivefold since 2002, though from an artificially depressed base. The stock market meltdown consequence of the puncturing of the dotcom bubble in 2000 left capital gains reported for 2002 relatively thin on the ground. Since then, booming property and stock markets have triggered increasingly large flows of capital gains tax into the Government's revenue accounts.

Given these compositional shifts in tax revenues, the rise in the national tax rate in recent years is broadly explained by three factors.

First, the economy rebounded from the economic slowdown of 2001-2002. Since almost all economic activity is taxed, as the pace of economic activity gathered speed from 2003 onwards, the flow of tax revenues into the Exchequer accelerated. At any given tax rate, a fully-employed economy will produce more tax revenues than an economy where capacity is underutilised.

Second, the Government's economic approach sought to stimulate activity by reducing taxes on income and work, thus increasing household disposable incomes.

However, as households spent or invested their additional disposable incomes, the Government took 21 per cent off the top in VAT, or 20 per cent of any realised capital gain. This helps explain why receipts from capital and expenditure taxes have risen so much faster than taxes on income.

Third, there has been a significant element of fiscal drag, where tax bands were not adjusted in line with inflation. This has been most pronounced in the case of stamp duty on housing transactions, where the stamp duty bands were not adjusted to take account of breathtaking inflation in house prices. In such instances, inflation itself acts as an additional unpaid tax collector for the Exchequer.

While the national tax rate has risen since 2003, it still remains well below average tax rates throughout the EU. In 2005, the Republic's ratio of taxes to GDP, at 32.2 per cent, was a full nine percentage points below the average for the euro zone, where taxes averaged 41.2 per cent of GDP. Selected tax ratios in the EU are shown in Table 3.

As shown, the total tax-to-GDP ratios are highest in the Nordic countries, topping 50 per cent in both Sweden and Denmark. The French national tax rate was also high in 2005, at 45.8 per cent. Germany and the UK stand on a lower tax step, with total tax rates in the 38 per cent to 40 per cent range. They are followed by the "convergence" economies (except for the Republic), with Spain, Portugal and Greece all maintaining national tax rates at about 36 per cent of GDP.

The Irish tax-to-GDP ratio in 2005 was estimated by Eurostat at 32.2 per cent, the fifth-lowest of the EU 25 and broadly in line with total tax rates in the "enlargement" economies such as Estonia.

However, the use of GDP as the denominator in the Irish tax equation is somewhat misleading. For most countries, GDP and GNP are interchangeable. However, largely because of the scale of the profits repatriated from Ireland each year by multinational companies, Irish GDP is now some 18.5 per cent higher than Irish GNP. Since GNP represents the resources available to Ireland, it is more realistic to use it as the basis for calculating the national tax take. Using GNP as the yardstick, the Irish tax rate in 2005 is estimated at 36.1 per cent, broadly in line with other "convergence" economies.

Even where we allow ourselves the benefit of the doubt in this way, there is still a problem that is growing in size each day as the election approaches. Politicians from all the major parties are promising tax cuts that will prove inordinately expensive for the Exchequer over the long haul. The most expensive tax promise thus far has attracted the least notice: the commitment made both by Fianna Fáil and the Fine Gael-Labour joint programme to index tax bands and tax credits, not to the future rate of price inflation, but to the future rate of earnings growth.

Having given with one hand, the major political parties are also giving with the other. They are promising major improvements in public services, but within a context where public spending in the future is predicted to rise at much slower rates than have been seen in the recent past. With the second benchmarking process hurtling down the tunnel at whatever government is ultimately formed, this is a circle that cannot be squared.

At some point, reality will have to be faced. And reality dictates that it is not possible for Ireland to enjoy Nordic levels of public service provision at Estonian tax rates.