Report of the Tax Forecasting Methodology Review Group. February 2008

Transcription

1 Report of the Tax Forecasting Methodology Review Group February 2008

2 Contents Page Executive Summary 3 1. Introduction 9 2. Main Developments in Tax Revenue Tax Revenue Forecasting Process Tax Revenue Forecasting Performance Controlling for Economic Forecasting Errors Retrospective Forecasting using Alternative Methodologies 47 - Incorporates Controlling for the Impact of the Property Market 7. Conclusions 60 Appendices 62 - Long-run Aggregate Tax Elasticity 63 - Composition of the Forecasting Errors 66 - An Examination of Data Revisions in the Quarterly National Accounts 68 - ESRI QEC Tax Revenue Forecasting Model 72 2

3 Executive Summary Objective The primary objective of this report is to examine the tax revenue forecasting methodology currently employed by the Department of Finance in light of the actual experience over the period The motivation for conducting a review is two-fold. Firstly, a considerable period of time has lapsed since the last review was undertaken, and an update is therefore timely. Secondly, on a headline basis, there has been considerable overshooting of tax revenue over the last three years. A detailed analysis of the tax forecasting performance over a longer timeframe is therefore required. Aggregate Performance At an aggregate level, the analysis finds that, on a headline basis, there has been a significant divergence between forecast tax revenue and the actual outturn over the period ; the overall root mean squared (forecast) error (RMSE) is found to be 6.1 per cent of the actual tax revenue outturn. Developments on a purely headline basis are subject to a number of important caveats. For instance, various one-off factors (both positive and negative) which are difficult to quantify ex ante will impact on the accuracy or otherwise of the tax forecasts. In addition, forecasts of macro-economic variables are a key input into the tax forecasting process, and economic forecasting errors will contribute to inaccuracies in the tax revenue projections. Therefore, in order to quantify the underlying tax forecasting error, the analysis controls for these factors. This is undertaken through retrospectively forecasting tax revenue on the basis of actual economic developments and by applying the actual revenue generated from the various one-off factors over this period. The result is a decline in the RMSE to 4.0 per cent, suggesting that economic forecasting errors and one-off factors had some impact on the accuracy of the tax forecasts. In terms of the direction of error, tax revenue has, for the most part, tended to exceed forecasts, possibly suggesting a prudent bias in the forecasts. In terms of comparison with the previous report, the scale of the error is larger over the later period, 3

4 suggesting a deterioration in the forecasting performance in more recent years. The direction of the error is unchanged vis-à-vis the earlier report. Performance of Individual Tax Heads Developments for the individual tax heads are also analysed. On average over the period, the four largest tax heads accounted for almost 90 per cent of total tax revenue, so that developments in these deserve special mention. On an underlying basis (i.e. having controlled for economic forecasting errors and one-off factors), the following results emerge: the average error for income tax over the period was found to be 3.9 per cent, with revenue from this source undershooting forecasts in five of the last six years. However, there were fundamental changes to the income tax system over this period, namely the introduction of tax credits and partial individualisation. VAT forecasts were found to be the most accurate of all the tax heads, with a RMSE of 3.3 per cent. Revenues have overshot forecasts in each of the last three years. Corporation tax receipts recorded the largest error of the four largest tax heads, with an error of 7.5 per cent over the period. Given the scale of multinational operations relative to the size of the domestic economy together with a number of important changes to the corporation tax regime in recent years it is perhaps not surprising that this tax head has proved to be difficult to forecast with any degree of accuracy. Moreover, Ireland is not unique in recording significant forecasting error for this tax head; broadly similar developments have been evident in the UK for instance. The RMSE of the excise duty forecasts over the period was 3.8 per cent. However, this is due in large part to the scale of the error in 2001, when excise duties were 18 per cent below target. Excluding this one year from the analysis reduces the RMSE to 2.8 per cent. Considered in aggregate, the underlying forecast error of the four largest tax heads is 3.2 per cent. This suggests that smaller tax heads have had an important role in the divergence between forecasts and outturn. 4

5 Significant double-digit error is found in the forecasting performance of these smaller tax heads, with revenue on average tending to overshoot forecasts. For simplicity, capital gains tax, stamp duties and capital acquisitions tax are grouped together under the heading capital taxes, and the chart below shows that these account for a large and increasing (in recent years) proportion of the total underlying forecasting error. The analysis finds that the lack of a suitable macro-economic driver of tax revenue from this source (especially for stamp duty and capital gains tax) has hindered the forecasting performance of these taxes, as has the cyclically high level of activity in recent years. In addition, these tax heads have very complicated and unstable bases that have, at best, tenuous links to the normal fluctuations of the business cycle. As a consequence, they are inherently difficult to forecast accurately and it is not clear that any meaningful improvements are possible. These factors have two important policy implications. Firstly, a cautionary approach to forecasting revenue from these sources was and is warranted. Secondly, any windfall gains from these tax heads should be saved and that spending commitments based on such windfalls should be avoided in all circumstances, as has been the case in recent years. Composition of Error Adjusted Forecast & Adjusted Outturn 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% Income Tax VAT Corporation Tax Excise Capital Taxes Customs Total Ireland s Performance in an International Context Internationally, Ireland s experience is not uncommon with deviations between tax revenue outturns and projections being relatively common in recent years. This suggests that internationally, tax revenue forecasting is an inherently uncertain 5

6 process, and some error is inevitable. The international approach to forecasting tax revenue is generally similar to that in Ireland, namely a bottom-up disaggregated tax head approach supplemented by a top-down check. The scale of deviation in Ireland is nevertheless found to be high by international standards. There are a number of exceptional factors, however, that have contributed to this. Firstly, the period dealt with in this report ( ) was a transitional one for the Irish economy. Substantial structural changes within the economy and within the tax system meant that the relationship between the relevant tax bases and their economic drivers may have changed over time. Unfortunately, pinning down a steady-state relationship during a transitional period of deep structural change is highly problematic. The residential property market is perhaps the most obvious example. In Ireland, the residential property market has been among the most dynamic in the OECD, with significant increases in both prices and turnover. As a result, it is estimated that housing-related tax revenue has risen from around 3½ per cent of total tax revenue in 1999 to 9 per cent in It is also worth noting that stamp duty and capital gains tax receipts emanating from activity in the nonresidential/commercial property market have contributed significantly to the excesses over target in tax revenues in recent years Secondly, the Irish economy remains amongst the smallest and most open within the OECD, with output concentrated in a relatively small number of sectors. As a result, overall economic activity and the tax revenue that this generates is potentially more volatile than in larger, more sectorally-diversified countries. For instance, the global ICT shock in 2000/01 had a very sharp, almost instantaneous impact on economic activity in Ireland, with noticeable tax revenue undershooting occurring as a consequence. This experience illustrates the volatility of tax revenue in Ireland to extraneous factors and provides a strong justification for a cautionary approach. Tax-GDP Elasticity Over the period, the implied aggregate tax-to-gdp elasticity was found to average This figure must be interpreted with caution however. There has been considerable year-to-year variance, with, for instance, an implied elasticity of around 0.3 in 2002, while in 2006 the implied elasticity was almost In simple terms, this means that for every 1 per cent rise in GDP, tax revenues rise by 1.1 per cent. See Appendix 1 for details of elasticity calculations. 6

7 Recommendations On the basis of the analysis contained in the report, the following recommendations are made under three main headings; namely methodological refinements, data improvements and transparency. Methodological Refinements Maintain an aggregate tax-to-gdp elasticity of 1.0 as a top-down check on the bottom-up approach. This recommendation was put forward in the previous report of the Tax Forecasting Methodology Review Group. Despite the shortterm variance evident at the aggregate level in recent years, the tax-to-gdp elasticity should still be viewed as an important check of the overall tax forecast. The current approach to forecasting VAT receipts should be complemented by an alternative approach which projects VAT receipts from new housing separately from other VAT receipts. In theory, the alternative approach would appear to be a more methodologically robust approach. However, retrospective analysis shows no improvement over the entire period in question, although significant improvements are evident in later years. Hence, there is a need for the two approaches to be undertaken in tandem and for the relative merits of both to be examined on an ongoing basis. This, of course injects an element of subjectivity into the forecasts, although this is not seen as a major issue. Using the macro-economic variable Gross Operating Surplus (defined as GDP minus compensation of employees) as a driver of corporation tax receipts could be considered. For most years the use of this variable leads to an improvement in the tax forecasting performance. However, because there is a deterioration in two of the years considered, it is recommended that this approach be used in conjunction with the current approach. Maintain the disaggregated approach to forecasting stamp duty that was first used in Budget 2006, namely using forecasts of new housing output and prices as a loose proxy to project receipts from residential property and using the nominal increase in other building and construction investment excluding roads to project receipts from non-residential property. 7

8 Given that the excess property-related tax revenue in recent years would appear to be cyclical rather than structural, a cautious approach to forecasting propertyrelated tax revenue is prudent and should be continued. Improved Data Given the increased importance of receipts emanating from the housing market in recent years, a more detailed breakdown of the actual VAT yield is desirable. This would allow the actual receipts from new housing to be identified. At present only estimates of the VAT yield from this sector can be obtained, through the Post-Budget VAT base. While a breakdown of actual receipts is desirable, it must be recognised that obtaining such data would involve drawing on significant resources of the Revenue Commissioners. Therefore it is recommended that this issue be investigated further. More timely data on the nature of property market transactions giving rise to stamp duty and capital gains tax receipts would also be useful although there must be acknowledgement of the recent improvements in this area and acceptance of the structural difficulties involved in going further. Transparency In light of the fact that the Irish economy has effectively been in a transitional phase over the period in which this analysis was undertaken, it is recommended to undertake more regular analysis of the tax forecasting performance. The results of such analysis could be published by the Department of Finance on an annual basis. This could also contain analysis of significant one-off factors which are considered important. 8

9 1. Introduction 1.1 The last full review of the Department of Finance s tax forecasting methodology was carried out in In light of the increasingly large variations which have arisen between tax revenue forecasts and outturns in recent years in particular, it was decided to carry out a further review of the tax forecasting methodology. 1.3 The Tax Forecasting Methodology Review Group (TFMRG) was established in December The focus of the Group s work was to carry out an evaluation of the tax forecast methodologies currently used by the Department of Finance. 1.4 The formal terms of the reference for the Group were as follows: To review the existing tax forecasting methodologies; To examine the reason for divergences between tax revenue outturns and forecasts; To analyse the information bases on which forecasts are made; To review the structural parameters of tax elasticities; To look at the tax forecasting experience in other relevant jurisdictions; To make recommendations for methodological changes, where appropriate. 1.5 The Group was chaired by a Senior Economist on secondment to the Department of Finance from the Central Bank and was comprised of other representatives from the Department, the Revenue Commissioners, the Central Bank, the Economic and Social Research Institute and the European Commission. 1.6 The following were the members of the working group: 9

10 John McCarthy (Department of Finance, on secondment from the Central Bank) Chairperson Paddy Molloy and Gerard Moran (Revenue Commissioners) Ide Kearney and Adele Bergin (ESRI) Diarmaid Smyth (Central Bank) Brian Finn, Emma Cunningham and Aideen Foley (Department of Finance) Martin Larch (European Commission) participated fully by and provided useful analysis and insight in relation to the international experience in the tax forecasting area. Alan Mahon (Department of Finance) Secretariat 10

11 2. Main Developments in Tax Revenue: This section of the report details the changing composition of tax revenue since The main developments in relation to the tax forecasting process since the previous report of the TFMRG are also outlined. Structure of Tax Revenue 2.2 Chart 2.1 shows the share of Exchequer tax revenue accounted for by each tax head in 1999 and in The tax heads are ranked in descending order according to their respective share of total revenue in The data illustrate that in 1999, aggregate tax revenue was concentrated in the four largest tax heads VAT, income tax, corporation tax and excise duties which together accounted for 21.7 billion or 92 per cent of total tax revenue. This concentration has declined over the period, with the proportion accounted for by these tax heads falling to 84 per cent in billion of a total 45.5 billion. This reflects the growth of stamp duties and capital gains tax (CGT) over this period. When these two latter tax heads are included, the six largest tax heads account for 99 per cent of total tax revenue. It is clear, therefore, that in terms of forecasting tax revenue, focusing on these particular tax heads is sufficient. Chart 2.1: Tax Receipts - % of Total in 1999 and VAT Income tax Corporation tax Excise duty Stamp duty CGT CAT Customs 11

12 VAT 2.4 VAT receipts accounted for 29.5 per cent of total tax revenue in 2006, 3.2 percentage points more than the equivalent figure in As a result, VAT has overtaken income tax as the largest source of tax revenue in Ireland (this occurred for the first time in 2003, and has been consistently the case ever since). Income Tax 2.5 In 1999, income tax was the largest source of tax revenue, accounting for 34.1 per cent of total tax revenue. By 2006, this share had fallen to 27.2 per cent. The decline in the share partly reflects a number of changes to the income tax regime, including a decline in tax rates and a widening of the bands. The revenue take from this source in recent years has been negatively affected by the significant Exchequer cost arising from the popularity of the SSIA scheme (the tax credits paid to SSIA holders were essentially treated as income tax repayments) but also positively impacted upon by the yields from the various Revenue Commissioners special investigations. The decline in the share also reflects the growth in other sources of tax revenue. 2.6 Income tax comprises separate PAYE and non-paye components. Non-PAYE consists, amongst other things, of Schedule D (paid by farmers and the selfemployed), Deposit Interest Retention Tax (DIRT), Withholding Tax (WHT) and Dividend Withholding Tax (DWHT). PAYE receipts have historically tended to account for approximately 80 per cent of total income tax. The extent of receipts from Revenue s special investigations, the majority of which are paid over as non-paye income tax have artificially boosted receipts from this subhead in recent years. Table 2.1 gives a Revenue net receipts 2 breakdown of income tax between PAYE and non-paye. 2 Net receipts (accounting concept) differ from Exchequer receipts (cash concept) mainly because of timing and accounting differences. 12

13 Table 2.1: Income Tax Revenue Net Receipts Breakdown Income Tax m PAYE % Non-PAYE % , , , , , , , , Corporation Tax 2.7 Corporation tax, as a share of total tax revenue has remained relatively constant over the period, rising slightly from 14.6 per cent to 14.7 per cent over the period, although it did reach a peak of 16.4 per cent in There have been a number of important changes to the corporation tax regime over this period, most notably the phased reduction to a standard 12½ per cent tax rate for trading income generally but also the decision to bring forward the payment date for preliminary corporation tax by seven months, effectively to a current year payment basis. 2.8 The 5 year transition period for the gradual move to a current year payment basis for corporation tax ended in The transition arrangements whereby 1/5 th of the amount due was brought forward in each year generated cash-flow gains in each of the transitional years but from 2007 this cash-flow gain is lost. This cash-flow loss broadly offsets the benefit to the Exchequer arising from the ending of the SSIA scheme. Excise Duty 2.9 Excise duties as a percentage of total tax revenue have declined from 17.2 per cent in 1999 to 12.3 per cent in Stamp Duty 2.10 Stamp duty as a percentage of total tax revenue has more than doubled since 1999, rising from 3.9 per cent to 8.2 per cent in Stamp duty receipts are mainly levied upon equity and property (residential and commercial) 13

14 transactions. The large increase in property prices together with the high level of activity in the market is primarily responsible for the increase in the share of revenue attributable to this source. Capital Gains Tax (CGT) 2.11 Receipts from CGT have increased significantly since 1999, from 1.9 per cent of total receipts to 6.8 per cent in While the yields from residential and commercial property transactions have undoubtedly played an important role in driving the increase in revenues from this tax head since 1999, other sources of CGT such as from the disposal of quoted and unquoted shares and agricultural and development land have also contributed significantly (see table 2.2 below). Table 2.2: CGT by Consideration Value of Asset Type Disposal 3 % of Total Quoted Shares Unquoted Shares Residential Property Commercial Property Agricultural Land Development Land Other Total *Figures may not add to 100 per cent due to rounding of individual categories. Other Tax Receipts 2.12 The data also illustrate that the revenue from other tax heads (capital acquisitions tax, customs and levies) are relatively small. In aggregate terms, receipts under these tax heads totalled to 1.3 per cent of total tax revenue in 2006, a decline from the 2.1 per cent share in Table 2.2 contains details of CGT by consideration value of disposals by asset type and as such is no more than indicative of the actual CGT yield. The figures are derived from CGT returns filed via the Revenue Online System (ROS) version and the paper version of Form 11 (the Pay & File tax return form). The 2005 figures are derived from CGT returns filed to early January 2007 via the ROS version of the Form 11 only. CGT returns can be made via other Forms but these figures capture the majority of returns. 14

15 Main Developments since the 1998 TFMRG Report (i) Direct Tax Base Working Group 2.13 The Direct Tax Base Working Group (DTBWG) is an informal group set up with the approval of the Minister for Finance in mid-2002 and is made up of officials of the Department of Finance and the Revenue Commissioners. It was established in order to analyse the reasons for the shortfall in direct taxes around 2001/2002 and to examine issues which may have had an impact on the tax yield from direct taxes, including income tax, for the purpose of improving the tax forecasting methodology. While the work of this Group is ongoing, the Group has identified a number of areas where improvements can be made The Group examined issues related to the sampling of the Revenue Commissioners income tax data files with a view to using more up-to-date but not fully complete information to improve the forecasting of income tax (in particular PAYE) receipts. The aim would be to cross-check and verify employment and earnings elasticity coefficients calculated on the existing historical basis using more up-to-date though partially incomplete Revenue taxpayer data. In a rapidly changing economy such as Ireland the hope would be to use a more up-to-date representative though incomplete sample rather than using an older although more complete sample The Group has also considered ways to improve the forecasting of stamp duties and CGT. In the area of stamp duty, a difficulty is the absence of timely data on the underlying transactions giving rise to stamp duty yields. Detailed current data (details of the residential and non-residential stamp duty tax yield for a particular month available by the middle of the following month) on the numbers and values of transactions in the residential and non-residential property area, from which the majority of the stamp duty yield is derived, has not been available. Similarly for CGT, the legislative processes operating mean that it is systematically not possible to obtain relevant information on the underlying transactions giving rise to current tax yields. For example, while the payment of CGT on transactions giving rise to liability in the first 9 months of 2006 was due on 31 October 2006, details of the transactions themselves are not required to be returned until one year later at end-october Some progress has been made on this issue (see Table 3.2 for details of CGT by consideration value of disposal by asset type for the years ). 15

16 2.16 The work of the DTBWG is still ongoing and it would be unwise to draw any conclusions at this time regarding the possible usefulness of its work for forecasting purposes. (ii) IMF Article on Ireland s Fiscal Forecasting Record 2.17 In October 2005, the International Monetary Fund (IMF) published an analysis of Ireland s track record on forecasting the fiscal balance. 4 On the revenue side (which is of most importance in the context of this Report), the research found that stronger-than-expected economic growth and buoyant asset price developments were the main reasons for the overshooting of tax revenue. In terms of economic growth forecasts, Department of Finance forecasts were found to be similar to those of other institutions, and the difficulty in forecasting economic growth in a period of strong economic growth was highlighted. 4 Favourable Fiscal Outturns: Is It Just the Luck of the Irish? IMF Country Report No. 05/370 16

17 3. Tax Revenue Forecasting Process 3.1 Tax revenues are forecast by the Department of Finance on a disaggregated individual tax head basis using relevant macroeconomic drivers supplied by the Economic Forecasting Unit of the Department of Finance and, where appropriate, certain elasticity factors. 3.2 There are eight main individual taxes, namely: VAT Income tax Corporation tax Excise duties Stamp duties CGT Capital acquisitions tax Customs duties forecast by the Revenue Commissioners The Department of Finance forecasts all of the taxes bar customs duties, which are forecast by the Revenue Commissioners, on the basis of the available macros provided by Department of Finance. In addition, in some instances (e.g., most of the non-paye income tax) the Revenue forecast figures are used. 3.3 As the first six of these tax heads are forecast to account for 99 per cent of total tax revenue in 2007, this Report focuses on them. The methodologies for forecasting capital acquisitions tax (CAT) and customs duties are not discussed in detail. 3.4 There are three tax forecasting rounds each year: May/June for the Budget Strategy Memorandum (BSM). This is for the information of the Government only and the forecasts are not made available publicly. 17

18 September/October for the Pre Budget Outlook (PBO). 5 An estimate of the aggregate tax revenue outturn for the current year 6 together with forecasts for the following two years is provided in the PBO. November/December for the Budget. An estimate of the tax revenue outturn, on a disaggregated basis, for the current year together with forecasts for the following three years is provided at Budget time. 3.5 As a top-down check on the validity of the overall tax forecast, in line with the key recommendation in the 1998 Report of the TFMRG, the forecast change in the level of nominal GDP is compared to the total tax revenue forecast growth rate constructed on an individual tax head or bottom-up basis, i.e. the elasticity of overall tax revenue growth with respect to nominal economic growth is checked. In general, this particular elasticity factor is likely to be close to one (see Appendix 1). However, this one to one relationship need not hold from year to year and can be influenced by factors such as the composition of economic growth and the impact of Budget changes. 3.6 There are a number of factors that effect tax forecasts: Budget tax forecasts are made at a time when final economic data for the current or forecast year are not available. In addition, most economic data published by the CSO are subject to revision. A recent Central Bank technical paper 7 examining national accounts data published by the CSO shows how initial estimates of GDP and its components can differ quite significantly from final estimates, which creates problems for economic forecasting purposes and hence for tax forecasting purposes. The paper found that the final revision to the growth rate of GDP was 1½ per cent, almost 20 per cent of average GDP growth over the sample. The average 5 This was first published in October The Department of Finance constantly monitors in-year tax revenue performance and has often given estimates of the current year aggregate tax revenue outturn at its end-q2 and end-q3 Exchequer Returns Press Conferences. 7 Research Technical Paper 10/RT/06 by Colin Bermingham. This paper is summarised in Appendix 3. 18

19 revision was positive indicating that initial estimates of GDP tend to be too low. The composition of economic growth has a significant bearing on the actual tax yield. This has been particularly applicable in recent years when the composition of growth in Ireland has been heavily driven by domestic demand. At Budget time, the base year actual tax outturn is not known and therefore the outturn is merely an estimate. The impact of one-off or extraneous factors from year to year can be significant. In recent years, the impact of Revenue s special investigations receipts has far exceeded expectations. These receipts cannot, by their nature, be forecast with any degree of certainty. The effect of structural changes (e.g. changes in the due date for payment) in the tax system can sometimes impact on taxpayer behaviour with unforeseeable results on tax revenues in the short term. Receipts from some taxes such as CGT and stamp duties, which have become increasingly significant in recent years, do not have as consistent a relationship with economic growth as, say, income tax or VAT, and are more difficult to forecast. These particular taxes are more dependent on activity in the asset markets (property and shares). Activity in asset markets is prone to more pronounced movements in volume and price than in the wider economy and is therefore less predictable. Corporation tax receipts from export profits are affected by international trading conditions and are known to be highly volatile, particularly in small open economies such as Ireland. 19

20 3.7 For all tax heads, the estimated impact of one-off or other factors expected to affect tax collection in the forecast year is added to or subtracted from the forecast. Value Added Tax (VAT) 3.8 VAT is forecast by reference to growth in the nominal level of personal consumption expenditure (PCE) including cars. An estimate of the base year outturn for VAT is made. This projected outturn is adjusted to take account of any known one-off factors, both negative and positive, likely to impact on the yield in the forecast year and also the effects of previous Budgets, which have been carried forward. This adjusted outturn figure is then grown by the forecast rate of increase in nominal PCE, i.e. PCE (including cars) volume multiplied by a PCE deflator and an elasticity factor, which has been 1 in recent years. The figures are then refined to take account of the impact of Budget measures, if any. 3.9 The bulk of VAT is due for payment in January and every second month thereafter on the basis of trading turnover in the two months prior to each due month. Income Tax 3.10 Although income tax appears as a single tax head in the Budget Booklet, it actually comprises separate PAYE and non-paye components. PAYE represents around 80% of income tax and is forecast by the Department of Finance. Non-PAYE consists mainly of Schedule D (paid by farmers and the 20

21 self-employed), Professional Services Withholding Tax (PSWT), Deposit Interest Retention Tax (DIRT), Back Duty (special investigations monies) and Dividend Withholding Tax (DWHT). With the exception of DIRT, which is forecast by the Department of Finance, the other non-paye income tax elements are forecast by the Revenue Commissioners There has been a major programme of structural reform to the income tax regime in recent years. The standard and marginal tax rates have both been cut, the standard rate band has been widened significantly, a system of tax credits has replaced the tax free allowances and an element of individualisation has been introduced. All of these changes coupled with the huge surge in employment and the composition of employment have made the job of forecasting income tax more difficult. PAYE 3.12 To produce the PAYE forecast: An estimate of the base year outturn for PAYE is made. The projected outturn is adjusted to take account of any known one-off factors, both negative and positive, likely to impact on the yield in the forecast year and also the effects of previous Budgets, which have been carried forward (in recent years relevant one-off factors have included the impact of the SSIA scheme). The adjusted outturn figure is then multiplied by an aggregate multiplier. This multiplier is a combination of the forecast increase in non-agricultural earnings together with an earnings elasticity factor and the forecast increase in non-agricultural employment together with an employment elasticity factor. The earnings and employment elasticity factors estimate the sensitivity of PAYE taxes to changes in numbers employed and in the level of earnings. For the Budget 2007 income tax forecasts, the elasticity factors used for non-agricultural employment and non-agricultural earnings were 1.0 and 2.1 respectively. The aggregate multiplier is calculated by applying 21

22 the earnings elasticity to the earnings macro and the employment elasticity to the employment macro. This is then applied to the cleaned PAYE base. The figures are then refined to take account of the impact of Budget measures, if any. Calculation of Elasticity Factors 3.13 The elasticity factors take account of the fact that new and existing employees are likely to pay tax at different marginal tax rates. In effect, the elasticity is a measure of the tax increase arising from the shift of taxpayers from a lower to a higher tax rate in the event of an income increase. The lower employment elasticity factor represents the understanding that new jobs do not initially generate as much in tax revenue as increases in the earnings of existing employees. This is because the employment elasticity relates to new employees and as the question of moving from one tax rate to another does not generally apply in the first year of employment, a flat increase in tax equal to the projected growth in numbers employed is therefore assumed The elasticity factors for any tax year t are derived from a projected taxpayer income and tax model for the tax year t based on historical Revenue taxpayer data for the tax year t-4. While lookback revisions of the elasticity factors tend to confirm the projected versions of the elasticity factors first used (see 3.15 below), it is now considered appropriate that future projections be supported by more recent information. An examination is underway to explore ways of basing future forecasts on more up-to-date but less complete sample data for the year t- 2 (see work of Direct Tax Base Working Group in Chapter 3 for more detail) A retrospective look back at the actual 2003 non-agricultural earnings elasticity factor, carried out by the Revenue Commissioners, gave a figure of 2.0. The figure used in the Budget 2003 PAYE income tax forecast, which was based on 1999 data was also 2.0, meaning that using more up-to-date information may not necessarily prove more accurate. The analysis was carried out for one year only and caution must be taken when drawing conclusions for other years. Theoretically however, it would make more sense to use the most up-to-date 22

23 data available, provided of course it is fully representative of the complete data series. Non-PAYE Income Tax 3.16 Revenue s forecast process for the main component of non-paye income tax, Schedule D/Farmers, follows the same principles as PAYE but with some differences such as: estimating preliminary tax separately from balances. Preliminary tax for the current tax year must be paid on or before the 31 October each year and must be at least 90 per cent of the final taxable liability for that year (or alternatively 100 per cent of the previous year s liability). Any balance of tax due for the previous tax year must also be paid on or before 31 October. computing Revenue s own income growth macro using historical trends of tax yields. adding in a separate estimate for the yield from normal audit activity. In recent years, estimates of receipts from Revenue s special investigations would also have been included. adjusting downwards to offset for higher withholding tax credits that arise from an increase in that tax. using a lower elasticity factor than is used for PAYE (income increases are less likely to be reflected in tax payments). monitoring trends of take-up on tax reliefs in case Revenue need to provide for higher tax repayments Forecasting non-paye income taxes has proven difficult in recent times. [There is no appropriate macroeconomic driver available to use in the forecasting of these taxes and so Revenue compute their estimates using a growth macro based on historical trends of tax yields]. Other issues such as the popularity of 23

24 tax incentives, most notably property based incentives which act as a legal tax shelter but the take-up of which is difficult to predict and compliance issues on foot of Revenue s special investigations have also added to the difficulty in forecasting non-paye income taxes. Corporation Tax 3.18 Budget 2002 began the process, on a 5 year transitional basis, of bringing forward the payment date for preliminary corporation tax by seven months, effectively to a current from a preceding year basis. Therefore, with the payment arrangements for corporation tax having undergone significant changes over the last five years coupled with the phased reduction to a standard 12½ per cent tax rate for trading income generally, the methodology for forecasting corporation tax was made more difficult during this period The 5 year transition period for the gradual move to a current year payment basis for corporation tax ended in The transition arrangements where 1/5 th of the amount due was brought forward in each year generated cash-flow gains in each of the transitional years but from 2007 this cash-flow gain will be lost. It is estimated that corporation tax revenues in 2007 will be approximately 700 million million less than they would otherwise have been as a result of this cash-flow reduction In an effort to improve forecasting methods, the top 50 companies have been contacted by way of a questionnaire from Revenue s Large Cases Division (LCD) in each of the last two years to see if they could forecast the expected growth in the corporation tax they were likely to pay in year t Corporation tax is forecast in the following way: An estimate of the base year outturn is made. This projected outturn is then adjusted to take account of any known one-off factors (LCD survey based or other known factors) likely to impact on the 24

25 yield in the forecast year and also the effects of changes in previous Budgets which have been carried forward. This figure is then multiplied by the growth in nominal GDP in the forecast year and an elasticity factor, which has tended to be 1 in recent years. A particular problem with corporation tax however is that just over half of all corporation tax is due for payment in November. Collection performance in the preceding months of the year is thus not a reliable guide on the November outcome. The figures are then refined to take account of the impact of Budget measures, if any For the Budget 2007 forecasting round, approximately 25 of the top corporation tax paying companies made an estimate in mid to late 2006 in relation to their 2007 profits with some of these indicating expected negative growth in their 2007 tax (most of these as a result of once-off factors). In the 2005 survey for use in Budget 2006 forecasts, those companies that did respond forecast zero growth in tax payments in 2006 which obviously did not happen. Nevertheless, the results of the 2006 survey were found useful in helping to determine the tax forecast for 2007 and were used to enhance Revenue s forecast methodology, largely by increasing their knowledge of one-off factors. Excise Duty 3.23 Vehicle Registration Tax (VRT) is included in excise duty. However, this component of excise duty is forecast separately. The process involved in forecasting these separate components is outlined below: Estimates of the base year outturns for excise duties (less VRT) and for VRT itself are made. 25

26 These projected outturns are then adjusted to take account of any known one-off factors likely to impact on the yield in the forecast year and also the effects of previous Budgets which have been carried forward. The base year outturn for excises (excluding VRT but including the 168 million Health Tobacco Levy paid to the Department of Health and Children) is then multiplied by the forecast increase in the volume of PCE (excluding cars). The 168m Health Tobacco Levy payment is then stripped out as it is not classified as an Exchequer tax receipt. The Revenue Commissioners favour a different approach in respect of excises other than VRT. Their estimates are usually compiled on the basis of expected trends in the consumption of goods liable to excise. The Department of Finance also analyses the Revenue s trend based excise duty forecasts thoroughly and has been known to adopt a combination of both methodologies if it feels it will produce the most reliable forecast. For VRT, the expected base year outturn is multiplied by the forecast increase in the price and volume of new car sales. Both the VRT and excise less VRT figures are then refined to take account of the impact of any Budget measures. Stamp Duty 3.24 Stamp duties are charged in respect of legal and financial transactions for which there is a corresponding document. Most stamp duties are charged ad valorem (at a certain percentage) of the value underlying the transaction in question. Where it is not feasible to determine a value on which to base an ad valorem charge, for example in the case of cheques, drafts and ATM cards, a fixed duty is levied Table 3.1 shows the percentage breakdown of stamp duty receipts for each of the years , using Revenue net receipts as the basis for calculation. It is 26

27 worth noting the increasing percentage of total stamp duty receipts accounted for by property and within property related transactions, the increasing importance of receipts from non-residential property transactions. Table 3.1: Stamp Duty Percentage Breakdown of Receipts % of Total Stamp Duty From: Land & Property Residential Property Non-Residential Property Stocks & Shares Companies Capital Duty Cheques/Bills of Exchange etc Insurance & Miscellaneous Levy on Financial Institutions Total For the forecasting exercise, stamp duties are broken down into the following sub-heads: Residential Property Non-Residential/Commercial Property Stocks and Shares Insurance Levy Others (including non-life insurance levy, credit etc. cards & cheques) 3.27 Forecasts of stamp duty receipts attempt primarily to model movements in the value and turnover of residential and non-residential property market transactions. However, the available economic indicators are not entirely satisfactory for predicting movements in property prices and turnover in the second-hand market, from which the majority of residential property market stamp duty receipts are derived. 27

28 3.28 Therefore, the following methodology is used to produce the stamp duty forecast: Estimates of the base year outturns for each component are made. These projected outturns are then adjusted to take account of any known one-off factors likely to impact on the yield in the forecast year and also the impact of changes in previous Budgets which have been carried forward. For residential property, the estimated change for the forecast year in the volume and price of new house activity is used as a loose proxy for the change in the level and value of stamp duty-liable transactions; this is augmented by an (upward) adjustment for the consequential movement into higher stamp duty bands brought about by the projected increase in house prices. On the non-residential 8 side the nominal growth in investment in nonresidential construction excluding roads is used to forecast the increase in yield from this source. The shares category 9 is increased in line with nominal GDP in the forecast year. The insurance levy is assumed to remain at the base year level (unless where otherwise indicated by Revenue). The others category is grown in line with projected consumer price inflation. The figures are then refined to take account of the impact of Budget measures, if any. 8 Revenue use an average growth rate derived from Stamp duty receipts from non-residential property over the past 5 years. 9 Consumer Price Index used by Revenue. 28

29 Capital Gains Tax (CGT) 3.29 CGT is chargeable on the gains arising from the disposal of assets. Any form of property, including an interest in a property (lease) is an asset for CGT purposes. The tax payment is liable once the asset is disposed of. Liabilities arising in the first 9 months of the year are payable by the end of October that year. Liabilities arising in the last three months of the year are payable by the end of the following January There is no agreed methodology for forecasting receipts from CGT. The forecast difficulties are compounded by the administrative structures under which the tax operates and under which tax receipts are received at two points in the year followed significantly later by the returns detailing the reasons for the underlying liabilities The following approach to forecasting CGT is currently undertaken: An estimate of the base year outturn for CGT is made. This projected outturn is then adjusted to take account of any known one-off factors likely to impact on the yield in the forecast year and also the impact of changes in previous Budgets which have been carried forward. This figure is then grown by the forecast rate of increase in nominal GNP in the forecast year. The figures are then refined to take account of the impact of Budget measures, if any. Capital Acquisitions Tax (CAT) 3.32 CAT comprises gift tax, inheritance tax, discretionary trust tax and probate tax and very minor amounts in respect of residential property tax and is forecast using the rate of increase in nominal GNP in the forecast year. In years prior to Budget 2007, the CPI was used as the multiplier but the Department of Finance considers that GNP is now a more appropriate growth factor. 29

30 Customs Duty 3.33 Customs duties are collected on a wide range of goods imported from non-eu countries. While all customs duties collected are paid into the Exchequer, 75 per cent of the amount collected is subsequently paid out of non-voted central fund expenditure to the EU as part of Ireland s EU budget contribution known as traditional own resources. The remaining 25 per cent is retained as collection expenses The forecasting of this tax head is undertaken by the Revenue Commissioners, with the Department of Finance generally accepting Revenue s estimate. However, the Department supplies Revenue with a macro-economic forecast of the nominal (value) increase in merchandise imports. Forecasting customs duties has become more difficult in recent years with the introduction of Single European Authorisation (SEA) arrangements. This allows a company with branches in different Member States to transact all of their customs business in one Member State. The Member State which issues the SEA acts as the Supervising Customs Authority for all Member States in respect of that authorisation and collects the customs duties in respect of imports into the various Member States. It then pays over an agreed amount of collection costs (up to 25 per cent) to the various Member States into which non-eu goods have been imported. For example, included in the customs receipts figure for 2006 was an amount of 44 million (around 17 per cent of total customs duties collected in 2006) under an SEA collected on behalf of another Member State. 30

31 4. Tax Revenue Forecasting Performance 4.1 This section of the report analyses the tax revenue forecasts produced by the Department of Finance over the period The tax revenue forecasts are the Budget day projections produced in December of each year for the following year. 4.2 While tax revenue has outperformed Budget day projections in six of the last eight years significantly so in each of the last three years it is clear that a number of extraneous factors have had a sometimes significant impact on tax revenue collection during that time. Such factors are often difficult if not impossible to forecast with any degree of accuracy. In the analysis below, therefore, the forecasting performance is shown, firstly, on an unadjusted basis (i.e. no allowance is made for extraneous factors) and secondly, on an adjusted basis (i.e. after making allowance for exceptional factors). This approach enables a broad quantification of forecast errors. Methodology 4.3 In terms of assessing the forecast performance, the approach taken below is to formally examine the Budget day one-year ahead tax revenue forecasting accuracy over the period using the following statistical tools: Mean (forecast) error, where: ME = 1/T*(Σe t ) Root mean squared (forecast) error, where: RMSE = [1/T*(Σe t 2 )] ½ 4.4 The error term for each year is defined as the difference between the outturn and the forecast, expressed as a percentage of the actual outturn. The ME is the simple average of forecast errors over the period. This provides an indication of the direction of forecast errors. However, because but it is affected by both positive and negative errors, it is not an appropriate tool to quantify the magnitude of errors. On the other hand, the RMSE defined as the square root of the mean of the errors squared is independent of the error sign and can therefore be used to quantify the magnitude of the forecast errors. In line with most of the recent international literature, the analysis below concentrates on the RMSE measure. 31