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

32 Unadjusted Analysis - Aggregate Tax Revenue 4.5 Chart 4.1 below shows the aggregate tax revenue forecast error over the period. The data are shown in raw, unadjusted form, i.e. no adjustment is made for the impact of one-off factors. Over the period, the tax revenue outturn was on average 2.5 per cent better than projected. The data show that tax revenue overshot forecasts in six of the eight years since 1999, the largest overshooting taking place in In 2001 and 2002, revenue fell short of forecasts, with a particularly significant undershooting occurring in Chart 4.1: Unadjusted Outturn Compared with Forecast - % of Outturn 10.0% 8.0% 6.0% 4.0% average 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% -10.0% In Chart 4.2, the total forecasting error figure is decomposed, on this unadjusted basis, into the part of the total error accounted for by each of the tax heads in the individual years. The chart shows that, in each of the last three years for example, capital taxes - stamp duty, CGT and CAT have accounted for over half of the total forecasting error 3.4 percentage points of the 6.1 per cent error in 2004, 3 percentage points of the 4.5 per cent error in 2005 and 4.8 percentage points of the 8.5 per cent error in This will be discussed in more detail later in the report. 32

33 Chart 4.2: Composition of Forecast Error Unadjusted Outturn & Forecast 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% Income Tax VAT Corporation Tax Excise Capital Taxes Customs Total 4.7 The forecasting error, as measured by the RMSE, was 6.1 per cent of the actual outturn on this unadjusted basis. To put that 6.1 per cent overall RMSE in context, a paper 10 comparing Canadian Budget forecasts with those of other industrial countries shows that the overall RMSE for tax revenues in Canada over the nine year period was 5.7 per cent. In the Netherlands, the RMSE was 5.4 per cent while in Germany it was 5.1 per cent. 4.8 As mentioned above, capital taxes have become increasingly significant. This is evidenced by the fact that the RMSE falls to 4.3 per cent, if it is assumed that capital taxes were on target each year over the period. 4.9 The previous report of the TFMRG showed an average (mean) error of 3.3 per cent of forecast tax revenue over the 10 year period Significantly, tax revenues outperformed their targets in nine of those ten years while in 1991 tax revenues were exactly on target. This is somewhat at odds with the period since The extent of the overall average (mean) errors in more recent years has generally been greater than over the period 10 IMF Working Paper 05/66 - How do Canadian Budget forecasts compare with those of other Industrial countries? 11 Whereas the previous TFMRG report expressed errors as a percentage of the tax forecasts, this report expresses the errors as a percentage of the actual tax revenue outturns. 33

34 while tax revenues came in below target in 2001 and 2002, by 9.1 per cent and 3.5 per cent respectively. - Disaggregate Tax Revenue 4.10 The forecasting performance of each of the individual tax heads over the period is illustrated in table 4.1. With the exception of PAYE income tax, excise duties and customs duties, tax revenues from all tax heads have exceeded forecasts. The largest overshooting occurred in the CGT, stamp duty and non-paye income tax heads (CAT and customs also recorded significant overshooting but as outlined earlier, these are relatively insignificant in terms of overall tax revenue). Table 4.1: Individual Tax Head Percentage Errors (Unadjusted) ME RMSE Income Tax PAYE non PAYE VAT Corporation Tax Excise Duty Stamp Duty CGT CAT Customs Duty Total Total excluding Capital 12 Taxes Ireland is not alone in having such large forecasting errors. For example, in the case of Canada 13, in seven of the eight years from to , total revenues came in ahead of projections, significantly so in the years , and The errors surplus tax revenue as a percentage of actual tax revenue in each of those years was 10.1 per cent, 5.4 per cent and 9.3 per cent respectively and of the main components of total revenue in Canada, both 12 Assuming zero forecast error for CGT, CAT and stamp duty i.e. receipts from these tax heads were on target. 13 Review of Canadian Federal Fiscal Forecasting Processes and Systems, June

35 personal income tax and corporate tax revenues came in ahead of target in six of the eight years. Adjusted Analysis 4.12 The raw data presented above do not take into account extraneous factors which can impact on tax collection and contribute ex post to a divergence between forecast and outturn. Over the period concerned, such one-off factors have, in general, tended to surprise on the upside, imparting an upward bias to forecast errors. The analysis below sets out the main identifiable one-off factors. It should be noted, of course, that the classification of some factors as one-offs can be somewhat arbitrary It is worth noting also that there have been significant payment date changes for a number of tax heads, which have also impacted on tax revenues in recent years On the basis of best judgement, table 4.2 sets out the main one-off factors which, when excluded, enable a more accurate like-for-like comparison between forecast revenue and outturn over the period There were no major one-off items in

36 Table 4.2: Total One-off Adjustments Unadjusted Outturn m PAYE One-Off Factors m Income tax Non- Stamp CT VAT CAT CGT Customs PAYE Duty Adjusted Outturn m , , , , , , , , , , , , , ,505 *A positive one-off figure in table 4.2 indicates an unexpected or one-off yield which is subtracted from the unadjusted outturn to get the adjusted outturn figure. Likewise a negative (-) figure indicates an unexpected loss which is added back to the unadjusted outturn to get the adjusted outturn figure It should be noted that no allowance is made in the analysis below for ongoing improvements in compliance or for stronger than expected take-up of various legal tax shelters (such as in property) that pertained over the period. These factors are difficult to quantify ex ante and have undoubtedly had an impact on the revenue outturn over the period in question (ceteris paribus contributing to overshooting in the case of improved compliance and to undershooting in the case of increased take-up of legitimate tax shelters). - Aggregate Tax Revenue 4.16 Chart 4.3 below shows the forecast and outturn once the identifiable one-off factors are taken into account. The mean error declines to 1.9 per cent while the RMSE declines to 5.9 per cent of actual tax revenue, suggesting some marginal improvement in the forecasting accuracy. 36

37 Chart 4.3: Forecast Compared with Adjusted Outturn - % of Outturn 10.0% 8.0% 6.0% 4.0% average 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% -10.0% Chart 4.4 combines charts 4.1 and 4.3 so that the improvement in the RMSE, arising from the factoring in of the adjusted outturn figures, can be easily seen. The blue bars represent the unadjusted outturns while the red bars represent the adjusted outturns is the only year in which adjusting for one-off factors worsens the RMSE. Chart 4.4: Improvement in RMSE with Adjusted Outturn 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% unadjusted average adjusted average -8.0% Blue = Unadjusted Red = Adjusted -10.0%

38 - Disaggregate Tax Revenue 4.18 The forecasting performance of each of the individual tax heads on the adjusted basis is illustrated in table 4.3. The results show that even allowing for one-off factors, there was still overshooting for most tax heads. Of the larger tax heads, the most noticeable improvement (i.e. lowering of the RMSE) occurs in non- PAYE income tax, owing to the exclusion of special investigations receipts. Table 4.3: Individual Tax Head Percentage Errors (Adjusted Outturn) ME RMSE Income Tax PAYE non PAYE VAT Corporation Tax Excise Duty Stamp Duty CGT CAT Customs Duty Total Total excluding Capital Taxes In summary, there has been a significant overshooting of revenue vis-à-vis forecasts over the period On an unadjusted basis, the aggregate forecasting error as measured by the RMSE was 6.1%. This period has seen a substantial number of exceptional factors which have impacted on tax revenue. Controlling for these factors which itself is subject to considerable uncertainty results in a slight improvement in the overall forecasting accuracy, with the RMSE declining to 5.9%. Other factors, such as improved compliance, would also appear to have had an impact on revenue but these are difficult to quantify. Chart 1 in Appendix 2 provides details of the composition of the forecast error on this adjusted outturn basis The 1998 report of the TFMRG concluded that the main reason for the divergence of the actual tax revenue outturns from the Budget day forecasts was 38

39 the stronger than expected economic performance. Given the continued strength of the economy in the years since the 1998 report, controlling for economic factors was viewed as the next step in attempting to explain the divergence of tax revenues from forecast in recent years. 39

40 5. Controlling for Economic Forecasting Errors 5.1 Projections for key macro-economic variables are a key input into the tax forecasting process (VAT is a function of the nominal growth of consumption; income tax is a function of employment and earnings growth, etc). Therefore, economic forecasting errors will have a knock-on impact on the tax forecasts. 5.2 In order to analyse the accuracy of tax forecasting, therefore, it is important to isolate the impact of economic forecasting errors. This is done through producing retrospective tax forecasts by application of the most up-to-date macroeconomic data A priori it is to be expected that these revised tax forecasts would be closer to the adjusted outturns for each of the tax heads than the original Budget day forecasts, i.e. the gap between forecast and outturn would be narrowed and a proportion of the forecast error could be explained. 5.4 The reasons underlying economic forecasting error, can in broad terms, be categorised under the following headings: Changes in Key Exogenous Variables Economic developments in Ireland are heavily dependent on developments elsewhere in the global economy (particularly on developments in the OECD area). Thus, in preparing national economic forecasts key assumptions are made in relation to key external developments, such as economic growth and trade in our major trading partners. In Ireland, these assumptions are based on the forecasts of various international institutions such as the European Commission, the OECD and the IMF. In framing the Budget forecasts, the assumptions of the European Commission are particularly important. In these circumstances, forecasting errors in key exogenous variables will generate errors in the domestic economic forecasts. As Ireland has become more globally integrated in recent years, these exogenous variables have become relatively more important in explaining growth developments in Ireland. 14 It should be noted that further revisions to the currently available economic data are possible. 40

41 Domestic Policy Assumptions In Ireland, the Department s economic forecasts are underpinned by the conventional no policy change assumptions in relation to a broad range of economic and social policies. To the extent that actual policies diverge from the no policy change benchmark, the divergence in the national forecast will be greater. Model Error Medium-term economic forecasting requires assumptions to be made regarding the economy s estimated trend or potential growth rate. In other words, once short-term demand-side fluctuations evaporate, an economy is assumed to grow in line with its potential, which in turn is determined by assumed increases in the factors of production together with assumptions regarding the efficiency with which these factors are used in the production process (total factor productivity). In these circumstances, an important source of the forecast error relates to assumptions regarding the economy s trend or potential rate of growth which have been incorrect. In an Irish context, there is considerably uncertainty regarding the potential growth rate of the economy, mainly related to the openness of the economy together with the extent of structural change that has occurred over the last decade or so. Economic Shocks Economic shocks both internally and externally generated can affect the forecasting performance. Given the size of the Irish economy, together with fairly concentrated sectoral economic activity (somewhat inevitable for a small economy), shocks can have a significant impact on overall activity. For example, the global ICT shock in 2000/2001 had a large unforeseen impact on the economic performance of the Irish economy over this period, with growth in 2001 being 3.0 percentage points below that forecast in the December 2000 Budget. Data Revisions Very often economic forecasts are based on preliminary estimates of macroeconomic variables which are subsequently subject to in some cases significant revisions. 41

42 5.5 Budget 2006 presented a review of the track record of the Department of Finance s Budget economic forecasts against those of other forecasting agencies. In late 2005 both the IMF and the ESRI 15 concluded that all forecasters of the Irish economy have, particularly in the 1990 s, consistently underestimated economic growth, mainly due to upside growth surprises. This was most clearly the case for external demand, which is particularly difficult to forecast in a globally-integrated economy like Ireland. Table 5.1 shows the average divergence between the outturn as measured by the CSO and the annual forecasts for the 1997 to 2004 period produced by a number of agencies, including the Department of Finance. The results, as measured by the error level across the different agencies, are very similar. The spread may well be explained, at least in part, by the timing of publication and the availability of up-to-date information. Information availability constrains all forecasts, particularly as short-term forecasting does not readily lend itself to the application of econometric or model-based analysis. The main conclusion from this analysis is that performance of the official Department of Finance forecasts published on Budget day compare well against those of other forecasting institutions. Table 5.1 Economic Forecast Performance Forecaster Publication Divergence from Outturn 16 Central Bank ESRI EU Commission IMF OECD Winter Bulletin Winter QEC Autumn Forecast WEO Sept/Oct Outlook Nov/Dec 2.66% 2.92% 2.57% 2.80% 2.62% Dept. of Finance Budget 2.59% Methodology 5.6 In order to produce revised tax forecasts for the period , based on the most up-to-date macroeconomic data available; the following approach was taken for each of the individual tax heads. 15 The Quarterly Economic Commentary Forecasting Record 1994 to 2004, QEC Autumn Ireland: Selected Issues, IMF Country Report No. 05/370, October Divergence from the CSO outturn is measured using Root Mean Squared Forecast Error. 42

43 5.7 When producing the Budget year tax forecasts in December of each year, the base year outturn essentially the starting point for the forecast is not known and must therefore be estimated. In producing the revised tax forecasts, the actual base year outturn is used as the starting point. 5.8 The Budget year tax forecasts are based on projections of macroeconomic activity or what are known as tax macros for the forthcoming year. Economic data can be subject to regular revision for a number of years after the end of the forecast year and the revised tax forecasts are based on the most recently available estimates of the actual outturns for these tax macros. A recent Central Bank technical paper 17 shows how initial estimates of GDP and its components can differ quite significantly from final estimates. The paper found that the final revision to the growth rate of GDP was 1.5 per cent, almost 20 per cent of average GDP growth over the sample. The average revision was positive indicating that initial estimates of GDP tend to be too low. Such revisions create problems for economic forecasting purposes and hence for tax forecasting purposes. 5.9 The actual base year outturns and the revised tax macros were then inserted into the Budget tax forecasting spreadsheets for each of the years to produce revised tax forecasts The actual base year outturns and the revised tax macros were the only variables that were updated in the context of producing these revised tax forecasts. Other issues which may have had an impact on the accuracy of the Budget day tax forecasts such as the employment and elasticity factors for income tax and the cost of the Budget day tax packages were not updated. This is because the aim of the process is simply to control for the base year outturn and the latest available macroeconomic data to see the impact this would have on the tax forecasts. Results 5.11 The results are set out in the table 5.2, which shows the RMSE for each tax head and for overall tax revenue. These figures include adjustments for once-off 17 Research Technical Paper 10/RT/06 by Colin Bermingham see Appendix 2 for summary of this paper. 43

44 factors discussed earlier and together with controlling for economic forecasting errors, this reduces the overall RMSE to 4.0 per cent, as compared with 5.9 per cent in table 4.3. Table 5.2: Individual Tax Head Percentage Errors (Adjusted Forecast & Adjusted Outturn) ME RMSE Income Tax PAYE non PAYE VAT Corporation Tax Excise Duty Stamp Duty CGT CAT Customs Duty Total Total excluding Capital Taxes Having controlled for economic forecasting errors, the RMSE declines for all tax heads, most noticeably so for income tax, VAT and excise. Given that these tax heads are more generally linked to identifiable macroeconomic variables employment, earnings, personal consumption etc than capital taxes are, the results are unsurprising. Nevertheless, the error remains relatively high in almost all cases, and at 4.0 per cent remains high for overall tax revenue. Assuming that capital taxes came in exactly on target, the RMSE declines further, to 2.8 per cent It can be concluded, therefore, that while economic forecasting errors explain some of the variation in tax forecasts vis-à-vis outturn, there remains a significant component of the gap which cannot be explained by reference to one-off factors or to economic forecasting errors. This is somewhat at odds with the 1998 report, which found that economic forecasting errors were the main reason behind tax forecasting errors. 44

45 5.14 Of the main tax heads, the largest errors in RMSE terms are to be found in CGT and stamp duty. Even after controlling for one-off factors and stronger than expected economic performance, the respective RMSEs are 30.5 per cent and 13.8 per cent. In the previous report of the TFMRG, which covered the period from the late 1980s to 1997, the performance of CGT and stamp duty was not analysed to any great extent, given the share of total tax revenue each accounted for and the fact that any divergence from accuracy in the forecasting of these tax heads was minor in overall terms. In 1999, for example, these two tax heads combined accounted for less than 6 per cent of total tax revenue. In 2006 that figure was 15 per cent. One possible reason for the larger errors in these particular tax heads is the performance of the property market in recent years and the large increase in tax revenues attributable to that particular sector of economic activity. Chart 5.1 below shows the composition of the forecast error on this adjusted forecast and adjusted outturn basis. The chart highlights the fact that capital taxes account for a large and rising (in recent years) proportion of the total forecasting error. Chart 5.1: 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 5.15 It is worth noting that the Irish economy has gone through a period of significant structural change in the last decade. Up until the early years of this decade, economic growth was characterised by large increases in manufacturing output 45

46 and employment as well as by a large contribution from net exports. However, more recently, labour intensive domestic demand has become the main driver of economic growth. Construction has become much more important to the economy; its contribution as a percentage of GDP is now two and a half times greater than it was ten years ago and this has obviously impacted to a great degree on the sources of tax revenue There has also been a strong surge in the numbers of people employed. A large increase in labour supply has been driven by three main factors: the natural increase in the population entering the working-age cohort; increased labour force participation rates, particularly for females; and considerable inward migration. This shift in the demographic profile has been a positive contributor towards economic growth but also to tax revenue growth. However, these demographic factors have been explicitly controlled for in the forecasts of economic activity and hence in the tax forecasts. For example, income tax is partly driven by increases in employment which is impacted upon by, among other things, the three variables mentioned above: natural increase, increased participation and migration. In recent years our Budget forecasts for employment have tended to underestimate the numbers in work but by retrospectively applying revised macroeconomic variables, including revised employment figures, the impact of this increased employment is controlled for. 46

47 6. Retrospective Forecasting using Alternative Methodologies 6.1 This section of the report gives consideration to the impact of using alternative forecasting methodologies for the following tax heads: stamp duty, VAT, CGT and corporation tax, three of which account for the largest errors in terms of the six main tax heads. 6.2 The buoyancy of the property market including both residential and nonresidential elements has undoubtedly had a positive impact on tax receipts in recent years. From a forecasting point of view it has contributed in large part to the excesses over target of stamp duty and to a lesser extent CGT. Ireland is not alone in this regard. Internationally, buoyant revenues associated with a strong residential property market performance (output and price) in many countries have driven a wedge between overall revenue and the economic cycle. 18 Ireland, where activity in the housing market has been especially buoyant over the period covered by this report, is a case in point. As outlined earlier, stamp duty and CGT receipts together have risen from less than 6 per cent of total tax revenue in 1999 to 15 per cent in 2006 (not all of these developments relate to housing market developments the strength of the commercial property market has also been a large contributory factor). Earlier analysis showed that the RMSE for these tax heads is high and these have contributed in no small part to the overshooting of overall tax revenue in recent years. 6.3 Therefore one of the aims of this chapter is to try to account for the strong property market performance, particularly in the housing sector and adjust for it in the tax forecasts. Housing Market Developments in Ireland ( ) 6.4 The housing market in Ireland has been particularly buoyant over the period in question. Table 6.1 shows for each year the number of new house completions as well as the annual rate of inflation in the new and existing homes sectors. 18 See, for instance, Richard Morris and Ludger Schuknecht Structural balances and revenue windfalls: the role of asset prices revisited, ECB Working Paper

48 Table 6.1 House Completions/Price Developments Completions Price Inflation New Houses New Houses Existing Houses , , , , , , * 80, * 93, Source: Department of Environment, Heritage and Local Government. * For technical reasons, around 5,000 units attributed to 2006 were actually completed in In terms of activity, well over half a million houses have been built over the period, a gross increase of around one-third in the housing stock. While less information is available regarding activity in the existing homes market, other available evidence suggests strong activity in this segment of the market over the period. 6.6 In relation to price trends, house price inflation was particularly dynamic over the period. For new houses, the national average price rose from 125,302 in 1998 to 305,637 last year, resulting in an annual average inflation rate of just under 12 per cent. The national average price of an existing house rose from 134,529 in 1998 to 353,104 last year, resulting in an annual average inflation rate of over 13 per cent. Revenue from the Housing Market 6.7 Developments in the housing market affect tax revenue both directly and indirectly. 6.8 In terms of the direct channels: VAT at the reduced rate (13.5 per cent) is payable on new housing output; Stamp duty is payable on: 48

49 new houses in certain circumstances, for example, when purchased by investors and by the owner-occupiers of large houses; sales of existing homes/second-hand homes. There were exemptions for first-time buyers where the value of the house was below a certain price level and reduced rates for houses above this threshold but the introduction of recent legislation means that first-time buyers no longer pay stamp duty on the purchase of second-hand homes, no matter what the cost. However this is not relevant to the forecasting performance between 1999 and 2006; CGT is payable on disposals of properties, other than principal private residences. 6.9 In terms of indirect effects, new housing output generates labour and investment income (i.e. wages and profits) upon which taxes are levied. The spending of this income generates further tax revenue as well as multiplier effects. In addition, wealth effects arising from higher property prices can affect the consumption patterns of existing homeowners, although evidence of this is limited in Ireland. 19 Furthermore, the savings ratio in Ireland has remained relatively stable in recent years, which lends support to the hypothesis that there has been no real wealth effect. Of course, construction sector companies will also pay corporation tax. In light of the difficulty in estimating indirect effects (as well as their likely magnitude) our analysis concentrates on the direct revenue sources. Stamp Duty - Current Forecasting Approach 6.10 Stamp duty is payable on transactions for which a document is stamped. Receipts emanate predominantly from residential and non-residential property market transactions and equity market transactions also. Other items liable to stamp duty include financial cards such as ATM cards, debit and credit cards and some insurance policies. 19 See, for instance, Nuala O Donnell Housing Wealth and Consumption in Ireland, Central Bank Quarterly Bulletin Number 1,

50 6.11 A priori, in the absence of changes to the regime, stamp duty revenue from residential properties in a particular period should reflect: number and price of new houses sold to investors. Generally, first-time buyers will not pay stamp duty on a new home, where it will be their principal private residence; owner-occupiers will not pay stamp duty if there is a floor certificate and if there is no floor certificate stamp duty will be charged on either the value of the site or on 25 per cent of the price less VAT (whichever is greater). volume of turnover of second-hand homes. price of second-hand homes rate drift GDP is a value added concept the sale of an existing house does not generate value added, with the exception of the solicitor/estate agent fees generated by the sale. This means that it is simply a transfer of ownership of an existing asset. Hence, macro-economic forecasts make no allowance for sales of existing homes. In terms of stamp duty, this lack of a macro-economic driver hampers forecasts of this tax head At present, in the absence of any suitable alternative, the forecast change 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 in the residential property market (both new and existing houses). This is augmented by an (upward) adjustment for the consequential movement into the higher stamp duty bands brought about by the projected increase in house prices, known as rate drift To estimate the impact of "rate drift", details of house purchase transactions which are recorded on Revenue s SDAS 20 computer system for stamp duties are used. The relevant details are the consideration (price), the rate of stamp duty and the amount of stamp duty. Transactions are identified from the most recent 20 The SDAS computer system consists of information obtained on the day a document is presented for stamping. It consists, in effect, of details of the consideration or value of the underlying stamping transaction, whether exemption applies and otherwise the stamp duty amount. 50

51 complete year in a set of price ranges where the consideration lies between the value of each rate threshold and a specific point below the threshold. That point is a consideration value which, if increased by the projected percentage price increase in the macro for new housing, would bring it up to the level of the rate threshold value. The difference between the total stamp duty at the existing rate and the total stamp duty at the new higher rate on these transactions is then calculated. The average rate of stamp duty paid by buyers under existing prices is first established. Then, after increasing these prices by applying the projected macro price increase for the forecast year, the same average rate of stamp duty is applied and the result is scaled up by the ratio of the new higher duty rate (exceeding the threshold) to the existing rate. The difference between the two amounts of stamp duty is the additional yield of stamp duty attributable to "rate drift" at that particular rate threshold. In effect, this is an estimate of an elasticity factor for stamp duty, where price increases drive transactions into different bands For non-residential property, the forecasts are based on the change in the nominal level of other building and construction investment excluding roads These methodologies were used for the first time in the Budget 2006 forecasts. While there was no improvement to the forecasts in 2006 in terms of the forecast error, theoretically, it would appear to make more sense to use this disaggregated approach rather than using nominal GDP as the sole driver of aggregate stamp duty receipts (as had been used up to Budget 2005). - Alternative Forecasting Approach 6.17 The alternative forecasting approach applied in order to retrospectively forecast residential and non-residential stamp duty receipts from 1999 onwards is to use the methodology first adopted in the Budget 2006 forecasts. The results are shown in table 6.2. The analysis shows a significant improvement in the forecasting performance over the period, with the overall RMSE almost halving. Nevertheless, the error remains significant in some years, most notably 2003 and

52 Table 6.2: Alternative Stamp Duty Forecasts Adjusted Outturn 21 Previous Methodology 22 Error % Current/New Methodology Error % m m m ,107 1, , ,227 1, , ,129 1, , ,660 1, , ,081 1, , ,687 2, , ,664 3, , ME = 7.9 ME = 4.6 RMSE = 13.8 RMSE = These results suggest that the economic drivers used in this retrospective analysis, while undoubtedly improving the accuracy of the forecasts, do not fully capture the strength of the property market performance over the period. In all probability, whatever macroeconomic variable had been used to drive stamp duty receipts from the residential and non-residential property markets, it is unlikely that it would have produced much more accurate forecasts given the level of stamp duty receipts coming from property market transactions in recent years. Given the likely return of the housing market to a more steady state in the near future, a sensible approach to forecasting would appear to be a continuation of the methodology introduced in Budget VAT - Current Forecasting Approach 6.19 VAT is payable on new housing at the reduced rate (currently 13.5 per cent). However, under the current forecasting methodology, overall VAT forecasts are based on projections for nominal personal consumption growth, and housing receipts arising from new house sales are not forecast separately. The main shortcoming with this approach is that because the value (comprising both volume and price effects) of new housing output has considerably exceeded the 21 The adjusted outturn figures are the outturn figures adjusted for one-off factors. 22 These are not the original Budget day forecast but rather are the revised forecasts which take account of revised macroeconomic data. 52

53 growth in nominal consumption over the period , ceteris paribus this approach will tend to result in an undershooting of overall VAT receipts. - Alternative Forecasting Approach 6.20 In an attempt to overcome the main short-coming with the current approach to VAT forecasting, the following alternative approach is used. Firstly, the VAT base was separated into new housing and non-housing components. However, this was not straightforward. The 1998 post-budget VAT base contained an estimate of the VAT yield likely to come from building. It was only in 2001 that the post-budget VAT base was broken further into separate components of building and estimates of the receipts likely to come from new housing were given. As a result estimates of the likely yield from new housing had to be constructed for the years prior to 2001 using the 2001 proportionate figures. It was then assumed that the outturn for VAT receipts was broken down in the same proportion as it was in the post-budget VAT base estimates This approach highlights the difficulties involved in getting data on the amount of VAT coming from new housing. While the Post-Budget VAT base supplied by Revenue breaks down the overall Budget target for VAT into yields likely to come from goods subject to the zero, lower (13.5 per cent) and standard (21 per cent) rates, there is no breakdown of actual VAT coming from different sectors of the economy (new housing etc). A detailed breakdown of the actual VAT yield would be most useful in forecasting VAT receipts from new housing New housing VAT is then retrospectively forecast by applying the new house volume and price data from The Department of the Environment, Heritage and Local Government to the previous years estimated VAT receipts from new housing. The non-new housing VAT is retrospectively forecast using nominal consumption as before. The two retrospective figures are then amalgamated to form the overall retrospective VAT forecast which is then compared with the adjusted VAT outturn The results are shown in table 6.3. The results indicate that this alternative forecasting methodology is no better than the current forecasting methodology insofar as the RMSE, at 3.3 per cent, remains the same. The mean error becomes more negative under the alternative methodology, suggesting that had this 53

54 methodology been used, VAT would have undershot (i.e. overly-optimistic forecasts) in four of the eight years in the period. Table 6.3: Alternative VAT Forecasts Adjusted Outturn 23 m Current Methodology 24 m Error % Alternative Methodology m Error % ,194 6, , ,470 7, , ,920 8, , ,885 8, , ,721 9, , ,672 10, , ,089 11, , ,385 12, , ME = 0.1 ME = -1.3 RMSE = 3.3 RMSE = While theoretically it would appear to make more sense to forecast VAT from new house purchases separately, particularly with the housing market likely to reach a more steady-state level in the near future, retrospective analysis shows no improvement in terms of lowering the RMSE. However it is worth noting the improvement in the RMSE in the last three years Therefore the current approach to forecasting VAT receipts should be complemented by this alternative approach whereby the new housing element of VAT is forecast separately. The relative merits of both approaches should be examined on an ongoing basis. Capital Gains Tax 6.26 A priori, CGT revenue from property transactions should reflect: the number of investment properties disposed of over the period in question. 23 The adjusted outturn figures are the outturn figures adjusted for one-off factors 24 These are not the original Budget day forecast but rather are the revised forecasts which take account of revised macroeconomic data. 54

55 the extent of capital appreciation over the period in which the asset was held In terms of CGT, as already mentioned, a number of institutional features make this a particularly difficult tax head to forecast. As with stamp duty receipts, revenue will be affected by the degree of turnover, which is not possible to forecast with accuracy. Moreover, as the actual capital gain is a function of price developments in the period between when the asset is purchased and when it is disposed of; disposals in any particular period will reflect a mix of properties each with different capital gains In the absence of a suitable alternative, receipts from this tax head have been forecast to grow more or less in line with nominal economic growth in recent years with compensating downward adjustments for potential cooling in the property markets CGT receipts do not have as consistent a relationship with economic growth as, for example, income tax or VAT. They are affected by movements in the asset markets (property and shares mostly). Activity in these markets is prone to more pronounced movements in volumes/prices than in the wider economy and is therefore less predictable. Receipts are dependent on the one-off decisions from year to year of numerous individuals and institutions in relation to their investments. The behaviour of these individuals is difficult to predict Even if had been possible to overcome these various difficulties and come up with a methodology which would have forecast the significant year-on-year increases in CGT receipts seen in recent years, it is questionable whether such a technical forecast would have been considered credible. In light of this, no change to the current forecasting methodology is proposed at this time. Corporation Tax - Current Forecasting Approach 6.31 Corporation tax is currently forecast to grow in line with nominal GDP and an elasticity factor which has been 1.0 in recent years. In some of the years prior to 2003, the elasticity factor used was 2.0. There have been a number of important changes to the corporation tax regime over this period, most notably the phased 55

56 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. These changes have made the job of forecasting receipts much more difficult. This is reflected in the large errors for this tax head. However, Ireland is not alone in having difficulties accurately forecasting corporation tax receipts. In the UK 25 for example, the average absolute error of the forecasts made over the period was 7.5 per cent of total corporation tax receipts, a substantial error as noted by the Institute for Fiscal Studies (IFS). Even if growth in corporate profits (the macroeconomic variable used to drive corporation tax in the UK) had been forecast correctly the average absolute error over the period would have been 6.4 per cent of actual corporation tax revenues. - Alternative Forecasting Approach 6.32 As noted above, the proxy used for the corporate tax base in the UK is corporate profits, and so the forecast growth in corporate profits is the input to their model. Therefore it was decided to look at this approach to forecasting corporation tax in an Irish context, using gross operating surplus growth rates from the CSO National Accounts rather than nominal GDP in order to reforecast. 25 Institute for Fiscal Studies (IFS) Working Paper 03/21. 56

57 Table 6.4: Alternative Corporation Tax Forecasts Outturn m Current Methodology Error % Alternative Methodology Error % m m ,441 3, , ,887 4, , ,156 4, , ,803 5, , ,161 5, , ,234 5, , ,688 5, , ,720 6, , ME = -0.2 ME = 3.2 RMSE = 7.5 RMSE = The results in table 6.4 show only a slight improvement in the overall level of forecasting accuracy with the RMSE decreasing to 6.9 per cent from 7.5 per cent. However there are some significant improvements for individual years, most notably in each of the years 2000 to It should be noted that when preparing the Budget forecasts using nominal GDP growth for the years , the elasticity factor used with respect to nominal GDP was 2.0, meaning that for every 1 per cent growth in the level of nominal GDP, it was estimated that receipts from corporation tax would grow by 2 per cent. Under the new methodology where we retrospectively apply gross operating surplus as the driver of receipts, the elasticity factor we used was 1, on the basis that for every 1 per cent growth in profits, corporation tax receipts would increase by 1 per cent. This seems a reasonable assumption in the circumstances, given that corporation tax receipts are based on the profits of companies and not the nominal growth in GDP per se While this approach would have produced more accurate forecasts, particularly in the years , it would be unwise to draw any definitive conclusions regarding the future approach to forecasting corporation tax receipts on the basis 26 The elasticity factor used in the 1999 Budget corporation tax forecast was

58 of an analysis covering a period in which there have been a number of important changes to the corporation tax regime Therefore, similar to the recommendation made with regard to the VAT forecasting methodology, it is recommended that this alternative corporation tax forecasting approach, based on the use of gross operating surplus growth rates as the driver of receipts should be used in conjunction with the current methodology. Summary 6.37 The buoyancy of the property market, particularly the housing market has been partly responsible for the de-coupling of tax revenue growth from nominal GDP growth in Ireland in recent years. This is similar to the experience in some other countries that have also experienced strong housing market dynamics In this analysis, we have considered alternative approaches for forecasting property-related tax revenue and corporation tax revenue also. Purchases of new houses are liable for VAT, and hence developments in new housing output and price should, in principle, affect VAT payments. While the incorporation of these variables into the analysis does not improve the forecast performance and VAT forecasts are subject to the lowest error, once economic errors are controlled for, theoretically it would appear to make more sense to forecast the new housing element of VAT separately. Therefore a complementary approach to VAT forecasting is suggested In terms of stamp duty forecasts, we recommend a continuation of the new approach introduced in Budget 2006, namely the incorporation of new housing output and price forecasts as a loose proxy for developments in the second-hand housing market and the use of projected growth in other building and construction investment excluding roads as the driver of non-residential property market receipts On a cautionary note, it is clear that the property market has been in a transition phase in recent years, with prices and volumes adapting to new equilibrium conditions. Continued double-digit growth in prices and volumes is not sustainable, and the forecasting of revenues from this market warrants a prudent 58

59 approach, as has been implemented in recent years. We are also conscious of recent developments in the property market, where activity appears to have slowed somewhat and prices seem to have stabilised. These developments support the continuation of a cautious approach. Finally, we feel it would be worthwhile to conduct further analysis on these property-related tax heads in the near future, as the market appears to be entering a more equilibrium phase With regard to corporation tax, while the retrospective use of gross operating surplus rather than nominal GDP growth as the driver of corporation tax gave more accurate forecasts, the analysis was confined to a period in which significant structural changes to the corporation tax system have taken place. Therefore, it would be unwise to draw any definite conclusions on the basis of this analysis and so, as with VAT, a complementary approach to the current methodology is suggested Table 6.5 shows the overall results based on these alternative forecasting methodologies for stamp duty, VAT and corporation tax. The overall RMSE declines further, from 4.0 per cent to 3.4 per cent. Chart 2 in Appendix 2 decomposes the forecast error based these alternative forecasting methodologies, into the proportion of the error accounted for by each tax head. Table 6.5: Individual Tax Head Percentage Errors (Alternative Forecasting Methodologies) ME RMSE Income Tax PAYE non PAYE VAT Corporation Tax Excise Duty Stamp Duty CGT CAT Customs Duty Total Total excluding Capital Taxes

60 7. Conclusions 7.1 There has been a significant divergence between forecast tax revenue and the actual tax revenue outturn over the period The overall RMSE is found to be 6.1 per cent of the actual tax revenue outturn over this period. 7.2 Controlling for one-off factors reduces the RMSE slightly, to 5.9 per cent. Controlling further, for economic forecasting error, the underlying RMSE declines to 4.0 per cent. While this is an improvement, the overall error can still be deemed significant. The previous report of the TFMRG found that economic forecasting errors were primarily responsible for the divergence of tax revenues from forecast, however, this conclusion cannot be reached in this report. 7.3 In terms of the main taxes, the largest forecasting errors are to be found in CGT, stamp duty and corporation tax. Even after controlling for once-offs and economic forecast errors, the RMSE for these tax heads remains large, at 30.5 per cent, 13.8 per cent and 7.5 per cent respectively. Retrospective forecasting of VAT, stamp duty and corporation tax using alternative methodologies further reduces the overall RMSE to 3.4 per cent. 7.4 The lack of appropriate economic drivers for stamp duty and CGT coupled with the exceptionally strong performance of the property market in recent years have been large contributory factors in the excess over target of revenue from these sources. 7.5 Attempting to control for the property market performance in producing retrospective forecasts of stamp duty improves the forecast error significantly and so the current approach to forecasting stamp duty, introduced in Budget 2006, is one which should be maintained, particularly as the property market heads towards a more steady-state. 7.6 While VAT has been the best performer in terms of forecast accuracy over the period and while the retrospective use of a disaggregated forecasting approach did not improve the forecasting accuracy, projecting VAT from new housing separately should be done in tandem with the current aggregate forecasting approach going forward. 60

61 7.7 Corporation tax has proved a difficult tax to forecast, not just in Ireland but in other jurisdictions too. In the Irish context, the significant structural changes to the corporation tax regime which have taken place in recent years rate decreases, payment date changes etc have undoubtedly made the task of forecasting more difficult. Retrospectively forecasting corporation tax using gross operating surplus growth rates rather than nominal GDP growth improved the forecasting accuracy slightly. However, as this analysis was carried out over a timeframe in which there have been significant structural changes to this tax head, it is recommended that this approach be used in conjunction with the current methodology. Table 7.1: RMSE under 4 Scenarios Unadjusted Forecast & Adjusted Outturn Adjusted Forecast & Retrospective Forecasts Outturn Outturn Income Tax PAYE non PAYE VAT Corporation Tax Excise Duty Stamp Duty CGT CAT Customs Duty Total Total excluding Capital Taxes [2.7] 61

62 Appendices 62

63 Appendix 1: Long-Run Aggregate Tax Elasticity In the 1998 report of the TFMRG, an econometric evaluation of the relationship between aggregate tax revenue growth and economic growth confirmed the existence of a long-run relationship between GDP and total tax revenue and suggested an elasticity of This means that for every 1 per cent increase in the nominal level of GDP, tax revenues increase by 1.1 per cent. A similar, further econometric evaluation has been carried out by the ESRI in order to ascertain whether the previous estimate of 1.1 is still appropriate. The results of a simple equation regressing total tax revenue on nominal GDP are given below. 28 The equation is estimated over the thirty year period, 1976 to It should be noted that changes in the tax rates that have taken place over the period are not controlled for in the equation. The results imply a long run tax to GDP elasticity of 0.9, which is significantly lower than the European Commission estimate. Estimate of the Aggregate Tax-GDP Elasticity: LOG(Tax) = A1+A2*Log(GDP_Nom) NOB = 30 NOVAR = 3 NCOEF = 3 RANGE: 1976A to 2006A RSQ = CRSQ = F(1/0) = PROB>F = 0 SER = SSR = DW(0) = COND = MAX:HAT = RSTUDENT = DFFITS = COEF ESTIMATE STER TSTAT PROB> T A A AR However estimating this as a single equation over this thirty year period is problematic. The results of a Chow test indicate that there was a break in the relationship around 1988/1989. Furthermore sub-sample estimation indicates that this estimate of 0.9 is biased downwards. Chart 1 shows the share of total tax revenue to 27 This econometric evaluation confirmed the European Commission estimate of 1.1 produced around the time of the 1998 Tax Forecasting Methodology Group Report. 28 The data for total tax revenue are taken from successive Finance Accounts and the GDP data come from the CSO with the estimate for 2006 from the Spring 2007 Quarterly Economic Commentary. 29 The statistical results can be read as follows: RSQ and CRSQ are the R-squared and the corrected R- squared statistics, F(/) is the F-test for the regression and PROB>F is the significance of the F-test, SER gives the standard error of the equation, and DW (O) is the Durban-Watson statistic. 63

64 nominal GDP. Prior to 1988/1989 tax revenue as a per cent of GDP was rising, whereas it has been falling on average since then. Chart 1: Tax Revenue - % of Nominal GDP % 30% 28% 26% 24% 22% 20% There is scope to undertake a detailed piece of work that would incorporate discretionary changes in fiscal policy into the analysis and this would produce a more accurate estimate of the aggregate tax to GDP elasticity. Given that there is a break in the data, estimating the simple equation over a shorter time period seems appropriate. Below are the results from estimating the simple equation over the ten-year period 1996 to The estimated elasticity is and is in line with the previous estimate from the European Commission. 64

65 Estimate of the Aggregate Tax-GDP Elasticity: LOG(Tax) = A1+A2*Log(GDP_Nom) NOB = 10 NOVAR = 3 NCOEF = 3 RANGE: 1996A to 2006A RSQ = CRSQ = F(1/0) = PROB>F = 0 SER = SSR = DW(0) = COND = MAX:HAT = RSTUDENT = DFFITS = COEF ESTIMATE STER TSTAT PROB> T A A AR Chart 2: Actual Aggregate Tax to GDP Elasticity Chart 2 plots the actual annual aggregate tax to GDP elasticity. Over the medium term the elasticity average is 1.1. However it is clear from the graph that the elasticity can deviate significantly from this average in individual years and indeed for periods of years. From the graph, we can see that between 1996 and 2003 the actual elasticity was below the average, while in more recent years it has been above. 65

66 Appendix 2: Composition of Forecasting Errors The tables and charts below show the composition of the forecast error, on: an unadjusted basis; an adjusted outturn basis; an adjusted forecast and adjusted outturn basis; and using the alternative forecasting methodologies It is clear that capital taxes account for a large and, in recent years in particular growing share of the total error. Chart 1: Composition of Forecast Error Adjusted Outturn 10% 5% 0% -5% -10% -15% Income Tax VAT Corporation Tax Excise Capital Taxes Customs Total 66

67 Chart 2: Composition of Forecast Error Alternative Forecasting Methodologies 10% 5% 0% -5% -10% -15% Income Tax VAT Corporation Tax Excise Capital Taxes Customs Total 67

68 Appendix 3: An Examination of Data Revisions in the Quarterly National Accounts Introduction A recent Central Bank technical paper 30 examined data revisions to the Irish Quarterly National Accounts (QNA) that are produced by the Central Statistics Office (CSO). This is relevant for the work of the Tax Forecasting Methodology Group, as tax forecasts are based in large part on forecasts of macro-economic variables. The QNA are revised as more information becomes available, most notably on publication of the annual National Income and Expenditure accounts. Such revisions mean that 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. In order to measure and analyse the extent of revisions, a real-time database was constructed. This database is a snapshot of official data for every period. Data Revisions Data are revised for two reasons if more information becomes available (an informative revision) and/or if there are changes in methodology (an uninformative revision). The former is of most concern as these types of revisions may be predictable. In preparing the QNAs, the CSO rely on a series of monthly and quarterly surveys. The delay or lagged responses to these surveys are partly to blame for subsequent data revisions. Furthermore, the CSO also use annual surveys (Services and Industry), which have considerable lags. Once the results from these surveys are analysed, the QNA are revised. Each QNA contains revisions to the data for the current year (usually the previous three quarters). Once per year, on publication of the NIE, the QNA may be revised for several years into the past. GDP and its expenditure components are subject to the most frequent and largest revisions and are the main focus of the paper. One way to look at data revisions is to compare the initial estimate with its current estimate. A problem with this approach is that the difference between the final and 30 Research Technical Paper 10/RT/06 by Colin Bermingham. 68

69 initial estimate may be small, when positive and negative revisions to the data offset each other. It is more useful, however, to look at the difference between data points in successive releases and calculate the absolute cumulative change. The main statistic used in the paper in examining revisions to GDP growth rate is the final Mean Absolute Revision. Growth Rate Revisions GDP and its components Revisions to growth rates are of most interest, as GDP in nominal terms and hence revisions, increase over time. The paper examines year-on-year growth rates calculated with quarterly data. Table 1: Revisions to Real GDP Growth Rates Revisions Q1 97 Q4 04 Frequency Average Mean Absolute Revision (relative to growth) Range 1 Qtr Horizon % 0.558% (7.4%) -0.91% 2.39% 8 Qtr Horizon % 0.149% (2%) -0.90% 0.77% Final Revision % 1.48% (19.7%) -3.63% 3.17% The first row in Table 1 shows revisions at the one quarter horizon, i.e. how the growth rate in GDP is revised in the quarter following its initial release. Frequency: 0.95 for Q1 - growth rate of GDP is revised in the quarter following its release 95 per cent of the time. Similarly, for Q8, the growth rate is revised 8 quarters following its release 26 per cent of the time. Revisions become less probable through time as expected. The last row shows that all GDP growth rates considered were revised at some point in time. Average: this is the average revision. At Q1 horizon, initial GDP was revised upwards by per cent on average in the quarter following its release. The average revision was found to be positive at most time horizons. Mean Absolute Revision (MAR): the average revision incorporates positive and negative errors, which may offset one another. The MAR overcomes this and is a 69

70 better indicator of the magnitude of revisions. Thus for one quarter, the MAR is per cent. This means that there is a 95 per cent chance that the growth rate of GDP will be revised in the quarter following its release and that the average size of the revision is per cent. In the context of GDP growth over the period (7.5 per cent on average), however, the MAR as a percentage of the average growth rate was 7.4 per cent in the first quarter, which is quite small. The Mean Absolute Final Revision is 1.48 per cent, about 20 per cent of GDP growth over the sample. So on average, the final figure for GDP growth is 1.5 per cent higher or lower than initially published. The same exercise was repeated for the expenditure components of GDP, with the results reported in Table 2. The average revision was again positive. The MAR for the components of GDP was generally larger than for GDP. The MAR for investment at 3.8 per cent, was about 48 per cent of the average growth rate in investment. The range of revisions was also largest for investment. This means that initial estimates of investment need to be treated with caution. In contrast, initial estimates of personal consumption were quite accurate in terms of MAR and also had the smallest range of revisions. Thus we can assume that (initial) indicators for personal consumption are more reliable than for investment (the latter is also quite reliant on annual surveys). From the paper, it is clear that GDP growth has been systematically underestimated in the initial release over the period (a positive bias ). This positive bias may be procyclical but the database is too short to test that hypothesis. Table 2: Revisions to GDP Expenditure Component Growth Rates Revisions Average Average Mean Absolute Range Q1 97 Q4 04 Growth Revision Revision (relative to growth) Consumption % (13%) -1.4% - 1.9% Public Consumption % (36%) -6.7% - 6.7% Investment % (48%) -6.4% - 8.6% Exports % (18%) -1.7% - 6.4% Imports % (31%) -5.9% - 7.8% Conclusion The data in the QNA are subject to revision, which makes any assessment of the current state of the economy uncertain. Using a real time database, the properties of 70

71 GDP and its components were analysed. The final revision to the growth rate of GDP was 1.5 per cent, almost 20 per cent of average GDP growth over the sample. The average revision was positive indicating that initial estimates of GDP tend to be too low. As estimates of tax revenue are primarily based on estimates of economic activity, the fact that economic variables are subject to such large and regular revision adds to the difficulties involved in accurately forecasting tax revenue. 71

72 Appendix 4: ESRI QEC: Tax Revenue Forecasting Model In early 2006 the ESRIs Quarterly Economic Commentary (QEC) team developed a new tax forecasting model for the major tax revenue items 31. The simple model links individual tax revenues to endogenous macroeconomic activity variables via a series of elasticities as follows: Corporation tax is driven by nominal GDP. For 2007 a downward adjustment was made to the forecast due to once-off effects of changes in payment schedules. Income tax is driven by non-agricultural incomes. Income tax data is first adjusted to take account of special investigations receipts and SSIA contributions. Customs are driven by the value of merchandise imports. Excise taxes are driven by volume personal consumption. Stamp duties are sub-divided: Stamp duty from residential property is driven by the value of investment in housing (an indicator of activity in the property market). Stamp duty from non-residential property is driven by the value of investment in building and construction excluding roads. Non-property related stamp duties are driven by the value of personal consumption. VAT is driven by the value of personal consumption. CGT is driven by the nominal value of investment in building and construction. CAT is driven by the value of personal consumption. 31 This was developed with the benefit of expert advice from the Department of Finance. 72