Dr. Tom McDonnell:

The principal rationale for price indexation is to offset the effect of cost of living increases on quality of life, poverty and deprivation. However, benchmarking the various welfare rates to some defined measure of sufficiency is an important complement to indexation. We need to know whether we are achieving our poverty reduction targets, so some measure is required. As such, we can say that price indexation is merely a proxy for stand-still policy. It might keep living standards at their current levels but it will not improve them. Inflation rates such as the consumer price index, CPI, may actually underestimate increases in the cost of living for lower income households. For example, the current high level of inflation is concentrated in areas like energy, housing and food and disproportionately affects lower income households.

The principal rationale for wage indexation is that it broadly prevents a worsening of income inequality. Crucially, wages generally rise faster than prices, meaning that wage indexation will tend to improve living standards for poorer households over the longer term. The main negative consequence of indexation is the fiscal cost and the opportunity cost. Indexation reduces scope for policy innovation and spending in other areas. The annual fiscal space for net growth of expenditure is linked to the economy's medium-term potential growth rate.

Of course, cost of living issues can be addressed in other ways. It should be noted that indexation of tax and welfare would need to be accompanied by proportional uplifts to legal wage minimums, such as the national minimum wage, as well as to the income thresholds for benefits. Doing so avoids the potential for labour market distortions that may arise. NERI proposes wage indexation as the most appropriate baseline. This could be supplemented with a system of modest and defined annual adjustments that gradually move the individual rates towards an empirically based and politically agreed benchmark for sufficiency that is based on the cost of living for various cohorts. The growth in average weekly or annual earnings is preferable to the growth in average hourly earnings, as it is weekly or annual earnings that determine living standards. On the other hand, if we replace our current ad hocsystem with price indexation, income inequality will rise over time as welfare benefits fail to keep pace with labour income and capital income.

We are not quite convinced, however, that a triple lock based on some arbitrary minimum is a particularly good idea. While the triple lock is an effective indexation link for maintaining and improving living standards, it is also the most costly to the Exchequer, limits policy flexibility and could cause economic distortions if it were to grow faster than wages consistently. I am happy to elaborate on this.

All social protection payments as well as thresholds for access to certain payments, including non-cash benefits, should be given equivalent treatment. Indexation should apply to all payments if it is to apply to any. Similarly, were indexation to be applied, it should be applied equally across all taxes on labour, notwithstanding the need to review the tax system on an ongoing and consistent basis against the core principles of fiscal sustainability, economic efficiency and equity. The issue of sufficiency benchmarking is relevant. Indexing should not replace the ongoing annual process of reviewing the tax and welfare system.

Excise duties, such as those on alcohol and cigarettes, would ideally be incorporated into any indexation system. However, price inflation rather than wage inflation is the appropriate baseline for indexing excise taxes because they are taxed per commodity unit rather than on a percentage basis. If they are not indexed to price, then they will gradually become cheaper relative to other goods. On the other hand, if they are indexed to wages, they will gradually become more expensive relative to other goods. Of course, that may be the policy goal.

The economy is a complex and dynamic system with many moving parts. Projecting often volatile wage and price trends is fraught with difficulty. This is particularly the case for forecasting over a six-to-18-month time horizon. As the committee knows, we are going through a period of very high price volatility on account of an extremely truncated economic cycle. Wage inflation itself can be highly volatile. Weekly earnings grew sharply in 2020 due to the compositional skew of jobs lost during the early period of the pandemic. Therefore, indexing to some assumed price or wage trajectory is problematic, although there are a number of potential workarounds. One way of designing indexation may be to make it backward looking rather than forward looking. This connects the increase in welfare rates and tax bands to actual developments in the economy. For example, weekly wage growth averaged over the four most recent quarters of annual growth could be one of many plausible options. A smoother pattern of growth over time would be generated by including more quarters of data. Alternatively, indexation could be set at a presumed long-run average for wage growth with this value re-estimated every few years. This would add certainty to household budgeting as well as to the public finances.

Sharp increases in inflation would remain a potential problem, but this is equally true of our current ad hocsystem. It is not realistic or desirable to expect an annual budget to be completely flexible and responsive to short-term price swings. Policy stability is important to the perception of the public finances and revaluations should only be triggered in extreme circumstances. In any event, the assumption is that sharp and sustained price increases would eventually be reflected in higher wage growth and, therefore, in the following year's indexation.

Inflationary pressures in particular areas such as energy costs or housing costs, as we are seeing at the moment, could in theory be addressed via changes to the relevant secondary welfare payments or benefit thresholds. However, this should only trigger in unusual cases. Recall that indexation based on wages will, on average, exceed CPI inflation in most years.

NERI anticipates long-run price inflation of close to 2% and long-run wage inflation of close to 3.5%.

Extrapolating from Economic and Social Research Institute, ESRI, estimates for budget 2020 conducted by Tim Callan, Claire Keane and Mark Regan and working on a static pre-pandemic basis for total unemployment suggests that price indexation at an average of 2% would cost close to €750 million of fiscal space per annum and that wage indexation of 3.5% would cost in the region of €1.3 billion.

The Irish Fiscal Advisory Council’s fiscal space calculator indicates that a 1% wage increase raises €181 million from not indexing the tax system. Annual price inflation has averaged 1% over the past three years, while weekly wage growth has averaged close to 4.5% per annum. Indexation in line with wage earnings is sustainable in terms of fiscal space and is fiscally neutral. It reduces policy flexibility but it adds to certainty for household budgeting. Arguably, it also adds to fairness and fiscal certainty because more politically powerful cohorts will have less opportunity to push for special treatment at pre-election budgets. I look forward to engaging with the committee.