Income tax cuts have featured in every budget in recent years, with tax credits increased, USC changes and the rate at which taxpayers enter the higher 40 per cent rate rising. These have been trumpeted by the minister of the day as putting money back in the pockets of taxpayers. And they have, as tax payments would have been higher had this not happened.
But to really understand what is going on and the impact on us all as income taxpayers, we need to take something else into account. And that is inflation and, specifically, the amount that wages rise each year. When we consider the impact of this, the actual burden of income tax has not fallen at all in recent years, despite the annual hoopla.
This makes reports that the Government has not yet provided for an income tax package in next week’s budget all the more important. When wage inflation is counted in, the average tax rate paid by many on their incomes will rise in 2026. It is a tax rise by stealth. Doing this, while at the same time giving a big cash boost to one sector – hospitality – via a VAT cut, and perhaps one to construction too via a cut on VAT on some building projects – is bound to be controversial.
In an analysis this week, the Fiscal Advisory Council pointed out that the full-year €870 million cost of cutting VAT for the entire hospitality sector is equivalent to the cost of increasing the standard rate income tax bands by €3,000 – worth €600 to someone who earns enough to get the full benefit – hiring 11,400 nurses or 7,800 teachers.
RM Block
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Perhaps some money may yet be found for income tax measures. But even if it is, will it be much at all?
For almost a decade after the financial crash there was little enough inflation, and wages for much of the time were pretty flat too. But as inflation has returned, wages have started to rise as well. This is a vital factor in assessing recent income tax changes and understanding what they have really meant.
As wages go up, tax bills change. To some extent this rise is natural. Over time, higher earnings mean people pay more in income tax. But unless tax bands and tax credits are adjusted, people end up paying a bit more of their income in tax each year – in other words the average, or effective, rate of tax on all their earnings creeps higher. This is known in economic jargon as fiscal drag.
What this means in Ireland is the subject of an interesting – and now, it appears, timely – new study from the Central Bank, written by economists Laura Boyd and Tara McIndoe-Calder. They find a few key reasons why not adjusting the system of taxing income – including income tax and USC – can hit taxpayers.
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The most important reason is that not adjusting the tax bands can push people into the income tax net and in particular leave more of their income taxable at the higher 40 per cent tax rate. The second key issue is that not adjusting tax credits – which are effectively cash deductions for taxpayers – means these reliefs are worth less in real, or inflation-adjusted, terms. The third key issue is that the USC bands, like the income tax bands, need to be adjusted to ensure taxpayers do not pay proportionately more at the higher rates.
Looking at budgets since 2019, the researchers find that policy changes have adjusted for about four-fifths of the wage inflation that has taken place. So despite the tax reliefs, the average effective tax rate on incomes has risen from 19.6 per cent in 2019 to 20.2 per cent in 2024.
Had the tax system remained unchanged, however, and there had been no budget changes, the average effective tax rate would have been 22 per cent. Had the system been fully adjusted for inflation, the average effective rate would have risen just slightly to 19.8 per cent (factors such as the proportion of people earning higher incomes also come into play here.)
What this means is that the minister for finance of the day has to change things if the income tax system is not to take a slightly higher amount of income year after year. And over the last few years the changes have almost kept pace with inflation, but not quite.
The same applies to welfare payments, of course, which need to match inflation if people reliant on them are not to lose out in real terms. Or to match wage inflation if they are not to lose ground.
There have been arguments over the years that Irish budgets should be automatically “indexed” for inflation – with the tax and welfare systems adjusting – as happens in some other countries. However, for reasons of flexibility – and no doubt for political reasons, too – Irish governments have never gone down this route. It would change the dynamic of budget day, as not indexing tax and welfare would then be a conscious choice.
Now reports suggest that a relatively small budget tax package of €1.5 billion will leave little or no room for income tax and USC changes this year. We will have to see if money is found over the weekend in final negotiations to provide some kind of personal tax package. However, it looks most unlikely that Minister for Finance Paschal Donohoe will find the €1.17 billion necessary – on Department of Finance estimates – to fully index the income tax and USC systems for wage inflation of any expected 4.5 per cent in 2026. Were Donohoe to find €780 million, he could adjust the system for wage inflation of 3 per cent, limiting most of the damage.
If there is no income tax package, however, and credits and bands remain where they are, then fiscal drag will be back with a bang in 2026.
Not indexing the system – and particularly not changing tax credits – has the biggest proportional impact on lower earners who pay tax. While the lowest earners have no income tax liability, those in the lower- to middle-earning group are particularly affected if tax credits are not adjusted.
At higher income levels, non-adjustment of the level at which earners enter the higher 40 per cent tax rate – currently €44,000 for a single employee and €53,000 for a married couple with one earner – is the biggest issue. If these are not adjusted, then more income will be taxed at the higher rate. And a particular issue for the self-employed is the 3 per cent additional USC charge that applies on incomes more than €100,000.
If there is no personal tax package in the budget, or something with just a few minor tweaks, and no once-off cost-of-living package, the gains for households are going to be slashed. The tax and cost-of-living measures in Budget 2025 delivered some €1,000 to single people on average incomes and well more than €2,000 to many families, and more to those with three or more children. If this number falls close to zero in this budget, then households will notice.
Budget 2026 will, we are told, focus on permanent supports in areas such as childcare. But the absence of a personal tax package would be a big political decision by the Coalition. Although it will be presented as a standstill, what it means is the income tax burden will creep higher next year.
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