IN ECONOMIC policy, the difference between the 'first-best' and the 'secondbest' solutions to any problem is that the latter is a politically feasible, and thus less effective, version of the former.
It is precisely this distinction that prompted Milton Friedman to remark, "I am in favour of cutting taxes under any circumstances and for any excuse, for any reason, whenever it's possible".
When on Wednesday, finance minister Brian Cowen released a survey on the effectiveness of the Business Expansion Scheme (BES), he inadvertently proved that (a) any tax cut is better than none, (b) targeted tax cuts are only second-best to a wholesale cut in the state's claim on our income and wealth, and (c) Irish trade unions will oppose any policy that does not line the pockets of their members.
BES, and its sister programme the Seed Capital Scheme (SCS), were set up to allow firms to raise capital by giving investors a tax break on their funding. The amounts involved are small. In the latest budget, Cowen doubled the ceiling on how much any firm can raise under the BES scheme to Euro2m. The limit on the tax-deductible contribution by any single investor went up to Euro100,000; 75% of the firms participating in BES raised less than Euro500,000. According to the estimates, the total cost of both schemes to the exchequer is expected to be around Euro25m in 2007. This equates to the advertising budget for a handful of quangos, or paying the public sector wage bill for just four hours.
Despite its small scale, the scheme has been productive in helping young businesses. A third of the companies using BES were start-ups, 70% were less than 10 years old and two-thirds had sales of less than Euro1m per annum. The majority of the funds were used to launch new services, hire staff and grow the business. Many firms were able to improve their capital investment and carry out R&D. Some of this funding supports high value-added activities and enhances our exporting capabilities.
Using figures provided in the survey, the exchequer's take from new businesses arising from BES and SCS should be Euro3m-5m a year more than the cost of these tax breaks. This does not account for added payroll tax and income tax revenues, suggesting that BES pays for all parties involved, including the taxpayers.
However, by setting the limits on how much can be invested through BES - a politically-motivated restriction to reduce BES's value to wealthy investors - the scheme incentivises some inefficiency. As the survey revealed, 58% of companies using BES were in manufacturing, 22% in international services and 12% in tourism.
Optimally, the share of investment in any industry should be roughly proportional to the total value added by the sector. Under this principle, we should see roughly 50% of all investment going to internationally traded services, 30% to high value-added domestic services and no more than 20% to manufacturing. Targeted to help smaller companies, BES produced the opposite results, effectively subsidising declining manufacturing.
The final lesson to be learned from the BES experience concerns unions.
Following the budget publication, the Irish Congress of Trade Unions (ICTU) went on the record claiming that BES was ineffective because the number of manufacturing companies using BES was declining over time. ICTU also accused BES of favouring investment in property and benefiting only rich investors.
The survey soundly dispelled the last two allegations. In contrast, the first one is a half-baked truth. As mentioned above, the share of manufacturing firms amongst BES participants is already inefficiently high. In 1988, 20.2% of the Irish labour force worked in industry. By the end of 2006, this figure has fallen to 14.3%.
Why would ICTU want to measure the scheme's effectiveness by its ability to beef up naturally declining sectors?
Was it because most of its private sector membership comes from these industries? After all, in the past, ICTU never opposed the lavish subsidies given by the state to public enterprise at the expense of taxpayers. Nor does ICTU oppose the exuberant wage bills and benefits paid in our semi-state companies as they rip off ordinary consumers.
Last week, the government once again proved that even the second-best targeted tax breaks work. From this point on, Cowen should build the case for general, across-the-board tax reforms in his next budget. Let's make all investments - whether in physical or human capital - tax-deductible, without any limit on the amount spent. ICTU will, no doubt, disagree. But in the end we all will be richer for it.
Dr Constantin Gurdgiev is an economist and the editor of Business&Finance magazine www. businessandfinance. ie
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