The Dynamics of Policy Bubbles: Explaining Irish Tax Policy

At times policies whose initial implementation delivers a positive return for society become more popular and over-supplied. Voters overvalue the policies and politicians oversupply them, either for the same reasons or because that the expected electoral return on supplying these policies is high. We argue that policy bubbles work in quite different settings to asset bubbles. Like Grossman (2013) and McCarty et al. (2014) we see irrationality (or more correctly bounded-rationality), ideology, institutional frameworks, and interest group politics as important drivers of policy supply and constraints on policy change. Furthermore it is possible that these reinforce each other, and could be that they must reinforce each other for policy bubbles to inflate. We will closely examine one case of dynamic policy making, looking at the changing structure of the Irish tax system over a 20 year period (1987-2007). We will calculate at what stage tax changes ceased to yield sustainable gains to the economy and started to present a risk to the public finances. We study a sample of the relevant advice given to governments by various groups such as the IMF, the European Commission, the OECD and domestic bodies. We will then derive qualitative values for the four variables and estimate to what extent each influenced the policy to continue to offer lower tax rates well after it ceased to offer returns in terms of positive economic outcomes and then contributed to the crisis Ireland experienced from 2008. This paper will contribute by offering a nuanced theoretical discussion of the variables that contribute to policy bubbles. We will discuss the extent to which the analogy to markets is helpful and where it is not. The paper will also offer a useful test case for the causes of policy bubbles, which should help the development of more systematic empirical tests.