The European Commission has advised the Government against abolishing the universal social charge (USC) and warned very high personal income tax rates may have to be imposed in its place.

The commission’s latest post-programme surveillance report has outlined a number of risks to the Irish economy including a stark warning it is in danger of overheating and its budgetary stance is “likely to be pro-cyclical”.

The report dated June 23rd, which was given to the Oireachtas committee on finance and which has been seen by The Irish Times, criticises decisions taken by the Government in Budget 2017 including the introduction of a help-to-buy scheme and increasing the earned income tax credit.

The measures narrowed the tax base and have the potential to exacerbate the risks to long-term revenue stability, the commission states.

It instead proposes maintaining the USC, eliminating reduced VAT rates applicable to the hospitality sector or increasing property tax revenues.

“Increasing revenue from environmental and property taxation, and eliminating reduced VAT rates could, in addition to broadening the tax base, help rebalancing the tax mix, while enhancing the growth and environmental friendless of the tax system.”

Progressive tax

On the issue of the USC, the commission says it is a highly progressive tax and removing the levy comes with a cost.

The Government must now outline how it intends to generate revenue and “maintain progressivity without imposing very high and distortionary marginal personal income tax rates”, it adds.

The report also questions policy decisions taken in the area of housing, suggesting the help-to-buy scheme has stimulated demand in an environment of “inelastic supply” and it states the rent pressure zones have been “counterproductive”.

On the issue of water charges, the commission expresses concern at the fiscal implications of the decision to abolish the levies. It states €240 million has been lost due to their ongoing suspension and there is no clarity on how the money paid will be refunded.

The commission does not offer any position on whether the recommendations of the Oireachtas committee on water charges meets the Water Framework Directive and will not make a statement on such until legislation has been introduced to enforce the measures.

On the overall economic picture, the commission states Ireland may breach European Union fiscal rules this year due to a significant deviation from the required adjustment path over 2016 and 2017.

The Government has exceeded the expenditure benchmark by a wide margin last year and has indicated a departure from agreed measures, it adds.

In the area of taxation the commission expresses concern on the State’s increasing reliance on corporate tax for total revenue saying it poses a risk to Ireland’s public finances. Corporate tax makes up 15 per cent in tax receipts.

Possible changes to the tax system in the United States present a considerable risk to the Irish economy, the report adds.

The commission and the European Central Bank visited Ireland in May to conduct the seventh post-programme surveillance review mission. Their report is designed to assess Ireland’s capacity to repay loans granted by the troika.

The outlook for the economy remains bright but external risks are significant most notably the outcome of the Brexit negotiations, it states.

It outlines its support for the rainy day fund, an initiative proposed by former minister for finance Michael Noonan.

Taoiseach Leo Varadkar is to use his first budgetary set piece to recommit to his Government maintaining a “rainy-day fund”.

Minister for Finance Paschal Donohoe is set to outline the summer economic statement, which will mark the beginning of the budgetary process, in the coming weeks.

Mr Varadkar will outline he will allocate at least €1 billion extra towards infrastructural spending and projects such as the Dublin Metro, the M20 motorway between Cork and Limerick and motorways to the north and northwest of the country are going to be funded.