Budget 2018: Tax cuts risk overheating economy

The Economic and Social Research Institute has warned the Government against cutting taxes while the economy is growing so strongly.

In a blunt warning contained in its latest quarterly review of the economy, the think tank said there was no good reason to further stimulate consumption through tax cuts and that such measures risked overheating the economy as it converged on full employment.

However, the institute stopped short of criticising the Government’s proposed budgetary adjustment for next year, which is likely to include cuts to income tax when unveiled on Tuesday, noting the overall package was in line with a neutral fiscal policy.

“With respect to the forthcoming budget, the key challenge for the Government is how to transition the economy from one enjoying elevated rates of economic growth into a more stable period of sustainable activity over the medium term,” the ESRI’s Kieran McQuinn said.

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In its report, the institute upgraded its growth forecasts for the Irish economy, citing the strong performance of the labour market and the related growth in consumption. It is now projecting that the economy will grow 5 per cent in gross domestic product terms this year, and by 4 per cent in 2018.

“Given the pace of growth over the past number of years, there is certainly no case for the Government to stimulate economic activity with the budgetary package,” its report warned.

If such accelerated growth continues, the Government may soon need to consider removing money from the economy by raising taxes, it said.

Infrastructural deficits

Prof McQuinn said the situation was complicated by the need to increase capital spending to address some of the infrastructural deficits in housing, education and health.

“It’s a balancing act between, on the one hand, recognising the infrastructure deficits that are clearly there, and ensuring that we are spending the money wisely and prudently in areas where we absolutely need investment,” he said.

The Government is on course to increase capital spending on infrastructure to €7.8 billion by 2021, which would be nearly double what it was in 2014.

“If you do want to really ratchet up investment or capital expenditure, there may be a need to raise personal taxation rates as a way of offsetting the overheating issues of the economy,” Prof McQuinn said.

However, he acknowledged that raising personal taxes would be a difficult sell for the Government.

Housing crisis

The ESRI’s latest report predicted unemployment would fall to just over 5 per cent by the end of next year, its lowest rate in more than 10 years, and a rate that the ESRI considers consistent with full employment.

On the housing crisis, the institute estimated that up to 35,000 units were needed each year to keep up with demand due to demographics and market fundamentals.

While acknowledging the Government's official housing supply statistics, which are based on ESB connections, were most likely overestimating supply, it noted that building activity was finally beginning to respond to increased demand.

It warned that the recent jump in new mortgage lending and the increased average loan size warranted careful monitoring and that such concerns should militate against any easing of the Central Bank’s mortgage lending rules.

In terms of the external environment, and notwithstanding the uncertainty posed by Brexit and changes to the US tax code, it said it expected Irish exports to continue to grow this year and next year.