John FitzGerald: Budget 2020 proposals may not be the right answer

The uncertainty about Brexit is having major consequences for Irish economic policy. Unfortunately, under EU rules, the budget for next year has to be submitted to the Dáil in early October, while we won't know the next twist in the Brexit saga until Halloween. At that point, the UK could choose to leave the EU without a deal.

The appropriate budget for a no-deal Brexit should be rather different from the one we should enact if the decision on Brexit is postponed.

In his Summer Economic Statement, published earlier this week, the Minister for Finance set out the bones of the October budget. What he proposes for next year is mildly stimulatory, due to a planned increase in public investment.

Although the economic statement sets out essentially a single budget package, it comes with two “scenarios” on Brexit.

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Currently the economy is booming and at capacity. If Brexit does not upset the apple cart, this should result in a small government surplus next year of about €1.4 billion, or 0.4 per cent of GDP. However, under a disorderly Brexit, a substantially unchanged budget (aside from additional support for affected sectors) would result in a deficit of between 0.5 per cent and 1.5 per cent of GDP.

Unemployment rise

The shock to our economy from a disorderly Brexit would reduce our national income by about 4 per cent, and lead to a major rise in unemployment. In turn, the loss of tax revenue and the increase in unemployment payments would turn a small budget surplus into a significant deficit next year.

While such a deterioration in the public finances would be very regrettable, it would not require immediate action, although eventually remedial steps would be needed. Should this situation occur, it would be very different in scale from the financial meltdown between 2008 and 2010, when immediate action was required to address the gaping hole in the public finances.

If there is no sudden Brexit shock, the appropriate budgetary response should be to take money out of the economy to reduce demand pressures

While the proposed single budget for all seasons (and for all Brexit scenarios) simplifies things, it must be questioned whether it is the right answer. The economy is still growing very rapidly and has reached capacity, with a fully-employed labour market. In particular, the building and construction sector is having great difficulty delivering necessary infrastructure and making any serious dent in the supply of housing.

Unfortunate

As a result, if there is no sudden Brexit shock, the appropriate budgetary response should be to take money out of the economy to reduce demand pressures. The current plan for the budget – to pump money into building and construction – when the sector cannot build much more, will lead to price rises rather than output increases. This was the situation between 2005 and 2007, and the consequences were unfortunate.

Under these circumstances, if the priority is to increase housebuilding, it would be appropriate to take the steam out of other parts of the building sector. This could be done by cutting the increase in the capital programme from €700 million to €200 million.

In addition, if the economy is growing more rapidly than it can easily deliver, instead of indexing direct taxation to inflation, a better strategy would be a modest increase in taxation. Together with cuts to capital spending, raising tax revenue by €500 million would increase the planned surplus by €1 billion.

On the other hand, if there is a disorderly Brexit at the end of October, the appropriate response would be to temporarily pump up to €1 billion into the economy.

2020 will almost certainly be an election year, something that has often been associated with fiscal profligacy

If the construction sector were badly hit by the downturn, the best approach might be to take advantage of the situation and actually expand the capital programme. A once-off increase in capital spending would be preferable to expanding current expenditure, as it could be readily reversed when that is appropriate.

Restore order

Once the initial effects of any Brexit collapse in growth were addressed, by 2022 we would need to restore order to the public finances.

Two different budgets along these lines, matched to the particular circumstances we may find ourselves in at the end of October, represent the appropriate response to managing the economy. Of course, the outcome might not match those intentions if health spending bursts its budget once again.

2020 will almost certainly be an election year, something that has often been associated with fiscal profligacy. However Brexit plays out, the Minister’s proposed 2020 budget is probably not optimal, but it doesn’t constitute a very imprudent election budget.

Under these circumstances, subject to keeping health spending in check, it could represent the second-best solution to a difficult situation not of Ireland’s making.