John FitzGerald: Budget adds fuel to fast-growing economy

When the economy is growing too quickly, as in the boom years before 2008, the budget should raise taxes and cut expenditure to slow the economy to a safe speed. When the economy is underperforming, and if the resources are there, the budget should support demand by cutting taxes and increasing expenditure. (Unfortunately, in the Great Recession, the resources were not there to provide such support.)

While most of the focus of budget commentary tends to be on which individuals or groups gain or lose, it is important to consider how appropriate the budget was for the needs of an economy that is growing rapidly but is also facing significant risks.

In a normal or “neutral” budget, designed to leave growth in the economy unaffected, the average tax take would remain unchanged and the level of services would also remain unchanged. True neutrality may require some growth in spending in order to maintain public services for a rising population, and to keep welfare payments abreast of inflation.

My assessment is that the budget last Tuesday added to demand by pumping an additional €900 million into the economy, or about 0.3 per cent of gross domestic product. Even after deducting the increase in European Union budgetary contributions, which don’t affect domestic demand, the injection was about €700 million.

In the context of a rapidly growing economy, this was €700 million too much and it probably also involved a marginal breach of fiscal rules.

In the history of Irish fiscal policy this is a rather limited breach and, rather like a driver who exceeds the speed limit by 3km/h, it won’t attract a fine. However, breaking the rules, even by a small amount, is a bad idea: with the risks facing the economy, a more prudent approach would have been preferable.

Improved services

The significant real improvement in services in the budget came in four areas: a real increase in welfare payments; improved childcare provision; increased provision for energy efficiency; and increased investment in housing.

I welcome these improvements in services but it would have been preferable to have funded them through slightly higher tax levels, reducing the pressure on domestic growth.

However, I have serious reservations about the first-time buyers’ tax refund, which will pump €50 million into a market in short supply – that will only bump up house prices.

One important aspect of Budget 2017 is that the carryover effects of the decisions made will significantly affect 2018. Because of delayed implementation, the cost of the improved services in 2018 will be an additional €500 million over the cost in 2017.

The tax changes will also have knock-on effects for 2018. This will leave even less room in 2018 for improving services or cutting taxes than was available in this budget. While the political problems in delivering Budget 2017 were significant, negotiations on Budget 2018 may be even more troublesome.

Economic risks

Ireland’s fiscal policy should take account of the substantial economic risks Ireland faces over the next few years. As a result, it is essential that fiscal discipline is imposed on expenditure in 2017, in contrast to this year, and that spending, in particular on health, must stay within budget.

The revenue from corporation tax is potentially very volatile. Future years could see a sudden drop, which might require urgent fiscal tightening at just the wrong time. However, in forecasting corporation tax revenue for 2017 the budget is very cautious. If, as looks possible, corporation tax revenue significantly exceeds expectations, the surplus should go to start the “rainy day” fund.

Brexit is going to make life very difficult, in particular for Irish-owned firms supplying the UK market. But their major competitive advantage compared with UK firms is their continued access to the huge EU market.

The answer is not to introduce UK-style tax arrangements to mitigate the impact, but to foster the changes needed to thrive in the new scenario. These firms need encouragement to develop new EU markets and adapt their products to continental tastes – the Irish pizza bought in Asda in Brighton won’t sell in Carrefour in Bordeaux.

Finally, there is a possibility that we will see a surge in building activity by 2018, providing essential houses and related infrastructure. In that event, to avoid overheating the economy, the 2018 budget will need to make space for this necessary investment by suppressing demand elsewhere through increased taxation.

Such a scenario might be the most difficult of all for the Minister for Finance next autumn.