International groups want to see restraint

Since the start of the year Irish budgetary policy has become a matter of global interest. A procession of eminent international organisations, including the IMF, the OECD, the European Commission and the newly-founded European Central Bank, has lined up to warn the Government that the economy is growing too fast. Concerned the fall in interest rates that must occur by next January will exacerbate risks of overheating, the almost universal advice has been to tighten fiscal policy by way of offset.

Superficially, this advice seems sensible, even if the Government is now running a large and growing surplus, but it raises a number of fundamental issues. In a small open economy like Ireland, because of the overwhelming weight of international trade in activity, varying the size of the budget surplus or deficit has a correspondingly small effect on output. So to significantly alter the level of output, the change in the budget surplus/deficit would have to be very large. So a very large increase in the budget surplus (over and above the increase that would occur because of the buoyancy of tax receipts) would be needed, in order to bring about a material slowdown in the economy.

Let us assume that, undeterred by this, the Government attempted to tighten fiscal policy anyway. This could be effected in two ways: by raising taxes or cutting expenditure.

It is surely the case that cuts in current spending are politically infeasible. At a time of unprecedentedly rapid growth in living standards, it cannot seriously be proposed that public servants or social welfare recipients should accept reductions in theirs. And it is entirely legitimate for the citizens of the State to expect some improvement in the quality of public services. If cuts in current spending are infeasible then we are left with cuts in capital spending and/or tax increases as the available instruments for fiscal tightening. But these are issues that go to the very heart of the Celtic Tiger's continued vibrancy.

An adequate supply of labour and capital is necessary for the growth of any economy. Critical to the outstanding performance of the Irish economy over the past decade has been the rapid growth of labour supply and investment. It is also on these two fronts that the greatest threats to that performance are now looming.

The Republic's infrastructure is creaking under the pressure of the rapid expansion in economic activity. There is a clear need for a programme of accelerated investment across a wide range of infrastructural services. The scale of investment required is unlikely to be accomplished without increasing the Public Capital Programme.

The situation in the labour market represents another serious threat to the maintenance of healthy growth rates. Wage inflation has started to accelerate, most notably in the construction sector. The reason is clear: the supply of workers is simply not keeping pace with demand at existing rates of pay. Left unchecked, this process will erode the competitiveness of Irish producers, undermine Ireland's attractiveness as a location for overseas firms and drag the economy's growth rate down to the tortoise-like pace of mainland Europe or below.

If we want to avert that prospect, economic policy must be designed to encourage greater numbers to enter the labour force. One means of providing that encouragement is to cut taxes on income. That way the returns from employment in Ireland are raised relative to the returns from employment abroad, and the incentive to stay in Ireland in the case of intending emigrants, or to return to Ireland in the case of people who have previously emigrated, is increased. Likewise, the incentive to seek paid employment instead of working in the home (the choice that faces most married women), or to choose paid employment instead of remaining on the dole, is increased.

Of course, tax cuts increase disposable income and almost certainly raise consumer spending. But this should occasion no more than mild concern. The bulk of the rise in consumer spending will be reflected in rising imports, and any increased pressure on domestic productive capacity is likely to be modest. That being the case, the cost in terms of exacerbating the risk of the economy overheating is likely to be small and must be set against the benefits of stimulating the growth in the supply of labour that the economy needs if the current expansion is to be sustained.

Jim O'Leary is chief economist at Davy stockbrokers. Dr Gerry Boyle is a senior lecturer in the economics department at NUI Maynooth.