No escaping need for deep and painful cuts

ECONOMICS:Current expenditure on social welfare and public sector pay cannot be sustained, writes JIM O'LEARY

THE MOST important feature of the current fiscal crisis is the fact the greater part of the budget deficit is structural.

We can’t be sure about the exact magnitude of the structural component. Some estimates suggest that about half the overall deficit is structural; others put the share of the structural element as high as 80 per cent. Whatever its precise size, we can be sure that it is pretty big, ranging from 6.5 per cent to 10 per cent of GDP, or from €10 billion to €16 billion.

The structural component is that part of the overall deficit that will not be diminished, much less eliminated, by the resumption of economic growth.

Waiting for it to disappear is not an option. Postponing the act of addressing it will not alleviate the problem. On the contrary, a passive approach will make the problem worse, because delaying corrective action will result in the accumulation of more government debt and increasing interest payments.

The persistent nature of a structural deficit has clear implications for the kind of measures that are appropriate to its elimination. Remember, we are talking here about the need to radically alter the structural balance between Government spending and revenues. This means the corrective measures must be permanent; temporary measures will not cut the mustard.

It follows that, in designing the package of adjustments, Government must be guided by a view of what the appropriate size of the public sector is in the medium term. That view in turn must be based on a recognition that this is an open trading economy for which international competitiveness is absolutely critical.

Taking this approach suggests that the adjustment strategy should be anchored in a judgment about what is a sustainable, medium-term tax burden. There is no iron law of economics here; it is a matter of sensible interpretation of the available evidence.

I addressed this question in my last column, and cited Patrick Honohan’s proposal that we draw on our experience of the late 1990s, a period of healthy, balanced export-driven growth when the tax burden (measured as taxes plus PRSI plus levies relative to GNP) was 35 per cent. The equivalent ratio this year will be 32 per cent, but the tendency for tax receipts to grow faster than GNP, allied to the fact that the full-year effect of the tax increases announced in the October and April budgets has yet to come through, means that the ratio will rise to at least 35 per cent in the medium term without further increases in tax rates or new taxes.

This line of argument is not to rule out a role for tax increases in the adjustment but to suggest that that role be modest.

The structural budget deficit may strike readers as a rarefied technical concept. A useful way of demystifying it is to look on it as a measure of the hole that has been created by the collapse of the bubble economy. The broad outline of the story is familiar. The bubble generated a tidal wave of transitory tax revenues which the Government, succumbing to the obverse of King Canute’s delusion, treated as permanent and used to ratchet up public spending and cut tax rates (mostly the former). The tide of revenues has since receded beyond the horizon, leaving the huge increases in spending that it financed looming starkly in its wake.

The tax hikes of last October and April, incidentally, have substantially clawed back the boom-time tax cuts, albeit the net effect has been to make the system much more progressive.

One of the great populist myths of the recession is that the good times left ordinary folk behind. Analysis of the pace and pattern of public spending growth through the boom years paints a different picture. Between 2000 and 2007, for example, most social welfare payments increased by a cumulative 70 per cent to 90 per cent in cash terms, or by 40 per cent to 60 per cent in real terms. The rate of child benefit for first and second children rose from €54 to €160, equivalent to a real increase of 144 per cent.

Public servants also benefited greatly from fiscal largesse. Recent research by the ESRI indicates that between 2003 and 2006, the margin by which public servants earned more than their private sector equivalents, calculated on a like-for-like basis, increased from 10 per cent to 22 per cent. This huge boost to an already large premium (comparable estimates for other countries are in the range 4-8 per cent) came about on foot of a boom-time benchmarking exercise.

Current levels of expenditure on social welfare and public sector pay are a boom-time legacy. They could only be sustained by boom-time tax revenues. They cannot be sustained by the kind of tax receipts the Government can reasonably expect to garner from the existing system even when the economy returns to full employment, much less the depressed revenue stream of 2009.

Some of the gap can be closed by raising taxes but, for a small open trading economy that must compete vigorously for skilled labour and mobile capital with relatively low tax neighbours, there is a limit to how far we can push things in that direction.

Our own history would suggest that that limit is quite close (perhaps just between one and two percentage points of GNP away).

The unpalatable but inescapable conclusion is that deep and painful cuts in spending are necessary. The hope is that the cuts will not only help to restore order to the public finances but also contribute to improving competitiveness across the economy and sowing the seeds of renewed growth in output and employment.