Budget needs to strike delicate balance

Brian Cowen's forecasts should address how the Government plans to steer the economy in the leaner medium-term as well as through next year's SSIA and housing boom, writes Marc Coleman, Economics Editor

When he presents his Budget next week, Brian Cowen will be the envy of his colleagues in the European Council of finance ministers.

Ireland's level of debt as a proportion of gross domestic product (GDP), at below 30 per cent, is way below the EU average, and instead of an expected general Government deficit of 1 per cent, the Government is likely to achieve a close to balanced Budget by the end of the year due to strong revenue receipts.

Under the Stability and Growth Pact, the economic assumptions underpinning the Budget have to be clearly stated on Budget day in a document called the Stability Programme.

Thankfully, this part of the pact survived its reform earlier this year and the Stability Programme will tell us how realistic the Government's assumptions are.

Budgetary strategy can go badly wrong if its underlying assumptions are wrong. In preparing its 2002 budget, for instance, the Government was way too ambitious about its income tax forecasts.

Halfway into that year, it suffered a serious revenue shortfall that had to be made up. In the subsequent budget, the Government resorted to increasing VAT, driving inflation up by a further full percentage point, and cutting back badly-needed public investment.

That experience harmed the economy, not to mention the Government's credibility.

The most important budgetary assumption relates to economic growth, and to how it will drive revenue.

The Government's expectations for revenue growth will be produced next Friday in the Budget white paper. Until then, we can get some idea of what is expected from economic forecasts for next year.

A growth figure of 8 per cent for nominal GDP growth - real GDP growth plus inflation - is consistent with the budgetary forecasts for 2006 contained in the so-called Stability Programme, as well as with most contemporary forecasts.

This conservatively implies revenue growth of about 8 per cent, but since last year, growth has become more driven by domestic demand.

Construction activity has caused stamp duty receipts to surge, while strong consumption spending has done the same for VAT.

So, while growth next year will be broadly in line with last year's expectations, it will be more "revenue rich" and we could add another percentage point or two onto the 8 per cent above.

Revenue growth of 10 per cent would seem reasonable.

Now for the spending side of the equation: Two weeks ago, Brian Cowen targeted an increase of 7 per cent in Government spending. This appears to give a three percentage point differential between revenue and spending growth.

With revenue and spending broadly balanced and both equal to about one-third of GDP, Brian Cowen should have about 1 per cent of GDP - about €1.6 billion - at his disposal on Budget day for measures not already outlined in the Estimates.

In reality, much of that money is already earmarked. Some €300 million is likely to go on a new pay agreement with public sector unions when the existing one runs out next summer. Childcare and social welfare measures are further inevitable big ticket items. A figure of €500 million would not be unreasonable for both of these.

In theory, extra capital spending would also be justified. In reality, the Government's inability to fully spend last year's capital envelope means that it will carry forward about €280 million from last year.

There will of course be other additional expenditures. But, assuming that they are balanced by stealth taxation or other budgetary sleight of hand, Cowen should have around €800 million to offer taxpayers.

This is broadly the amount spent on last year's package of tax cuts.

Last year, cuts focused on increasing the employee tax credit and adjusting standard rate bands for taxation.

This year, there are hints of indexing the tax bands and cutting the top rate of tax. The point here is that these are measures of no return.

A once-off increase in a tax band will be eroded within one or two years as wage growth causes more income earners to drift back into the higher tax bands. But indexing bands and cutting tax rates are politically harder to reverse. They are braver decisions to make.

For that reason, it's worth casting an eye over just how solid the Government's assumptions really are.

On the revenue side, it is hard to see any downside risks. One is that the European Central Bank (ECB) is likely to start raising interest rates this week. But this increase is likely to be very modest, one quarter of a per cent, and won't be followed any time soon.

On the upside, the European economy appears to be improving slowly but surely, and with €14 billion worth of SSIAs due to enter the economy towards the end of next year, the Government's revenue forecasts could be exceeded as they were this year, in spite of rate hikes.

And, with tens of billions in personal credit being added to the economy by a housing boom, growth will continue to be revenue rich. The same applies for 2007.

By 2008 however, the housing boom will be winding down and the SSIAs will have gone through the economy like grain through a goose.

Borrowing and SSIAs will have raised the economy to a level of activity that will be hard to beat.

Globalisation will continue to put pressure on a growing array of business and interest rates will, by then, be at least one percentage point higher than they are now.

Fortunately, the Stability Programme requires the Government to predict economic and budgetary outcomes not only for next year, but for a three-year horizon.

Ideally, next week's Budget speech will address how the Government intends to steer its expenditure burden into the post-SSIA and post-housing boom period of 2008 and beyond.

Unfortunately, an election will intervene in 2007. Taking a longer-term view than that is the prerogative of statesmen.