Budget recipe: part prudence, part politics

Economics: Brian Cowen's third budget is awaited with more than usual interest. It is not exactly because his first two set the world on fire and people are anticipating an instalment of financial pyrotechnics, writes Jim O'Leary

In truth, Cowen's budgets to date have been worthy, workmanlike affairs with the fingerprints of cautious officialdom all over them.

No, on this occasion the excitement, such as it is, derives from the fact that the December budget will be one of the last big political acts before the 2007 general election, and observers are curious to see how the apparent tensions between the politically profitable and the economically sensible are resolved.

There is a strong economic case for a tight budget - one which would target a substantial budget surplus. The usual arguments for such a stance are well-known. The economy is growing at a healthy pace and is operating at full capacity. It doesn't need fiscal stimulus and, if given any, will manifest even greater inflationary pressures than are now present.

I must say, I've never found these arguments persuasive given, among other things, the exceptional openness of the Irish economy. However, there are other considerations which apply at this juncture that I believe provide a compelling case for a big surplus.

These have to do with the extraordinary conditions that pertain in the property sector of the economy right now: the frenzied pace of construction activity, particularly house-building, and the dizzying heights to which property prices have been driven.

These extraordinary conditions, which are unlikely to be sustained, have translated into an extraordinary boost to tax revenues. The budget should be based on recognition that this flow of revenues is unlikely to be sustained indefinitely. Accordingly, the Government should target a bigger budget surplus than it would otherwise aim for.

How big would be big enough? The Department of Finance's pre-budget outlook, published two weeks ago, projected a budget surplus amounting to 0.4 per cent of GDP for 2007 on the basis of a 5 per cent growth rate for the economy. The same report helpfully provided an estimate that, as a general rule, every 1 percentage point shortfall in the overall growth rate would cause a deterioration in the budget balance of 0.5 per cent of GDP.

This suggests that things would have to become very bad indeed for the deficit to become unacceptably big. Specifically, these numbers seem to indicate that overall economic growth would have to turn negative to the tune of 2 per cent before Ireland would breach the 3 per cent of GDP deficit ceiling laid down in the EU's Stability and Growth Pact.

On this basis, a budget surplus of around 0.4 per cent of GDP looks more than big enough.

However, this is not the end of the story. In the first instance, as the Department of Finance states in its pre-budget outlook, changes in the composition of growth can "impact significantly" on the general rule referred to above. A slowdown in the economy's overall growth rate driven by a contraction in house-building and/or accompanied by a softening in the residential property market, for example, would lead to a much sharper deterioration in the budgetary arithmetic than indicated by the rule of thumb. In a recent research note, Davy stockbrokers estimated that the budget deficit would reach the Maastricht limit if house prices and the number of houses built both fell by 20 per cent.

There is the additional point that, faced with a slowdown in overall economic activity, a government would like to use fiscal policy as a countervailing measure by increasing spending and/or reducing taxes.

Faced with a serious slowdown in construction activity, a future Irish government might wish to bring forward capital spending on infrastructure, for example. Clearly, its ability to take this sort of step would be severely constrained if the deficit was already in breach of the Stability and Growth Pact.

Looked at in this light, a target budget surplus for 2007 of 0.4 per cent of GDP, in circumstances where GDP is expected to grow by 5 per cent and tax revenues are expected to be greatly boosted by an unsustainable level of activity in the property and construction sectors, would not seem like excessive prudence. Indeed, on prudential grounds, one could more easily justify a significantly bigger surplus than defend a significantly lower one.

What kind of budget-day package would a target surplus of 0.4 per cent of GDP allow? By "budget-day package" I mean the package of measures announced on budget day itself together with whatever adjustments to the "no policy change" spending total for 2007 are made between now and then (principally in the Book of Estimates).

The answer is a package costing about €1.5 billion net or about €2 billion inclusive of so-called "tax buoyancy" effects. On the Richter scale of budget-day generosity, something of this order of magnitude would be rated as moderate rather than earth-shattering. It might actually make for good politics.

There is at least one reason to believe that the Irish electorate will not respond positively to a nakedly giveaway budget, namely their memory of what happened before and after the last general election.

Still, the most fascinating aspect of the December budget from a political point of view will be taxation: how the budget package is divided between spending increases and tax reductions and whether any income-tax reductions take the form of rate cuts rather than increases in credits, allowances and bands.

The PDs, for whom tax is the erogenous zone (as Olivia O'Leary puts it), will be pushing for a budget package tilted decisively towards lower taxes and, presumably, for lower tax rates. Indeed, it could be argued, given how little of note has been done on the tax front since the present administration's term of office began, that these are political imperatives for the PDs. For Fianna Fáil, they are not.

What happens on budget day, therefore, will say much about the distribution of bargaining chips between the two government parties as Election 2007 hoves into view. It might also tell us something about how much longer the marriage between them will last.

Jim O'Leary currently lectures in economics at NUI Maynooth. He can be contacted at jim.oleary@nuim.ie