Government right to alter spending plans but must avoid fuelling inflation

Summer Economic Statement signals additional outgoings and tax measures in budget due to surplus

One year in and the Government’s new 5 per cent spending rule, the one that was meant to usher in a new era of budgetary discipline and transparency, is out the window.

The €6.7 billion budgetary package flagged in Monday’s Summer Economic Statement breaches the rule adopted just 12 months ago, while the additional tax measures signalled also go back on prior commitments.

The statement suggests Government spending in Budget 2023 will rise by approximately 6.5 per cent – in actual money terms that’s about €5.3 billion – €1.3 billion over what the Government had originally planned for. Tax measures of €1 billion are also double what was originally intended.

Inflation and the cost-of-living squeeze has altered the financial landscape. Household budgets are fraying and the Government is under intense political pressure to act. But is the Government justified in jettisoning this new spending discipline in the face of higher prices? Yes. In fact, the additional spending is relatively modest in the circumstances.

Within the original 5 per cent spending rule there are two basic and perhaps overly simple assumptions, namely that the long-run growth potential of the Irish economy is 3 per cent and that inflation will average about 2 per cent. (3+2=5)

The latter part of this equation blew up a while back in the face of soaring commodity and energy prices. Inflation in Ireland is now running at 8-9 per cent depending on the gauge you look at.

These higher prices are, however, flowing into the exchequer in the form of higher VAT receipts. Wages are also rising, delivering higher income tax receipts as employment returns to pre-pandemic levels.

Exchequer returns for June, published on Monday, indicate the Government collected almost €37 billion in taxes for the six months to the end of June, up 25 per cent or €7.4 billion on the same period last year, on the back of strong income and VAT receipts.

The Government can rightly claim that it is merely pushing what is a step change in price growth and employment back out into the economy in the form of higher spending.

The budgetary arithmetic is also being nursed along by record corporation tax receipts, which will deliver a budget surplus this year, way sooner than expected after the financial outlay on pandemic supports.

However, this is where things get tricky. Providing households with greater spending power during an inflationary surge can be self-defeating for obvious reasons. If the measures aren’t targeted they’ll add fuel to the inflationary fire.

Take the €200 energy credit (another one is being considered). Because of its indiscriminatory nature the bulk of the expenditure goes to relatively well-off households – those that can afford to pay the higher energy prices – allowing them spending more that they otherwise would have on other goods and services in the economy.

A further move on excise duty on fuel will have the same effect.

We can do nothing about higher energy costs as we’re a net importer of energy. However, we must try and limit inflation spilling over into higher prices in other areas – what economist calls second round effects – which can have corrosive and long-lasting effects.

Part of this is unavoidable as businesses use energy too and higher prices, particularly in the area of food, reflect that, but the Government doesn’t need to add to these second round effects by placing more money in middle and higher-income households.

That might seem harsh – particularly in the context of the squeezed middle-income households – but higher energy prices are now a fact of life. And the public finances, already strained in the wake of Covid, can’t be deployed to counteract international price surges.

The hawks in the European Central Bank are closely monitoring the price gauges that exclude energy to assess these spillover effects, particularly on earnings, as they will ultimately determine how embedded in the economy price growth becomes.

The Economic and Social Research Institute (ESRI) recently calculated that prices here, excluding energy and food, are now rising by over 4 per cent. This is elevated in the context of recent years.

Other budgetary measures on the table, including permanent and once-off welfare measures, are more targeted as the households involved are effectively means tested.

It’s a delicate balancing act for the Government, made worse by the political noise that now surrounds inflation.