Budget 2015: How much leeway is there for tax cuts or spending increases?

Opinion: Increasing investment in key infrastructure projects (such as social housing) and in education would strengthen the country’s balance sheet

The Exchequer figures published this week show that the public finances continue to improve. The budget deficit for 2014 as a whole is on track to come in about €1.5 billion below what the Government estimated in last October’s budget.

This time last year, the Government had thought that budgetary consolidation measures of €2 billion would be needed in 2015 to reduce the budget deficit to below 3 per cent of GDP.

On current trends, the Government may be able to reach that milestone without introducing any new discretionary tax hikes or spending cuts on Budget day. Debate has now turned to the amount of leeway available to the Government for tax cuts or spending increases.

After six years of gruelling fiscal consolidation, during which time households’ tax burdens have increased markedly, it is understandable that politicians would want “to give back something to the people”. At this stage in the political cycle, the temptation to loosen the purse strings is hard to resist.

A closer look at the Exchequer data, however, as well as the lessons learned from our recent experience with boom-and-bust, would caution against prematurely bringing to a halt efforts to restore order to the public finances.

The improvements in the public finances are being driven in large part by increased tax receipts. With the economic recovery gathering momentum, the boost to tax revenues from greater economic activity is likely to be sustained. Of course, as a small open economy, we are very dependent on external developments. The downside risks to growth, especially those stemming from the poor performance of the euro area economy, cannot be ignored. Importantly, however, the public finances are also being buoyed by several factors that appear to be more temporary in nature.

For starters, the current very low level of interest rates on government borrowing has resulted in lower-than-expected spending on servicing the national debt. Though market participants are not anticipating increases in interest rates over the next few years, it is clear that at some stage the cost of refinancing the national debt will have to rise from current historically low levels.

Unexpected capital gains

Similarly, media reports suggest that government receipts are being boosted by unexpected capital gains arising from the ongoing sales by the Central Bank of its holdings of government bonds.

When the Central Bank’s entire stock of bonds has eventually been sold, this source of revenues will disappear.

A key lesson from our recent experience is that governments should save transitory revenues, not use them to increase current spending or cut taxes. A major cause of the crisis in our public finances was that transitory property-related tax receipts during the bubble years were used to reduce the tax burden on households to unsustainably low levels and to finance unsustainable increases in day-to-day government spending.

Successive governments have rebuilt the tax system over the past six years and these efforts are bearing fruit. Measures to broaden the tax base and restore tax rates to pre-bubble levels were not introduced as emergency measures that could safely be reversed when the financial crisis abated. Rather, the focus of tax policy has been to construct a tax system that is capable of raising the resources necessary to pay for essential public services in a normally functioning economy.

Recent data suggest that such a system is now almost fully in place and that rising tax revenues resulting from economic growth will do much of the heavy lifting in the future. It hardly seems wise to begin to deconstruct that system by cutting taxes just because next year’s budget milestone looks achievable.

Moreover, it is not at all clear that households face excessive tax burdens at the moment. For sure, tax burdens have risen significantly since 2008, but such increases were inevitable after the bursting of the property bubble.

Interestingly, data from the OECD show that tax burdens, including the effect of the Universal Social Charge, are no higher today for most workers than they were in the late 1990s; and in fact are lower for most workers with below-average earnings.

That is not to say that the Government should not consider a multi-year programme of tax reforms which would shift the burden of taxation from one area of economic activity to another in a revenue-neutral way.

Taxation on labour

Indeed, studies by economists at the Department of Finance point to potential growth-enhancing effects of a shift from taxation on labour towards consumption or property tax.

Tax reform, however, should not be confused with straight tax cuts. Finally, there are a number of ways to save transitory revenues that the Government could consider.

The Government could simply aim for a lower deficit, and therefore borrow less than currently planned. As a country, we need to reduce our debt levels relative to GDP, so there is considerable merit in this approach. But with long-term borrowing costs below 2 per cent, the difference to the annual interest bill would not be large.

Arguably, a better approach would be to invest these transitory revenues in long-term real economic assets. By doing so, the Government could enhance our economy’s productive capacity.

Increasing investment in key infrastructure projects (such as social housing) and in education (to boost human capital) would actually strengthen the country’s balance sheet, so long as these projects could deliver a return greater than the Government’s borrowing costs of 2 per cent. Given the currently low levels of interest rates, depressed levels of public investment, and brighter economic prospects, finding projects that fit the bill should not be too difficult.

Professor Alan Ahearne is Head of Economics at the National University of Ireland, Galway