Subscriber OnlyEconomy

Budget 2021: Ireland faces five big economic challenges

Covid-19 and Brexit form a bleak backdrop to plans for Government spending next year

Minister for Finance Paschal Donohoe will probably never frame a budget against a more uncertain backdrop. Covid-19 has caused an economic shock three times worse than the 2008 financial crisis, one that will reverberate for months, perhaps years, to come. With recovery tied to an epidemiology which no one can predict, governments are reduced to feeling their way in the dark.

If that wasn't bad enough, Ireland is facing the very real prospect of a no-deal Brexit with both sides seemingly entrenched in mutually opposed positions on state aid and fisheries.

This could place the State’s largest European trading partner behind a wall of tariffs with extremely negative implications here, especially for the food industry.

According to a report published this week by the London School of Economics, up to one-third of the State’s food exports could be knocked out if the EU and the UK fail to reach a deal.

Twelve months ago, the Minister was presiding over the fastest growing economy in Europe and budgetary surplus. Now he's looking at an economy sliding into recession and a budget deficit that could hit €30 billion before the year is out.

In a strange way, the scale of the crises facing the State makes Budget 2021 less complicated than its predecessors. The Covid-19 and Brexit emergencies give Donohoe a ready-made excuse to lower expectations both inside Leinster House and among the wider public.

The clamour for giveaways or the imposition of unpopular cuts, the things that typically make budgets difficult and controversial, are largely absent as are the financial constraints imposed by the EU’s spending rules, which were suspended in March.

Changes to income tax are already off the agenda while most of the additional spending will be taken up by the pandemic or is already committed under the National Development Plan (NDP). This is not to say there aren't challenges and big ones at that, such as keeping a rein on spending in a crisis while maintaining vital supports and public services.

Here are five of the big economic issues the Minister must juggle as he tries to frame Budget 2021 on Tuesday week.

1 - The deficit – how big can we go?

Until the coronavirus crisis hit, there had been a concerted drive by governments to balance their budgets. German-like fiscal discipline was the prevailing orthodoxy, a hangover from Europe’s sovereign debt crisis. That’s all out the window now with spending on Covid-related supports soaring and tax revenues crumbling.

The Government’s budget deficit is expected to be close to €30 billion this year, equivalent to 10 per cent of gross domestic product (GDP). That’s back to where we were during the financial crisis.

There’s a big difference, however. Back then, there was a structural imbalance between tax revenue and public spending, one that had to be rectified by a long and arduous programme of cost-cutting. By contrast, the Covid drag on the exchequer is expected to be temporary.

Nonetheless it involves adding more debt to an already heavily indebted balance sheet – the national debt is expected to hit €250 billion this year, equating to nearly €50,000 for every man, woman and child in the State.

How big can the deficit be before the markets get spooked and start seeing debt-heavy states such as Ireland and Italy as a bad bet? Judging by the National Treasury Management Agency's (NTMA) recent oversubscribed bond auctions and the fact that the State is borrowing at interest rates of less than 1 per cent, we're nowhere near that point.

This could change, and change rapidly. Historical precedence tells us that. The big fear is that, with everyone borrowing heavily, something will have to give.

Borrowing related to the pandemic will be in order of €20 billion this year and Donohoe has already signalled the State will need an additional €15 billion-€19 billion next year.

“Gauging the international winds is key,” says KBC Bank economist Austin Hughes, “trying to make sure that your fiscal policy is seen to be prudent, not a blowout, that the spending is surgical.” Donohoe says he wants to position Ireland in the middle of the pack in terms of borrowing so as not to be viewed as the weakest link in the event of another debt crisis.

2 - Wage supports – avoiding a cliff edge

After the 2008 financial crisis, the State was forced into a massive austerity drive to rectify imbalances in the public accounts, one which aggravated the downturn. Economists typically want fiscal policy – the Government’s tax and spending measures – to be counter-cyclical, in other words to pull against the prevailing cycle. In practice, this means spending in a downturn and cutting back in a boom.

In the past, Irish governments have tended to do the opposite, exaggerating upswings and compounding recessions, leading to a corrosive series of boom and busts. This time, it is different. The Government has stepped in and effectively nationalised part of the private sector wage bill via the wage support scheme, filling the gap in private sector demand that would have ensued from workers not getting paid and businesses collapsing.

This has cushioned us from the full extent of the shock. And while it has led to eye-watering deficit figures on the Government’s ledger, the economy has a better chance of returning to a normal growth path quicker, which will in turn bring down the deficit faster.

The question for Donohoe is how long can he maintain it and can he exit the scheme without inflating unemployment.

The UK’s decision to withdraw the bulk of its wage supports in October means the economy there is facing something of a cliff edge. The Government here is keen to avoid this and has pledged to operate its scheme – the Employment Wage Subsidy Scheme (EWSS), which currently supports 350,000 workers – until the end of March next year, albeit on less generous terms and stricter qualifying criteria.

The scheme is expected to cost at least €2.25 billion for the seven months between September and the end of March. Donohoe may use Budget 2021 to signal even more restrictive criteria and a further tapering of supports or, possibly, how he plans to extend the scheme after March.

This gets into the emotive area of saving viable firms versus jettisoning what are seen as non-viable businesses and where that line is drawn.

3 - Housing, health and the green economy

It’s obvious to anyone living in Ireland that public services and infrastructure have not kept pace with private sector growth. Everywhere you look, there are bottlenecks, none more so than in housing, health and transport. It’s what economist JK Galbraith used to refer to as “private affluence and public squalor”.

A key challenge for Donohoe is to sustain public sector investment in these areas while dealing with the current crisis. This is perhaps the trickiest of all the tasks he faces.

The National Development Plan, which runs to 2027, commits the Government to spending €116 billion on developing strategic infrastructure and transitioning to a green economy. The plan includes a €2 billion Dart interconnector (or Dart underground) project and the Metro North project, both seen as key to alleviating transport congestion in the capital.

The capital budget was €7.3 billion in 2019 and €8.1 billion in 2020, an increase of just over 10 per cent. Minister for Public Expenditure Michael McGrath has already signalled that capital expenditure will be €9.1 billion next year, effectively committing the Government to a further 10 per cent hike.

“Covid and Brexit have distracted from climate challenge and other long-term issues around infrastructure and housing as debated in the general election in February,” Ibec’s Fergal O’Brien says.

O’Brien believes the Government needs to develop a more sophisticated public-private partnership model to address the State’s infrastructural deficit.

It would also be good to see some innovative thinking on how the €10 billion increase in savings by Irish households since March can be unlocked to support the economy and much needed investment in SMEs, he says.

4 - Tax and the squeezed middle

Fine Gael’s perennial promise to adjust the tax system to better reward hard-pressed middle-income earners, namely by raising the threshold at which they start paying the top rate of income tax which is seen as punitive by international standards, has once again been overtaken by events. Last year it was Brexit, this year it is Covid-19 and Brexit.

For a single worker, the higher 40 per cent rate of income tax kicks in at incomes above €35,300, which is 10 per cent below the average industrial wage. The Minister for Finance has ruled out any changes to income tax credits or bands, USC or PRSI in Budget 2021, insisting major changes in taxation would be counter-productive at this delicate stage.

Some see the current programme of wage supports not just as an emergency measure but as something that should be adopted on a permanent basis to support those on lower or less guaranteed income, an expansion of Ireland’s social security net. How this might be funded in the future is perhaps a question for another time.

The Government has pledged to establish a commission on tax and social welfare to look at the tax system here and this seems like the ideal year for Donohoe to push this project forward.

There are two other pressing matters on tax – VAT and carbon tax. The hospitality industry, which is bearing the brunt of Government restrictions to curb the spread of the virus, is calling for the 13.5 per cent VAT rate for hospitality and tourism to be cut again to 9 per cent but Government may see this as too costly and too difficult to unwind when conditions pick up.

On carbon tax, the scheduled €6 per tonne hike has also been criticised as too little to radically alter fuel usage and reduce long-term emissions, particularly in light falling of oil prices internationally.

5 - The Brexit shock

The prospect of Ireland experiencing a double economic shock next year with a no-deal Brexit coming on top of the Covid crisis has heightened in recent weeks. The UK has, in the words of a German minister, cast a "dark shadow" over EU trade deal negotiations by threatening to break international law and override the withdrawal agreement. The European Commission has retaliated by launching formal infringement proceedings against the UK.

The Central Bank predicts the Irish economy could contract by 2 per cent in the event of a no-deal outcome but a study by the Economic and Social Research Institute (ESRI) suggests the shock could be amplified by the pandemic.

Donohoe has signalled the budget will be framed on the basis of a no-deal but, as with Covid-19, he has no clear line of sight.

The Government has put in place a multiyear €5 billion Brexit buffer fund to be deployed on top of its annual budget spend, if needed. If the talks fail and the UK crashes out in January, he is likely to come under pressure to frontload a significant portion of this money into the worst-hit sectors, pushing our State’s balance sheet further into the red. Deploying this money at the right time and in the right areas will be key.

The criticism of the current raft of Covid business supports is that they are not targeted enough and are being channelled through loan-averse banks.

"Setting aside an appropriately-sized contingency to cover the costs of a no-deal Brexit and further supports for Covid-19 beyond next March is key," says Ifac chief economist Eddie Casey.

Ireland is likely to experience the most exaggerated K-shaped recovery from Covid in the world, with some sectors such as IT and pharma already bounding forward while others, such as hospitality, remain in the doldrums, a consequence of what business says is the Government’s conservative approach to health measures.

Headline GDP is now expected to contract by just 2.5 per cent instead of the 10.5 per cent previously forecast, with the State’s large multinational sector shielding Government finances from the worst of the crisis. That gives Ireland and Donohoe some wriggle room, for now at least.

READ MORE