Yesterday’s news on public service cuts will ease our international borrowing costs

BROADLY, THE measures announced yesterday by the Government to curb public expenditure should be of reassurance to international financial markets that Ireland is not headed into a spiral of debt.

Such a course would exacerbate the budgetary difficulties because the cost of Government borrowing would continue to increase relative to more fiscally prudent countries such as Germany.

Before the announcement of the measures, the cost of borrowing for the Government over a 10-year period was roughly 2 per cent per annum more than for Germany. To put this in context, the additional cost of the €25 billion the Government may have to borrow this year would be about €500 million per annum.

Over a 10-year period, that would amount to €5 billion. or about 2.5 per cent of gross domestic product (GDP). During most of the period between 2004 and 2007, Ireland could have borrowed more cheaply than Germany. Thus the credibility of the measures announced has a tangible effect and is not just about keeping up appearances as a good member of the euro area.

The redirection of policy towards achieving a balanced budget can be accelerated by a favourable reaction in the markets leading to a reduction in the cost of Government borrowing. After the cutbacks in Government expenditure in the late 1980s, Ireland’s public finances entered a “virtuous” circle, where a reduction in the cost of debt turbo-charged the improvement in the fiscal position.

The first element of the measures taken is a €2 billion reduction in public expenditure. About €1.4 billion of this is to be achieved by a graduated levy on public sector workers in respect of their pensions. The public sector pay bill is estimated to be of the order of €20 billion this year.

While some argue that public expenditure in Ireland is relatively small compared to other EU countries, this perhaps misses the point that the tax base is small, implying that the burden of public sector pay on employees actually paying tax is large.

The €20 billion public sector pay bill is supported by about one million taxpayers. That amounts to a contribution of €20,000 per annum from each of these in support of a public sector worker. This estimate does not take into account that some of these one million taxpayers are in fact public sector workers. The burden per private sector earner may thus in fact be higher. The narrowness of the income tax base has been brought about by successive budgets which aimed to remove earners from the tax net.

The second major element in the measures is that the increases in public sector pay to be paid in September this year and June next year are not now to go ahead. Against the background in which pay in the private sector is being cut and redundancies announced, this is not unexpected.

The payment of increments to public sector workers has not been affected under the measures announced and this adds a few percentage points to the public sector pay bill per annum. Real spending power for public sector workers will continue to increase, as prices are generally expected to decline as the year progresses.

Exchequer data for January showed a deficit for the month of more than €700 million compared to a surplus of more than €600 million in the same month last year. While one month’s data is not much guide to the likely outcome for the year, the tax side of the data illustrates starkly the shifting sands on which the expenditure increases of the last few years were built.

In January 2006 and 2007, stamp duties represented 7 per cent of tax revenue. This January, they were only 1 per cent of tax. A similar picture holds for capital gains. Stamp duty and capital tax revenues were down by the order of 70 per cent on a year ago.

Meanwhile, income tax was only 4 per cent below January 2008.

The January tax data conveys the message evident all last year: sustained expenditure can only be built on a stable tax base.