Tax surplus is supporting tight fiscal stance

Economics: In January 2001, a group of economists, myself included, were invited to meet Pedro Solbes, the then European commissioner of economic and monetary affairs.

He was in Dublin to discuss Charlie McCreevy's 2001 budget, which had fallen foul of the European Commission on the grounds that it was too expansionary for a booming economy. The Republic was eventually reprimanded by the EU for its fiscal stance and some of the assembled economists backed the commission's decision, partly on the notion that the Irish case was a dry-run for more serious fiscal cases to come.

The alternative view, which I shared, was that the commission's approach was unwarranted, ridiculous even, on the grounds that the reduction in spending sought was relatively small and that the projected budget surplus was very large by any measure, equivalent to 4.3 per cent of gross domestic product (GDP).

History has not been kind to the commission, nor to its domestic supporters. We now know that the likes of France, Germany and Italy have consistently breached the EU's fiscal rules without any censure, running up large budget deficits, so the Irish case certainly didn't set down a marker. Moreover, far from adding fuel to an already overheating Irish economy, the 2001 budget ended up supporting an economy in which activity slowed sharply - growth in 2001 declined to 3.9 per cent from 9.5 per cent the previous year. Consequently, tax receipts took a hammering and the budget surplus that eventually materialised, at only 0.9 per cent of national income, was well below what was originally projected.

This saga of the 2001 budget came to mind when reading the IMF's latest musings on the Irish economy, including a detailed study of fiscal policy. The IMF worries that Irish budgets tend to be pro-cyclical: governments often raise spending and lower taxes in periods of strong economic growth and curtail spending or increase the tax burden in periods of weak economic activity (the budgets of 2003 and 2004 were perfect examples of the latter tendency).

Furthermore, the IMF believes the economy has little or no spare capacity at the moment, so it has urged a tight budget in 2006. This doesn't mean the Government has to slash spending or raise taxes, but rather that a large planned budget deficit would be unsuitable and that the authorities should not seek to add further demand to an economy where private sector spending is growing strongly.

Fine, as far as it goes, but the problem is that attempting to fine-tune the Irish economy using fiscal policy is fraught with difficulty, given the large degree of uncertainty surrounding the likely budget out-turn in any year, as shown in the 2001 example. Indeed the IMF's own research on the Republic makes the same case, as it shows that the budget out-turn has consistently missed the target, in part because economic growth has also surprised relative to forecast.

The IMF's recommendation does serve a useful purpose, nonetheless, in highlighting the absence of any clearly identified fiscal strategy from the Irish authorities. In theory, membership of the euro does impose a fiscal constraint on the Minister for Finance in the form of the Stability and Growth Pact, which limits annual deficits to 3 per cent of GDP. In practice this is of limited relevance given the cavalier disregard of the pact by the likes of Germany and Italy. Moreover, the financial markets, once seen as vigilant punishers of errant governments, have ignored such breaches - Germany can borrow money for 10 years at an annual cost of 3.2 per cent, the same as for the Republic, and for Italy the price is 3.4 per cent.

In practice then the range of options open to Brian Cowen is broad, while the prospect of a sharp rebuke from the financial markets or from Brussels is remote.

Yet other than vague platitudes about fiscal responsibility, no Irish finance minister in recent years has articulated a clear fiscal strategy, despite a remarkable fall in the Republic's debt-to-income ratio which has transformed the debt constraint.

What is clearer is that, in practice, recent budgets have tended to aim for modest fiscal deficits of under 1 per cent of GDP (although the outcome is often very different as will be the case in 2005). Yet this entails running very large current budget surpluses given the scale of capital spending by the authorities. For example, the 2005 budget projected a current budget surplus of some €4 billion, offset by a capital deficit of €7 billion. In other words the Republic is funding capital spending out of current tax receipts: which few firms or individuals would consider as sensible, particularly when the long-term cost of borrowing has never been lower.

In the UK, in contrast, the stated policy is to fund capital deficits through borrowing, as long as the national debt remains relatively low, and to run the current budget in broad balance. One could therefore make a respectable case that the Republic is in fact running a very tight fiscal position, given the huge surplus of tax revenue over current spending.

Dan McLaughlin is chief economist at Bank of Ireland