As the economy slows, there is great scope for improving productivity and tackling protected monopolies, argues economist Philip Lane.
What are the implications of the deceleration in output growth for fiscal policy? Over 2003-2006, government spending has grown markedly faster than nominal GDP - the biggest deviation is in the public sector wage bill, which has grown 50 per cent more quickly than GDP. This is also evident in the labour market: employment in the non-market services sector has grown by 42.2 per cent over 2001-2006, which is double the overall increase in employment.
The increase in public spending has been accompanied by a sizeable increase in government revenues. Taking the 2003-2006 period, indirect taxes, income taxes and corporation taxes have grown at rates that are roughly in line with nominal GDP growth. However, total tax revenue has grown 50 per cent more quickly than GDP due to the extraordinary buoyancy in capital gains taxes and stamp duties: the former has grown by 344 per cent since 2002, the latter by 219 per cent.
The rapid growth in public spending and tax revenues has provided a very favourable environment for the public sector. Accordingly, the transition to a period of more modest output growth rate poses an adjustment problem. In particular, the strong rate of output growth in recent years exceeds plausible estimates of trend output growth for the Irish economy, such that some element of deceleration is required to put Ireland on its trend growth path. Second, cyclical adjustment may also involve some below-trend growth in order to restore lost competitiveness and rebalance the composition of economic activity.
The fiscal diagnosis is sharply different for the capital and current budgets. The prolonged period of under-investment during the 1980s and early 1990s means that the level of public capital in Ireland is below its optimal level.
Accordingly, it is appropriate for public investment to grow more rapidly than overall output for a sustained period to close the gap between existing and equilibrium levels of public capital. An efficient expansion in the public capital stock is also centrally important in restoring export competitiveness.
One interpretation of the recent fiscal experience is that the recent high rate of expenditure growth reflects reversion to a long-term trend ratio of current spending to GDP. By this account, the extraordinary rate of output growth and the sharp reduction in debt interest payments in the late 1990s saw current expenditure plummet as a ratio to GDP and the subsequent acceleration in spending just reflects a catch-up phase. However, if the long-term ratio of current spending to GDP exceeds the current level, this requires that the tax burden increase as a share of GDP.
An alternative view is that the high rate of current spending growth reflects some combination of trend optimism (that high output growth rates might persist indefinitely), with pro-cyclical fiscal exuberance reinforced by the strong growth in tax revenues. Since the property price and construction booms have driven the tax surge, a sustained downturn in asset prices and the volume of property transactions may be expected to affect all tax revenues. Moreover, to the extent that the adjustment process for these variables involves an overshooting phase of below-trend growth, this may involve an especially sharp short-run plunge in tax revenues.
If tax rate increases are ruled out, growth in current spending has to be considerably restricted. In tackling the competitiveness problem that is a contributor to the slowdown, a reduction in the growth of the public sector payroll can relieve labour cost pressures in the private sector and facilitate a rebalancing of the economy towards the export sector.
Since Ireland is ranked second only to Greece in the OECD ranking of regulatory barriers in the services sector, there is scope for improving productivity and reducing business costs by tackling protected monopolies. Improving productivity in the public sector would also relieve the pressure on the labour market.
An additional extra-budgetary policy challenge relates to the rapid growth in the minimum wage, which is high relative to other advanced economies: a slowdown could make the level of the minimum wage a more substantial barrier to employment.
Managing the transition to slower output growth and public sector expansion can be best achieved in a supportive socio-political environment. While social partnership proved effective in facilitating recovery in the mid-1980s, expectations must be well managed during a moderate slowdown in growth.
Philip R Lane is professor of international macroeconomics at Trinity College Dublin