Tough budget needed to stave off grimmer future

 

ANALYSIS:IRELAND IS experiencing a horrendous recession. There has been a sharp decline in employment and output since 2007. Unemployment has grown rapidly, while many opt to exit the labour force or emigrate. Accordingly, decisions about economic policy have rarely been as important, writes PHILIP LANE

While progress needs to be made on many fronts, the two main policy challenges are to set the Irish economy on a sustainable growth path while stabilising the public finances.

The nature of the macroeconomic adjustment poses difficult challenges for fiscal policy. Ireland is not just undergoing a cyclical demand slump where the standard recommendation would be to undertake an offsetting fiscal expansion. Rather, the distorted nature of the pre-crisis bubble economy means that Ireland is also undergoing an economic restructuring, which requires a reduction in relative pay levels.

Accordingly, fiscal policy must strike a balancing act between supporting macroeconomic adjustment while also limiting the impact of the demand slump. The situation is compounded by the large structural deficit, which will not disappear of its own accord once economic recovery kicks in. A combination of long-term tax increases and spending cuts are required to tackle the structural deficit, such that the Government must simultaneously tackle cyclical and long-term problems in the public finances.

The urgency of tackling the structural deficit is reinforced by the fragile state of the international sovereign debt markets. While spreads have narrowed considerably since the peak of the international financial crisis, the spread on Irish debt remains elevated and would increase yet further if the commitment to fiscal stabilisation were to be undone.

Furthermore, the projected long-term increase in public spending due to the ageing of the population indicates that the Government should be running a structural surplus in order to pre-fund the increased healthcare and pension costs. Accumulating excessive levels of debt through the deferral of fiscal adjustment would result in future living standards facing a double squeeze from the levels of taxes required to service higher public debt and higher future spending needs.

For these reasons, the Government’s fiscal strategy must be more restrictive from a cyclical perspective than under ideal textbook conditions. This is a highly regrettable situation and reinforces the importance of redesigning the fiscal policy process in order to avoid such damaging pro-cyclicality.

In terms of supporting macroeconomic adjustment, the de facto pay reductions already imposed on public sector workers through the pension levy and the cancellation of scheduled pay increases have been important steps. However, the scale of the unemployment crisis means that more cuts in public sector earnings will help promote more rapid adjustment across the labour market.

In relation to the next round of public sector pay reductions, it may be better to phase these in on a month-by-month basis. That is, an x per cent overall target for 2010 would be parcelled out into small monthly reductions. Moreover, pay reductions in the public sector will help to preserve the level of public services, in view of the trade-off between pay levels and employment levels in determining the aggregate public sector pay bill. It is also important to recognise that public sector reform can further help to preserve service levels and constitutes an important potential source of aggregate growth in productivity and competitiveness.

To the extent that progress on fiscal stabilisation is achieved, it may indeed be possible to consider some further policy initiatives to support the preservation of existing jobs and the creation of new ones. However, this requires fiscal “space” that can only be created through the narrowing of the structural deficit.

The 2010 budget next month represents a pivotal step in the Irish fiscal adjustment process. It is important to recognise that major steps have already been taken since summer 2008. On the tax side, there has been a substantial increase in (consolidated) tax rates, with the distribution of the tax increases skewed towards higher earners. Moreover, there is a limit to the extent that a marginal effective income tax rate in the neighbourhood of 54 per cent (that currently kicks in at a relatively modest income level) can be raised if Ireland is to attract and retain the highly skilled mobile professionals that are key to future economic growth.

Rather, the main objective on the tax side should be to greatly broaden the tax base. This involves eliminating or greatly restricting many of the tax expenditures identified by the Commission on Taxation. However, it also involves restricting the scale of tax credits, allowances and non-taxable income sources that result in many Irish workers contributing below the European norm in terms of net taxes as a proportion of income. The scheduled introduction of a carbon tax is welcome, while a commitment to the early implementation of a well-designed annual property tax regime can help relieve pressure on other tax sources.

The structural budget deficit cannot be narrowed by tax measures alone. We have already outlined the case for a further reduction in public sector pay levels. However, the scale of the structural deficit is such that some contraction in aggregate service provision and public investment is also warranted.More radical actions in some areas may enable smaller cuts in other expenditure lines, with the goal of ensuring that those that offer the highest economic and social benefits suffer the least.

In relation to the overall fiscal framework, the projected 2009 outturn (according to the ESRI’s Autumn Quarterly Economic Commentary) is for a general Government deficit of €21.121 billion rather than the €18.413 billion envisaged in the April budget. Relative to GDP, this means that the deficit ratio will be 12.9 per cent of GDP rather than the planned 10.75 per cent of GDP. According to the latest ESRI projections, the target €4 billion overall package for 2010 will still leave the general Government deficit at 12.8 per cent of GDP, rather than the 10.75 per cent of GDP target for 2010 that was planned in the April budget.

In part, this slippage represents some deterioration in the forecast for GNP for 2009: the April budget assumed that the contraction in GNP in 2009 would be 8 per cent but the latest forecast is for an 8.7 per cent decline. (In contrast, the projection for GDP has actually improved since the April budget, reflecting the resilience of the multinational-dominated export sector.)

However, the scale of the decline in projected tax revenues for 2009 indicates that the structural deficit is larger than previously forecast. In turn, this suggests that the scale of the required structural fiscal adjustment in 2010 and subsequent years is even larger than that envisaged in the April budget. In the other direction, the improvement in the 2010 forecast for GDP growth (-2.9 per cent in the April budget, -1.1 per cent in the latest ESRI projections) should mean that the cyclical component of the budget deficit will be smaller than previously anticipated.

As indicated, a €4 billion package in 2010 still leaves the deficit at 12.8 per cent of GDP: in line with consensus thinking, a major proportion of the fiscal adjustment is being deferred until the economy recovers. However, a failure to attain this partial level of stabilisation will raise questions among taxpayers and investors about the medium-term commitment to return to a sustainable fiscal position.

Fiscal instability and uncertainty about the future tax burden will only reinforce the current impulse towards a high level of precautionary saving and delay the recovery.


Philip Lane is professor of international macroeconomics at Trinity College, Dublin