Irish Fiscal deficit may rise this year

Ireland’s GDP is unusually volatile, as is government revenue, which makes  for frequent forecasting errors in both. For the last three years the errors have proven positive, in that tax receipts have emerged ahead of Budget projections, resulting in lower than anticipated fiscal deficits as well as allowing the government of the day to augment spending in the latter months of the year.  Unfortunately that serendipitous trend appears to  be over, judging by the revenue figures available to end-April, and a tax undershoot for the year is looking more likely.

The 2017 Budget projected tax receipts of €50.6bn, and the Department of Finance still expects that to materialise, which requires a 5.8% increase on the 2016 outturn. Yet the annual increase over the first four months of the year is just 0.5%, with most headings actually down on last year, implying a serious risk of undershooting. Corporation tax has been the most difficult to forecast (exceeding the target by over €700m last year and by an extraordinary €2.3bn or 50% in 2015 ) and is currently some 23% down on 2016, with Stamp duty, Excise and Capital taxes also running well below the previous year in percentage terms.

The main exception is VAT, which is extremely strong, rising at an annual 14.5% or double the pace forecast in the Budget. This is curious given that retail sales grew by an annual  0.9% in the first quarter, but may reflect strong car imports and a rise in house completions. Income tax is also a puzzle, showing annual growth of just 1.2%, which appears at odds with other data implying a continuation of strong employment growth. The Budget forecast that Income tax receipts would end the year 5.6% above the 2016 outturn so , again, there is a lot of catching up to do if that target is to be hit.

The tax position against profile ( i.e. that expected on a monthly basis) is also  likely to be of concern to the Government, with a shortfall of €345m or 2.4%. VAT is running €257mn ahead but that has been more than offset by large shortfalls elsewhere, including €225mn in Corporation tax, €200mn in Income tax and  €120mn in Excise duty. The late Easter may be having an impact and Corporation tax is extremely lumpy on a monthy basis but the risk now is that the fiscal deficit will emerge above the current target of 0.4% of GDP. Moreover the 2016 outturn has now been revised down to just 0.5% so the 2017 figure may well be above this. A 2.4% shortfall in tax receipts at the end of the year, for example, equates to €1.2bn and all else equal would raise the deficit to 0.8% of GDP.

Does it matter?  The Exchequer’s cash position will  likely  be boosted by proceeds from the  sale of shares in AIB , so the debt ratio may well continue to fall. That transaction will not benefit the General Government balance, however, although Ireland has no longer to meet a  headline target for the latter under EU fiscal rules. In fact there are two, related constraints, which will come into play for 2018. One is that the deficit adjusted for the economic cycle  (the structural balance) has to fall by over 0.5% of GDP, and to aid in that process  a limit is put on government spending ( the famous Fiscal Space). The latter is already closing given an array of  spending commitments carried over into 2018 but the Government would not be able to use all the available space anyway if the  tax base emerged below forecast in 2017.

 

Forecast Errors in Budget 16 Highlight Fiscal Risks for 2017

This blog has argued that Ireland should not have moved its Budget date from December to early October, as it increases the risks of  forecasting errors, which history shows can be large. That was again evident in 2016, but what is also revealing, and perhaps ominous, is that the final fiscal outturn was also very different to that expected less than three months earlier, making the 2017 targets more challenging than initially thought.

The 2016 Budget envisaged the State running a current budget surplus of €0.5bn, offset  by a capital deficit of €2.1bn , so leaving a borrowing requirement of €1.6bn. Current spending was projected to rise modestly, by 1.6%, and tax receipts were forecast to increase by 3.6%: Corporation tax had spectacularly exceeded the target in the previous year , by 50%, and was now expected to decline modestly. but offset by stronger tax headings elsewhere, notably from VAT, which was projected to grow by 7.7%.

As the year unfolded  it became clear that tax receipts were running well above profile and by end-June were €740m or 3.4% above expectations, with corporation tax again well ahead of target, accompanied by excise duties. VAT was running behind profile but over the summer the Department of Finance projected a new tax outturn for the year, with receipts now expected to be €900m above the original figure,  partly offset by higher current spending. These new projections were again reiterated in October, with the current budget surplus now expected to emerge modestly higher at €0.7bn , with the overall deficit slightly lower than originally projected, at €1.4bn.

That earlier tax buoyancy fell away in the latter part of 2016, however, and tax receipts came in over €600m ahead of the original target but well shy of the €900m overshoot pencilled in. Indeed,  by end- December, most tax headings fell short of the forecasts made only a few months earler, including VAT (-210m) and Corporation tax (-€150m). Furthermore, current spending actually finished the year below the original target and a full €550m below the higher figure announced over the summer, so the government could not spend all it hoped.

Non-tax revenue also emerged well away for the revised target, this time to the upside, and the net effect was a current budget surplus of €1.3bn, some €0.8bn above the original Budget target and €0.6bn ahead of the forecast made a few months ago. The capital deficit was slighly higher than forecast, leaving an overall deficit of €1bn.

So the forecast errors in 2016, as in 2015, came in on the ‘right side’ , resulting in a smaller than expected deficit, but  implying that the Government could have spent more than it had initially thought, while  still hitting the fiscal targets. The forecast errors can also be on the ‘wrong side’ of course,  and the 2016 outturn   now means that tax receipts have to grow by 5.8% to reach the 2017 target, instead of 5.2%, with the required rise in VAT now 7.7% ( was 5.9%) and 5.0% for Corporation tax ( was 2.9%). The 2017 fiscal arithmetic therefore looks more challenging than it did when the Minister presented the Budget just a few months ago.

Government to spend tax bounty in final three months of this year.

Earlier in the year the Irish Government spelled out what the EU rules  on   Exchequer expenditure meant for the 2016 Budget; the fiscal space available was around €1.3bn, which could be used to fund tax reductions or spent. That figure then became a €1.2bn to €1.5bn range, with the Coalition indicating a probable 50/50 split between additional expenditure and tax cuts. What is now clear, following the overnight release of the White Paper on Receipts and Expenditure, is that spending will  be substantially higher than initially planned in 2015, thanks to a spree  over the final few months of the year. Essentially, the authorities are choosing  a deficit  of 2.1% of GDP instead of the 1% figure that might have been achieved.

Tax receipts were originally  expected at €42.3bn this year but by April the Department of Finance had revised that figure up by €1bn,  and it soon became obvious that the outcome would higher still. Finance now expect €44.6bn or €2.3bn (5.4%) above the initial target. Non-tax receipts are also stronger than forecast, by some €0.4bn, thanks to higher profits at the Central Bank, while savings on debt interest provided an additional windfall for the Exchequer.

The Government now plans to spend most of that unexpected bounty. Voted current expenditure ( essentially day to day government spending) was projected to fall  to €38bn in 2015, from €39bn in 2014,  and has been running  marginally below profile year to date, coming in at €29bn at end-September. Spending could  therefore amount to  €9bn over the final three months of this year to hit the Budget figure. The White Paper shows that spending will  now end the year at €39.5bn, which implies  €10.5bn will be spent in just three months .

The capital deficit is also larger than it appeared likely,  at €1.7bn, with money transferred  from the Exchequer to the Ireland Strategic Investment Fund. Consequently the Exchequer cash deficit ( current budget balance plus capital balance) is now projected at €2.8bn, with the General Government deficit ( the EU’s preferred fiscal measure) at €4.4bn. Finance has also revised up its forecast for Irish GDP this year, to €210bn, so the deficit equates to 2.1% , substantially below the initial 2.7% target but also well above what might have been achieved had the Government chosen to adhere to  the  initial spending plans.

As to 2016, Finance expects current receipts to rise by over €2bn and expenditure to be broadly unchanged, resulting in a current budget surplus,  which  alongside a modest capital deficit gives an  Exchequer cash deficit of  only €0.8bn.The General Government deficit is projected at €1.9bn, or 0.8% of projected GDP. There is an argument that the economy does not need any additional stimulus ( GDP is deemed to be operating at  2.5%  above potential by the EU) but it appears unlikely that the 2016 Budget will  not use the available fiscal space of up to €1.5bn, taking the post-Budget deficit forecast to €3.4bn or 1.5% of GDP. On our estimates this would imply a structural budget deficit of 2.6% ( i.e. taking account of the economic cycle and the official view that we are in a boom) against a 2015 outturn of 3.2%, so the decline would be above the 0.5% required under EU rules.

 

The 2014 Budget outturn was very different to that envisaged when delivered

Ireland’s Budget for the following calendar year is now presented in early October, which increases the probability of forecast errors. Such errors are a feature of any fiscal projections but are notable in the Irish context; the median difference between the  forecast Exchequer balance and the outturn over the past fifteen years is €2.5bn. This is not to put any blame on the Department of Finance or to suggest any inherent bias ( the  sample is evenly split between overshoots and undershoots relative to target), but rather to highlight that errors are highly likely in an economy as volatile and open as that of Ireland, and that unexpected events can and often do materialize.

Take the 2014 budget. The fiscal projections were predicated on real economic growth of 2% , including a pick up in consumer spending and a very modest contribution from the external sector, with exports forecast to grow by 1.9%. It now seems likely that the economy grew by 5% last year , with exports growing at a double digit pace. Moreover, consumer spending growth was probably less than 1% while inflation has been much lower than forecast, although the labour market has been much firmer, with the unemployment rate averaging around 11.5% against the projected 12.4%.

The Budget arithmetic had anyway changed by the beginning of the calendar year, with debt service costs  then seen to be €400mn lower than initially envisaged and revenue boosted by  the full amount of receipts from the sale of the national lottery (instead of half).As a result of these factors and other changes the projected 2014  Exchequer deficit was revised down in April to €8.7bn from the original Budget target of €9.6bn

It also became clear early in the year that tax receipts were running ahead of profile and that trend continued over the course of 2014, with a final outturn €1.2bn above target; tax revenue grew by 9.2% instead of the envisaged 6%. All tax headings came in above expectations with the exception of the Local Property Tax , including a  €400mn overshoot in VAT, €234mn from Corporation tax and  in excess of €200mn from Stamp duty, including monies from the pension levy.

That tax oveshoot would have resulted in a deficit below €7.5bn, all else equal, but in the event  the Government chose to use some of the largesse to increase spending. That decision was taken relatively late in the year as expenditure has been on or below target for much of 2014, but  at end- December  emerged €840mn or 2% above profile. Most of this additional outlay went on Health, which begs the question as to the realism of the original target spend for that Department.

As a consequence the Exchequer deficit for 2014 emerged at €8.2bn, above what might have been achieved but well below the original target of €9.6bn and  the lowest deficit since 2007. The NTMA funded the shortfall by borrowing a broadly similar amount and used existing cash balances (i.e. previous overfunding) to repay €8.2bn to the IMF.

So one might say it turned out all right in the end but somewhat different from that envisaged when the Budget was originally delivered, an all too common experience for the Irish exchequer and one which implies it would be fruitless for Ireland to try and fine-tune economic growth via fiscal policy, even if that were possible given euro rules. On final point: the Government is now using the Irish semi-state companies (particularly the utilities) in a more aggressive way to raise revenue, with dividends  received amounting to €475mn in 2014, against €264mn in 2013 and €112mn in 2012. The ESB alone ( and therefore its customers) have  has contributed €840mn since 2008.