Irish Government may not be able to spend any tax bounty

The latest Exchequer figures show that Irish tax receipts are again well ahead of profile, raising the prospect of a much smaller fiscal deficit  in 2016 than planned and tempting the new Government to spend some of the largesse before year end. That was the case last year but this time is different and any tax bounty may have to be used to reduce debt rather than to increase expenditure, although of course economic shocks such as Brexit may mean that bounty is smaller than now appears.

The 2016 Budget projected tax revenue of €47.2bn for the year, implying a 3.6% rise on the 2015 outturn. That appeared a modest target and at end-May receipts were running 8.9% up on the previous year  and €770mn or 4.3% ahead of the monthly profile. That aggregate overshoot is very similar to the pattern in 2015, with corporation tax again the main factor, although this time excise duty is also extremely buoyant, with income tax on target and VAT running below expectations.

By the autumn of last year the tax overshoot had accelerated to almost 6% and the Government announced supplementary estimates, intending to spend a fair proportion of the windfall. In the event  they did not manage to spend as much as indicated although voted expenditure still ended the year some €1.3bn above the original target.Tax revenue continued to exceed expectations, emerging 7.8% above profile, or a massive  €3.3bn.

At that time the only EU fiscal constraint on Ireland was to get the deficit below 3% of GDP, which was duly achieved even with the additional spending ( the final figure was 2.3%). In 2016  there are two constraints, however, with neither relating to the headline deficit. The first is the expenditure benchmark, which sets a limit on permitted expenditure in the year. The second is that the fiscal deficit, when adjusted for the economic cycle, must fall by at least 0.5% of GDP. Regular readers of this Blog will be familiar with the problems associated with determining  Ireland’s potential growth rate, and hence estimating the cyclically adjusted fiscal position. As it currently stands the Irish Government believes that  the structural deficit is set to decline by 0.4% while the European Commission argues that the reduction is only 0.1% and  has stated that ‘ further measures will be needed to ensure compliance in 2016′. The Irish Government will argue the case and other countries have been given leeway so the outcome is uncertain, but it may well be that the current tax buoyancy will not result in much or any additional  unplanned spending this year.

 

Ireland’s Fiscal Space

The Irish General Election campaign is now underway and  the electorate will be bombarded with pledges and promises , including commitments on taxation and  plans on spending. Nothing new there, but this election will be the first fought against the constraints imposed by Euro rules on how much an Irish government will be allowed to spend, net of any tax changes. The outgoing Administration’s freedom of fiscal manoeuvre was also limited , of course, by the need to get the budget deficit  down to below 3%  but how that was achieved  was left to the government of the day. Ireland is now under the ‘Preventitive Arm’ of the Stability and Growth Pact and as such the ‘Fiscal Space’ – the amount available to raise spending or cut taxes- is circumscribed, and this restriction will likely feature prominently in the campaign, putting pressure on parties to spell out how this Space will be utilized.

The available Fiscal Space over the next  five years  is subject to defined rules but is not set in stone; the Department of Finance produced a figure  of  €10.9bn in the 2016 Budget, while the Fiscal advisory Council believes the effective Space is just over €3bn. Indeed, there are now reports that the European Commission may change the rules, allowing Ireland  perhaps an additional €1.5bn.

The  detail of the rules may be complex but  the basic idea  is simple enough- government budgets should be sustainable, so preventing any windfall tax gains in a boom being used to increase expenditure. Consequently, allowable expenditure is determined by the country’s potential growth rate , in turn  calculated as an average based on past growth and  that forecast over the next few years.  Ireland’s  potential growth rate in 2017 is deemed to be 2.8%, for example, rising to 3.4% by 2020, as the recessionary years fall out of the average calculation. The spending limit is in real terms and is translated into current money by using the EU’s forecast for price inflation (the GDP deflator, not the CPI)

General Government Expenditure in Ireland is planned at €74.1bn in 2016 , or €67bn with certain adjustments, including debt interest  and a portion of any additional capital spending, and this figure then becomes  the benchmark for the rule. The  inflation forecast is 1.2% so that would allow Ireland to increase spending by 4% (2.8% real and 1.2% inflation)  or  €2.7bn in 2017, absent any other constraints. There is an additional constraint ,however; Ireland is still running a structural budget deficit ( the actual deficit adjusted for the economic cycle) which is estimated at 2.5% of GDP in 2016 and so the 4% allowable  increase in spending,  calculated above, is lowered by what is known as a convergence margin (again set by the EU), in order to put downward pressure on the structural deficit. In 2017, for example, the convergence margin is currently set at 2%, so the allowable rise in real spending  is cut to 0.8% (2.8% minus 2%) and the permitted rise in nominal spending  reduced  to 2%. Our base is €67bn, implying a €1.3bn allowable rise and this is the Fiscal Space open to the Government, to be used as it sees fit- spending could rise by that amount, taxes could be cut or a combination of both. What cannot happen, under the rules, is a fiscal package costing  more than the €1.3bn.

A number of key parameters are determined by the EU and these may change , so  driving a change in the Fiscal Space in the medium term. Estimates of the potential growth rate for example, or forecasts of Irish inflation. Another key metric is the speed at which Ireland has to reduce its structural deficit, and indeed the final target- currently the target is to eliminate the structural deficit but that may change to a deficit of 0.5% of GDP. If the former, the convergence margin disappears from 2020, allowing a more rapid rise in spending  from that date,   but if the latter more Space than currently envisaged would open up.

These are all possible changes in the future so why is there a divergence in estimates of the Fiscal Space deemed  available under the current parameters?  One answer is the speed at which the budget deficit is reduced- the Department of Finance assumes 0.6% per annum, while the Advisory Council have a higher figure (0.75%), The key difference though relates to  spending assumptions. The  headline Finance figure  for the Fiscal Space  is €10.9bn over the five years 2017-2021 which reduces to €8.6bn when account is taken of existing  capital spending plans, public sector pay increases under the Lansdowne Road agreement and demographic pressures on Health and Education. These figures also assume indexation of the tax system but the spending estimates do not factor in any increases in line with inflation i.e. pensions ,social welfare and public sector pay fall in real terms. Finance argue that any decision on that is up to the incoming government, although presumably so is the decision to index the tax system or to continue with previously announced capital plans. IFAC, in contrast, have factored in rises in spending in line with inflation and this  is the prime reason why their Fiscal Space figure is  so much lower.

No doubt these nuances will be teased out and debated over the next four weeks but the novel feature of this election remains that an arcane economic concept- Fiscal Space- is likely to be a recurring theme.

The Irish Exchequer’s Annus Mirabilis

It is not uncommon for the Irish fiscal balance to end the year in a very different position than envisaged at the time of the Budget presentation and 2015 has seen more of the same, albeit with a larger than normal  forecast error. This  time the divergence is on the positive side, with the Exchequer emerging with a  cash deficit of just €62mn instead of having to borrow €6.5bn as originally projected. As a result  the level of debt will be lower than forecast and the debt ratio in 2015 may be below 96%  of GDP from 107.5% in 2014.

A key factor in the much better than expected outcome is a number of unbudgeted capital receipts, amounting to almost €4bn.  Early in the year the National Pension  Reserve Fund transferred €1.6bn from the sale of Bank of Ireland shares to the Exchequer, with the latter then benefitting from the sale of Permanent tsb shares (€0.1bn)  and Capital notes (€0.4bn) . The sale of the State’s holding in  Aer Lingus  netted another €0.3bn and in December the Exchequer received €1.5bn from AIB, with the latter redeeming  part of the Preference shares issued in 2009.

Current receipts were also much stronger than expected in 2015. Non-tax revenue came in at €3.5bn instead of the €3bn projected, largely reflecting higher profits at the Central Bank, and tax revenue was €3.3bn or 7.8%  ahead of the initial Budget forecast. This  was in part due to much stronger than expected economic activity ( real GDP probably grew by at least 7% last year against a 3.9% forecast) which led to overshoots in income tax (€379mn), VAT (€170mn)  and Capital taxes (€254mn). However the main driver was an extraordinary forecast error in terms of Corporation tax, which emerged €2.3bn or 49% above the original projection.

On the spending side, debt interest was €0.7bn below forecast, offset by higher  voted current expenditure, following a decision in October  by the Government  to spend some of the unexpected tax bounty,  Nevertheless, total current spending was only marginally ahead of the original Budget target and 1.3% lower than the 2014 outturn. Overall, the current Budget was in deficit to the tune of just €4mn which alongside a capital deficit of   €58mn produced the €62mn Exchequer shortfall.

The General Government balance , the preferred EU fiscal measure  , excludes transfers across the Government sector and includes additional adjustments which have to be confirmed by Eurostat. It would seem though that the General Government deficit is likely to be around €3.2bn,  which is  €2bn below the original projection  and  equates to 1.5% of GDP , against  the Budget target of 2.7% and the revised 2.1% estimate made a few months ago.

The 2015 fiscal outturn also means that  the 2016 Budget assumptions now look redundant. The latter envisaged a 5.8% increase in tax receipts from an expected base of €44.6bn, giving a 2016 tax figure of €47.2bn. That now only requires a rise of 3.5% to achieve given the €45.6bn figure actually received in 2015.  So if tax receipts do indeed rise by 5.8% this year’s figure will emerge at €48.2bn or €1bn ahead of the target announced in October’s Budget. On that basis the projected deficit of €2.8bn could be €1.6bn, or just 0.7% of GDP instead of the 1.2% currently forecast.

On the face of it then the Irish fiscal situation has been transformed and the outlook is indeed positive although there are two caveats. One relates to the international backdrop, which may be less supportive for the economy in 2016. Another relates specifically to Corporation tax, the source of over two-thirds of the tax overshoot last year. A forecast error of that magnitude clearly raises the risk around any projection  of the corporate tax take in 2016 and hence the overall revenue figure.

Ireland should move the Budget back to December

The last three Irish Budgets have been presented in mid-October, a departure from  the previous practice of delivering them later in the year, usually in early December. The change was triggered by new Euro  rules designed to improve economic surveillance (the two-pack)  which stipulated that member States ‘ must publish their draft budgets for the following year’ by October 15, although budgets need not be adopted till December 31. Ireland chose to present and adopt the Budget at the earlier date although others do not pass theirs till later in the year, and there are a number of reasons why the Irish Government should consider publishing a broad outline of its fiscal targets in October but wait till December to adopt the full Budget.

Ireland’s GDP is much more volatile than the norm across developed economies, which makes for large forecasting errors in terms of  economic activity and tax receipts ; the average  annual forecast error for the Exchequer balance  since 2000 is €1.5bn. Forecasting  the following year is difficult enough in early December as  the only published GDP data relates to the first two quarters of the year but at least there is some available information about the third quarter, which is not the case in mid-October.

Another factor is the November tax month, which includes income tax from the self-employed and is also a big month for corporation tax; in 2015, for example, total  receipts in November were expected to be  €6.5bn against a monthly average over the rest of the year of €3.3bn. Consequently, a much stronger or weaker November inflow may  not only render redundant the end-year fiscal projections made in October  but also compromise the forecast made for the  year ahead.

The past few months has highlighted that risk in Ireland, albeit this time  with the forecast errors on the positive side. The 2015 Budget projected tax receipts of €42.3bn, or 2.5% above the 2014 outturn, and it became clear as the year unfolded that economic growth was running well above expectations and  tax receipts would substantially exceed the initial target, albeit largely due to a massive overshoot in one category, corporation tax. In  October the Government formally revised up its tax forecast for the year, by €2.3bn to €44.6bn and announced additional spending of €1.5bn. The projected Exchequer deficit  was also reduced from the initial €6.5bn to €2.8bn, reflecting unbudgeted  capital receipts as well as the tax bounty. The Exchequer balance is a cash based measure  and the broader General Government deficit  (the preferred  EU fiscal metric) for 2015 was also revised down, to 2.1% of GDP from 2.7%, with a 2016 target of  1.2%.

The November Exchequer returns  have changed the picture. Receipts in the month came in at €6.9bn or €470mn above profile, leaving the overshoot year to date at €2.9bn, with corporation tax 58% or €2.3bn above expectations, a spectacular forecasting error. Spending is also still running behind the original target, so it appears unlikely  the Exchequer will actually meet the higher spending figures announced in October. The net result is that tax receipts will probably end the year at €45.4bn, 10% above the 2014 outturn and €800mn above the official estimate made just six weeks ago. That and the fact that the revised spending target will not be met implies an Exchequer deficit  of €1bn or less and a General Government deficit of 1.7% of GDP. Moreover,the Exchequer estimate does not include the €1.6bn payable from the partial redemption of AIB’s Preference shares so  a cash surplus for the year is possible, depending on when the money is transferred,

The 2016 Budget projected  a 5.8% rise in tax receipts which now implies a tax figure of €48bn next year or €0.8bn above the existing forecast, which even with the same spending targets gives a General Government deficit of 0.9% of GDP instead of the budgeted 1.2%. Of course there is no guarantee that  the 2016 tax receipts will emerge on target ( particularly in relation to corporation tax) but on the face of it fiscal policy in Ireland was tighter than the authorities wanted it to be in 2015 and will now be tighter than planned in 2016. Government debt will be lower as a result on this occasion but a return to a December Budget would probably reduce the  scale of forecast errors, although not eliminating them.

What if the electorate is reckless?

It is now received wisdom that the Irish authorities pursued bad or at least inappropriate economic policy in the years before the 2008  crash .Fiscal policy is usually seen as one culprit, with Budgets perceived as fuelling the boom rather than dampening down economic activity. Fiscal policy should have been counter-cyclical, it is argued, with the government of the day seen as culpable in not’ doing the right thing’. If we ignore the hindsight bias present in such analysis it also begs a simpler question- what if the electorate does not reward prudent policies and prefers what by normal economic criteria would be considered reckless ones?

In Ireland’s case the counter-cyclical argument is that the government should raise taxes and/or cut discretionary spending when the economy is growing too fast ( leaving aside the problem of establishing what is sustainable growth at the time). Yet commentary on the Budget and the monthly Exchequer returns is predicated on exactly the opposite- strong growth in tax receipts is seen as opening the door for higher public spending and ‘ a giveaway’ when next the Finance Minister delivers his Budget address to the nation.

A glance at the 2007 general election manifestos, for example, shows that all the main political parties envisaged tax cuts and further strong growth in exchequer spending . Were the politicians being irresponsible or simply rational, based on the belief that electorates want higher spending and lower taxes and will not reward a government which indeed adopts a counter cyclical policy, even if the need for that was  perceived clearly at the time ?

There are additional constraints other than the electorate, although perhaps not well understood by voters. One is the fiscal rules imposed by membership of the euro, and these have tightened considerably since 2010, including the stipulation that Ireland will need to limit current government spending in the medium term and to run a persistent Budget surplus when adjusted for the economic cycle. It remains to be seen what role these constraints will play in shaping the next general election.

The new fiscal pact also resulted in the setting up of the Irish Fiscal Advisory Council, which is there to assess the budgetary stance and monitor compliance with the fiscal rules. Yet it does not appear to resonate with the public and the government has ignored its recent advice, to no great media  clamor or cost in terms of public opinion.

The markets, too, play a role, and can punish profligate governments. Yet bond yields across the euro zone are generally at record lows, despite the fact that debt burdens are still rising, so QE has apparently trumped that potential constraint, at least for a while.

The issue of the electorate’s role in shaping policies is currently on show  in Greece, where the new Government is seen to have a mandate to end austerity, kick out the troika  and yet secure additional funding from Greece’s creditors. It is unclear how they can pull this off but the electorate has spoken. Yet the same electorate has tolerated the fact that no Greek government has run a Budget surplus in 34 years ( and no doubt longer but that is the limit of the IMF data base) with the average deficit amounting to 7.7% of GDP over that period. Clearly the Greek electorate are willing for future generations to pick up the tab. Some might say this is irresponsible while others seek to blame the creditors for funding what must qualify as reckless behaviour.

 

Irish Budget could now add up to €1bn in stimulus to economy

In April, the Irish Government expected that another round of tax increases and spending reductions would be required to get the 2015 Budget deficit below the 3% target set by the EU, with €2bn seen as the adjustment figure. That would have taken the cumulative adjustment to €32bn since the initial retrenchment started in 2008 but in the event it now appears that such is the transformed economic outlook that the 2015 Budget ( to be delivered on Tuesday Oct 14) will now provide a stimulus to the economy, which may amount to up to €1bn, depending on how much leeway the Minister for Finance chooses relative to the 3% target.

A key factor behind this remarkable change in the budgetary position is the performance of the economy over the first half of 2014. That has prompted the Department of Finance to revise up its real growth forecast for this year and next; 4.7% growth is now envisaged in 2014, from an initial 2%, with the economy forecast to expand by 3.6% in 2015. Nominal GDP is also now seen as being much higher than originally  projected, with  a figure  of €193bn  forecast by the Department , an extraordinary  €19bn above that forecast six months ago. A stronger economy implies a lower cash deficit, via reduced welfare spending and higher tax receipts, with a higher nominal GDP figure also helping to lower the fiscal and debt ratios.

It has been apparent for some time that this year’s deficit would be much lower than initially forecast and the Government’s ‘Estimates of Receipts and Expenditure’, published last night, predicts a 2014 General Government deficit (GGD) of  €6.9bn, which is €1.2bn below that envisaged in April. The deficit ratio is also much lower, at 3.7% of GDP instead of 4.8%. In fact that outturn, if it materializes, would be a little worse than some had expected; revenue is projected to come in €1.8bn ahead of the April forecast, including a €1bn overshoot in tax receipts, but spending is now forecast to be €800mn above the initial target, including over €500mn in voted expenditure, perhaps indicating that the current Health overspend will not be corrected.

Voted  current spending is projected to fall in 2015, by €1.3bn from the 2014 outturn, but again this hides a significant change in plan, as next year’s figure is almost €1bn above that envisaged last April . As a consequence the GGD  in 2015 is only €0.5bn below that projected in April, coming in at €4.7bn. This is 2.4% of forecast GDP and hence well below the 3% target, although had the initial spending plans been adhered to the deficit would be substantially  below 2%.

The figures are on an unchanged policy basis and so the Minister has significant leeway now to raise spending and give some tax relief, with the scale of any largess dependent on his final target. In addition, he may announce some ‘savings’, so increasing the scope for a potential stimulus, including lower debt interest on foot of some repayment of the IMF loan, refinanced at cheaper market rates. That might amount to say €300mn. so reducing the pre-Budget deficit further, to €4.4bn. Consequently a final target of say, , €5.4bn,, or 2.8% of GDP, would imply a spending and tax package of around €1bn, not counting any tax buoyancy on foot of the stimulus  or positive impact on GDP.

The global economic outlook looks cloudier than it did a few months ago , with the euro area particularly weak, which adds a greater degree of uncertainty than usual to any fiscal forecast. The Minister may  err on the side of caution and go for a lower forecast deficit but the difference now is that he has far more options than envisaged earlier in the year and certainly far more than in recent budgets. A deficit of 2.8% would also mean a strong primary surplus (the budget balance less interest payments).

Ireland’s fiscal adjustment-too soon to know

Ireland’s 2015 Budget is four months away but the debate about the scale of fiscal adjustment required has intensified, with contributions from the IMF, the Irish Fiscal Advisory Council, the Minister for Finance and  other assorted politicians. Some argue for the €2bn figure  set out some time ago while others claim that  a lower figure will suffice. In truth it is far too early to be definitive as there is a high degree of uncertainty , both about the fiscal outlook and prospects for the Irish economy, and given this lack of clarity it is puzzling that so many can take a dogmatic position.

Ireland’s total fiscal adjustment since 2008 amounts to some €30bn, and was required to keep the fiscal deficit on a declining path with a target for the latter of under 3% of GDP by the end of 2015. So the adjustment in any given Budget, be it cuts to government spending or measures to raise additional revenue, is a residual with the size determined by the forecast deficit ratio in the absence of any new policy measures. Note that the target is not the actual deficit itself but the deficit relative to GDP, so there are two areas of uncertainty, one relating to the performance of the economy and the other to the evolution of exchequer spending and receipts, although the latter is of course strongly influenced by the pace of economic activity. Inevitably, the actual deficit and the level of GDP will diverge from that forecast, making any projected adjustment less meaningful, particularly into the medium term. Yet in recent years the forecast Irish fiscal adjustment figure has become  a target in itself, rather than the residual. Some claim that sticking to an announced adjustment enhances credibility, which seems to be the IMF view, although it is not clear why a figure projected a few years earlier must be adhered to even if circumstances have changed, and given that such adjustments will dampen economic activity.There is also a temptation for the government to ‘spin’ the Budget presentation in order to be seen to ‘achieve’ the  previously announced adjustment.

Take the 2013 Budget. The  adjustment figure ahead of time was seen as €3.5bn and according to the  pre-Budget Estimates  the 2013 fiscal deficit would be €15bn, or 8.9% of forecast GDP , on unchanged policy.The deficit target was set at 7.5% of GDP, with an actual deficit of  €12.7bn, and the government duly proclaimed an adjustment of €3.5bn, even though the measures announced on Budget day amounted to €2.8bn, with the remainder mainly due to ‘carryover’ effects from previous spending and revenue decisions. In the event the deficit came in almost €1bn below forecast, at €11.8bn, thanks to a significant overestimation of debt interest  and higher non-tax receipts than projected, including profit from the Central Bank. However, real GDP actually contracted in 2013 instead of growing as expected and nominal GDP emerged €3.6bn lower than forecast, so the deficit ratio came in only marginally below target, at 7.2% of GDP, despite the much better than projected outturn in the deficit itself.

The 2014 Budget projected a deficit of €9.8bn in the absence of any adjustments, or 5.8% of forecast GDP. Consequently, policy measures were required to hit the deficit target , announced at 4.8% of GDP, with an adjustment figure of around €3.0bn widely discussed. Indeed, that was the figure announced by the Minister ( actually €3.1bn ) although the measures introduced on the day amounted to just €1.9bn, with the residual due to the familiar ‘carryovers’ and  previously unidentified ‘resources’ on the expenditure side , including ‘savings’ and lower debt interest. So the €3bn ‘adjustment’ was anything but, although the announced measures are forecast to reduce the deficit to €8.2bn, or 4.8% of GDP.

Five months into the year  the authorities are confident that the deficit figure will be achieved and  tax receipts are running 2.9% ahead of profile, which may persuade the Department of Finance to revise up their tax projections for 2015, hence implying a lower deficit figure before any adjustments. It is early days yet, however, as we do not  even know how Ireland’s GDP performed in the first quarter- retail sales have picked up at the headline level but the value of merchandise exports actually fell on an annual basis in q1 thanks to a decline in price, which will dampen nominal GDP. Uncertainty over the latter is also compounded by the change to a new standard for national accounts (ESA 2010) which will count R&D as capital spending for the first time,  and this along with other minor changes may boost the level of Irish GDP  by 2% or more and so impact the deficit ratio, albeit marginally.

So it is by no means clear at this stage what adjustment will be required to meet a 3% deficit target next year, be it  lower or indeed a higher figure. Austerity fatigue has set in across many European countries and the IMF call to maintain a previously forecast adjustment can be seen in that light, but any adjustment involves serious economic and social costs and  is a means to an end rather than an end in itself.