2018 Budget now seen as pro-cyclical and breaking EU fiscal rule.

One of the standard criticisms of Irish economic policy is that tax and spending changes in the Budget tend to be pro-cyclical  i.e. the government of the day is often adding spending power to an already buoyant economy. This may be due to mistakes in estimating economic activity or simply reflecting what the electorate appears to want- higher spending and/or lower taxes. There are EU imposed constraints now, of course, designed to limit how much the government can inject into the economy , but these rules apply to the budget as adjusted for the economic cycle, as opposed to the headline balance, and that can throw up some odd situations for Ireland, given the volatility in our GDP.

It now appears 2018 will provide a good example of an Irish Budget which was deemed in line with the EU rules but now appears in breach. When presented, in October last year, the economy was  thought to be operating  well above capacity by the EU but the expected growth rate of 3.6% in 2018 was seen as  below the economy’s potential growth rate ( 4.5%) so reducing the output gap somewhat, albeit still leaving it in postive territory. So although the actual fiscal deficit was forecast at 0.2% of GDP  the cyclically adjusted (or structural)  deficit was actually higher, at 0.5%, given the (EU) view that the budget was being flattered by a buoyant economy. However, this was still deemed to be acceptable as the structural deficit  as forecast was seen to be falling from an estimated 1.1% of GDP in 2017, hence meeting the EU rule as well as being net contractionary in terms of its impact on demand in the economy.

Today’s release of the annual Stability Programme Update (SPU) by the Department of Finance shows a very different picture. Growth in 2018 in now forecast at 5.6% ( over 2 percentage points higher than in the Budget) and also 0.9% above the estimated potential growth. As a consequence the economy in 2018 is now seen to be operating 1.2% above potential ( the 2017 output gap was also revised) and although the headline deficit forecast is unchanged at 0.2% of GDP, the structural deficit is now much higher, at 0.9%. Moreover, last year’s structural deficit is now put at only  0.4% of GDP so on the face of it Ireland’s strucural deficit is actually rising by 0.5% of GDP instead of falling by a similar amount, as per the preventive arm of the Stability and Growth Pact. This is not only  a breach of EU rules but also indicates that the Budget is adding net spending to an economy already operating above capacity.

Any breach of EU fiscal rules is unlikely to mean much as there does not appear to be the political will in Brussels to rigorously enforce them. The Department, and others, would also argue that the output gap measure used above is wrong and that alternative measures still show the economy  still with some, if rapidly diminishing , spare capacity. Indeed, Finance expects the unemployment rate to continue to fall before bottoming out at 5.3% in 2020, which is not consistent with  the headline output gap measure. Regardless of the precise measure used, it does seem that the economy is operating at or close to capacity and so the old arguments about pro-cyclical policy are likely to resurface ahead of the 2019 Budget, albeit with little impact on the final outcome.

 

Government has €200m to fund tax cuts in 2018 Budget

The Irish Government has just published the Summer Economic Statement which sets out updated economic  and fiscal forecasts, with emphasis on the 2018 Budget, scheduled for delivery in October.  Economic growth this year is still expected to be 4.3%, slowing marginally to 3.7% next year,  while the main change in the fiscal outlook over the medium term is higher capital spending, which means that Ireland continues to run a modest deficit until 2020. The new Minister for Finance also reiterated that a ‘rainy day’ fund  would be initiated in 2019, although now at €500mn per annum instead of the €1bn indicated by his predecessor.

Most interest will no doubt centre on the outlook for the upcoming Budget and the resources or Fiscal Space available to the Government to fund new spending or tax reductions. Under the existing euro fiscal rules an Expenditure benchmark is set and it now appears that Ireland will breach  the 2017 limit by some €500mn or 0.2% of GDP, so the Government now intends to undershoot the 2018 benchmark, albeit modestly.

The latter is determined by the European Commission and dictates that Ireland must limit  spending  next year to  €71.2bn from €69.6bn in 2017, a rise of 2.4% ( the benchmark excludes certain items, notably debt interest and some capital spending).  That gives a Fiscal space of €1.6bn or €2.1bn given that Ireland does not index its tax system (i.e higher prices and wages would increase tax revenue by around €500mn). Some  €800mn of that will be eaten up by demographic pressures on spending and prior commitments on pay, leaving a net figure of €1.3bn, which the Government has chosen to limit to €1.2bn.

That would translate into €1.5bn in cash terms ( because not all of any additional capital spending is included in the  Benchmark) and the Statement indicates that €1.1bn of this will take the form of additional spending ( €0.6bn current and €0.5bn capital ) leaving €400mn for tax reductions. Further, the carry over effects of last year”s cuts will use up almost €200mn of this , leaving just €200mn on budget day to fund  net tax cuts ( leaving aside any refund of water charges)

Of course it is always open for the authorities to free up additional resources by cutting  some existing spending programmes or indeed  raising indirect taxes if it wants to pay for a reduction in income tax or USC. To that end it is noteworthy that the Department of Finance has drawn attention to the cost of the cut in VAT introduced in 2011 to support the tourism and hospitality sector ( from 13.5% to 9%) . The cost of accomodation has risen by over 20% since that move, and reports suggest that the lower rate is costing the Exchequer around €0.5bn. On the available arithmetic the Government will not be able to fund any meaningful direct tax cuts unless it finds money elsewhere.