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.

Published by

Dan McLaughlin

Economics Lecturer and Commentator