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.

What to do with the €3bn?

The Government has decided to proceed with the sale of 25% of AIB, and has indicated that it expects to raise around €3bn from the transaction. What to do with the money has been the source of some political debate, although the constraints imposed by the EU’s fiscal rules may leave the authorities with little room to manoeuvre.

The proceeds of the sale will not affect the General Government balance , as under Eurostat rules it is classed as a financial transaction , merely  exchanging one type of asset within general government for another, in this case cash. However, the €3bn inflow will impact the Exchequer Borrowing Requirement (EBR), the  deficit on a cash flow basis. The 2017 Budget made no allowance for  any sale proceeds and projected a €2bn EBR  so on the face of it the Exchequer may now emerge with a €1bn surplus at end-year, assuming the initial underlying target is achieved .

The Budget also indicated that the NTMA would  over-fund in 2017 (i.e issue more debt than required to finance the EBR and to cover redemptions)  so in sum gross Government debt was projected to rise by around €4bn, to  €204.6bn or 72.9% of forecast GDP. Adding in the AIB proceeds would therefore reduce the forecast debt level to €201.6bn, or 71.9%.

The limited impact on the debt ratio ( just 1 percentage point) has prompted some to question whether the money might be better utilised to fund capital or even current spending, with most of the argument centred on the former. Whether this would be wise given that the economy is operating at or even above potential is one consideration, albeit not an argument one often hears from politicians, but there is a more significant constraint; Ireland is subject to the budgetary rules of the EU’s Preventive Arm, designed to reduce the risk of utilising one-off receipts, like the AIB monies, to fund increases in spending.

To that end an Expenditure Benchmark is in place setting a limit on the level of General Government spending ( Fiscal Space) allowed, net of any taxation changes, and the AIB  proceeds are not classed as General Government revenue. Capital spending, it could be argued, differs from current spending in that an asset for the State is created, but total capital spending is not exempt from the spending rule, only any increase relative to a 4-year average. For example, if the Government announced it intended to spend €6bn next year and the 4-year average was €4bn, a net €2bn would be exempt from the Expenditure Benchmark, However, the €6bn would obviously boost the  Budget deficit, which is also subject to EU rules, in this case a requirement to reduce it by at least 0.5% of GDP when adjusted for the economic cycle.

Putting the money aside or into a special fund would make no difference in terms of the above constraints. Ireland could simply ignore the rules, of course, and de facto there seems little prospect of any State being fined for a breach, but one doubts if there would be any appetite from the current Administration for such a move, as it risks alienating  key European partners amid Brexit negotiations .

Government Fiscal projections beg some questions

As pointed out in a recent Blog (‘Next Government may have €2.5bn more to play with’) the European Commission has revised up its estimate of Ireland’s longer term potential growth rate and as a result the Government has more fiscal room to manoeuvre than previously envisaged. The ‘Summer Economic Statement’ projects spending and taxation figures out to 2021, based on these new assumptions, and as such helps to clarify and quantify some of the budgetary options open to the Administration, although begging other questions about the effective Fiscal Space available.

For 2016,  tax and PRSI revenue is now expected to be €1bn ahead of target, with about half of that earmarked for higher spending, largely on health. Consequently , the fiscal deficit is now projected at 0.9% of GDP instead of 1.1%.

A lot of media coverage has focused on the outlook for the 2017 Budget. That is predicated on 4.2% GDP growth following 5% this year, which feeds into revenue projections, and under the Expenditure benchmark the Government could increase spending  (net of any tax changes) by up to  €1.7bn, or 2.5%,  and thereby keep the structural budget deficit on a downward path. Of course the option is always there to increase spending by less than the stated sum, which would reduce the deficit and therefore the national debt at a faster pace, which some would argue for, given that the economy is operating above capacity.

The €1.7bn fiscal space is likely to be used, nonetheless,  and Finance estimate that demographic pressures and existing public sector pay commitments will swallow up an additional €0.7bn, leaving a net €1bn for the Minister to utilize. The Statement indicates that two-thirds of this will go on increased current spending, with the balance used to fund tax reductions, a split set to continue out to 2021.

On the published figures the gross fiscal space over the next five years is projected at €14bn, with a net figure of €11bn. However, the €3bn gap makes no allowance for any general rise in public sector pay or  the indexation of the tax system  and may also substantially underestimate the demographic pressures on areas such as education and health, particularly the latter if the recent past is anything to go by.  As a result gross voted current spending actually falls substantially relative to GDP ( to under 20%) which appears unrealistic and inconsistent with a pledge to devote far more resources to the provision of public services.

Public Capital spending has plummeted in recent years and the Statement makes great play with the need to significantly increase resources devoted to infrastructure and housing. Yet, by 2021, gross capital spending is still only 2.7% of GDP, against 2.1% this year. In fairness, the EU’s fiscal rules are a constraint in that capital spending in the aggregate is not excluded from the Expenditure benchmark, but it is clear that public sector investment will still be taking a very low share of GDP by international standards ,and the planned increases are certainly  not transformative.

Economics is about choice  and this Statement highlights that while the new Government may  have a little more flexibility than thought it will still be faced with difficult decisions as to how to allocate the fiscal space between taxation and spending, and indeed how much is used to expand the volume of public services and how much in higher pay for those delivering the services.

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.

 

Next Government may have €2.5bn more to play with

A new Irish Government has yet to be formed post-election but EU fiscal rules have not gone away and to that end the Department of Finance has just published its annual Stability Programme Update (SPU) which has to be submitted to the European Commission  by the end of April. The SPU sets out medium term fiscal and debt projections based on updated economic forecasts. The publication would also normally provide a detailed breakdown of the monies available to the government of the day given the constraints imposed by Brussels in order for Ireland to comply with the Stability and Growth Pact. However, in this case, there is no detailed breakdown of the ‘Fiscal Space’ available to the incoming administration, although it is possible to arrive at some broad conclusions given other published information. On that basis it seems there may be more Space available than previously envisaged, as much as  €0.5bn annually over the next five years.

Irish GDP growth emerged at 7.8% in 2015, well above any earlier forecasts, which has prompted a rise in the consensus estimate for the current year. Consequently it is not a surprise that the SPU has also revised up the official  growth forecast for 2016, to 4.9%, from the initial 4.3% underpinning the  Budget. That has not resulted in any change to forecast tax receipts, although other minor revisions mean that the General Government deficit is now expected to be marginally lower that previously projected, at 1.1% of GDP instead of 1.2%.

The EU rules impose limits on the growth of government expenditure (net of certain adjustments like unemployment benefits, debt interest and capital spending) with that limit depending on  the economy’s potential growth rate averaged over a decade. A key development in the SPU  is that Ireland’s potential growth of late is now estimated to be much higher than previously thought. In 2015, for example, potential growth was estimated at 3.4% but is now put at 4.4%, with a figure of 5% now seen for both 2016 and 2017. In addition , Irish Government expenditure  in 2015 has been revised up by €1.5bn (reflecting a reclassification of State transactions with AIB ) which therefore raises the expenditure  benchmark. These two changes mean that spending can now rise by  a greater amount while still complying with the fiscal rules.

In the 2016 Budget, for example, the Government was limited to a €1.2bn increase in spending (net of any tax change) and this Fiscal Space was fully realized. It now appears that the figure could have been higher, perhaps €1.7bn.  In 2017, the gross Fiscal Space  available was estimated  at €1.3bn but  may well be above that given these new figures, at €1.7bn or €0.9bn  in net terms when allowing for  known demographic pressures on spending  and  other existing  expenditure commitments. This net Fiscal Space figure compares with the €0.5bn previously published.

Further out in time, the higher GDP growth figure will boost the Fiscal Space , as will the EU decision to allow Ireland to aim for a small budget deficit (0.5% of GDP) rather than the budget balance target previously agreed. The  result is that the  net Fiscal Space available over the five years from 2017 to 2021 may be around €11bn , rather than the €8.5bn previously published by Finance. How those resources are allocated will be up to the new government, although one should note that they make no allowance for any broad based increases in public sector pay and may underestimate the pressures on the Health budget.  Of course the government also has the option to eliminate the deficit completely and to run down  the national debt at a faster clip, by choosing not to utilize all the available Fiscal Space, but that appears unlikely given the present political backdrop.

 

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.