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.

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.

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.

 

Euro Fiscal Rules to the fore in Irish Medium Term Outlook

The Irish Government has just published the annual Stability Programme Update, incorporating macro-economic projections out to 2020 and  a forecast of the fiscal position over that period. The figures indicate that this  Administration has the scope to deliver some further modest tax reductions in the 2016 Budget, and no doubt that will  garner the most column inches, but a key feature of the text is the degree to which EU fiscal rules will remain a constraint for Irish Budgetary policy.

The near term economic and fiscal outlook certainly looks brighter than it appeared in last year’s Update, or indeed at the presentation of the 2015 Budget (in October last year). Tax receipts are running well ahead of target and the Department of Finance now expects a €1bn overshoot, which appears conservative. Non-tax receipts have also surprised to the upside , thanks to a higher Central Bank surplus, and debt interest is now expected to be substantially lower than initially forecast. Capital receipts are also likely to be well ahead of the Budget projection, with the result that the Exchequer deficit ( the cash sum that  it needs to  borrow ) is now forecast at  €3.5bn instead of the initial €6.5bn. The impact on  the  General Government deficit is not as large ( some of the unplanned capital receipts are excluded ) and that is now expected to come in at €4.6bn, or  some 2.3% of GDP , against a Budget target of 2.7%.

Surprisingly, perhaps, the Department has resisted the temptation to  materially revise its previous growth forecasts; real GDP in 2015 is now projected to increase by 4% instead of 3.9%, with 2016 now 0.4 percentage points higher, at 3.6%, but growth in each of the next two years is now expected to be 0.2 percentage points lower. Nominal GDP is forecast to rise strongly this year, up 6.9%, but by 2018 is only 1% higher than previously envisaged.

In the past greater tax buoyancy often resulted in higher exchequer spending and/or tax reductions ( ‘if I have it I’ll spend it’, to quote Charlie McCreevy) but Ireland’s membership of the euro imposes fiscal constraints. One, under the corrective arm of the Stability and Growth Pact,  was the requirement to reduce the  fiscal deficit to under 3% of GDP. That achieved, Ireland has now to adhere to the Preventive arm, and this imposes two constraints over the next few years.

The first is that Ireland has to move to a structural budget balance ( the actual balance adjusted for the economic cycle). According to the EU Ireland is now operating around full capacity ( a strange assumption, in truth ) so none of the actual  deficit forecast for 2015 is deemed cyclical. Hence the structural deficit is projected at 2.6% and under the rules Ireland has to reduce that by at least 0.5% of GDP each year.

A second rule, designed to complement the first, limits the  amount the government can spend. Certain items are excluded from the requirement, such as debt interest, capital spending and some unemployment benefits , which in Ireland’s case means  that €66bn falls under the with the limit, from a grand total of €73bn. The former can only grow in line with the potential growth rate of the economy or in Ireland’s case at a lower rate in order to ensure that the structural deficit declines. That potential growth rate is in turn calculated periodically by the EU, and it appeared that the existing  formula would leave the Government with little room to manoeuvre  in the 2016 Budget ( with little ‘fiscal space’ in economic jargon) . However, the EU has now been persuaded to update potential growth estimates on an annual basis and although spending is still constrained the permitted rate of  spending growth in Ireland has increased, to 1.6%, and it  now appears that the Government has around €1.3bn in terms of ‘fiscal space’, or around €1bn more than envisaged a few months ago, Those additional resources , according to the Minister for Finance, will be used to increase spending by around €0.6bn in 2016 while also reducing taxation by a similar amount.

One issue is that the structural deficit is only projected to decline by 0.4 percentage points in 2016 ,to 2.2%, which may cause problems for the EU. Further out, the Update projects that tax receipts will rise slightly faster than GDP and that the structural deficit  will decline by 1% per annum in both 2017 and 2018 , before moving to surplus in the following year. Yet  that outcome is achieved by assuming  unchanged  current spending in nominal terms, which is clearly incompatible with any real increase  if inflation is anything above zero.  The implication is that any Irish government, of whatever political hue, will continue to face significant fiscal constraints over the medium term, and the limited resources available will intensify the debate about  the efficacy of tax cuts as against  spending increases.