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.