Irish Fiscal deficit may rise this year

Ireland’s GDP is unusually volatile, as is government revenue, which makes  for frequent forecasting errors in both. For the last three years the errors have proven positive, in that tax receipts have emerged ahead of Budget projections, resulting in lower than anticipated fiscal deficits as well as allowing the government of the day to augment spending in the latter months of the year.  Unfortunately that serendipitous trend appears to  be over, judging by the revenue figures available to end-April, and a tax undershoot for the year is looking more likely.

The 2017 Budget projected tax receipts of €50.6bn, and the Department of Finance still expects that to materialise, which requires a 5.8% increase on the 2016 outturn. Yet the annual increase over the first four months of the year is just 0.5%, with most headings actually down on last year, implying a serious risk of undershooting. Corporation tax has been the most difficult to forecast (exceeding the target by over €700m last year and by an extraordinary €2.3bn or 50% in 2015 ) and is currently some 23% down on 2016, with Stamp duty, Excise and Capital taxes also running well below the previous year in percentage terms.

The main exception is VAT, which is extremely strong, rising at an annual 14.5% or double the pace forecast in the Budget. This is curious given that retail sales grew by an annual  0.9% in the first quarter, but may reflect strong car imports and a rise in house completions. Income tax is also a puzzle, showing annual growth of just 1.2%, which appears at odds with other data implying a continuation of strong employment growth. The Budget forecast that Income tax receipts would end the year 5.6% above the 2016 outturn so , again, there is a lot of catching up to do if that target is to be hit.

The tax position against profile ( i.e. that expected on a monthly basis) is also  likely to be of concern to the Government, with a shortfall of €345m or 2.4%. VAT is running €257mn ahead but that has been more than offset by large shortfalls elsewhere, including €225mn in Corporation tax, €200mn in Income tax and  €120mn in Excise duty. The late Easter may be having an impact and Corporation tax is extremely lumpy on a monthy basis but the risk now is that the fiscal deficit will emerge above the current target of 0.4% of GDP. Moreover the 2016 outturn has now been revised down to just 0.5% so the 2017 figure may well be above this. A 2.4% shortfall in tax receipts at the end of the year, for example, equates to €1.2bn and all else equal would raise the deficit to 0.8% of GDP.

Does it matter?  The Exchequer’s cash position will  likely  be boosted by proceeds from the  sale of shares in AIB , so the debt ratio may well continue to fall. That transaction will not benefit the General Government balance, however, although Ireland has no longer to meet a  headline target for the latter under EU fiscal rules. In fact there are two, related constraints, which will come into play for 2018. One is that the deficit adjusted for the economic cycle  (the structural balance) has to fall by over 0.5% of GDP, and to aid in that process  a limit is put on government spending ( the famous Fiscal Space). The latter is already closing given an array of  spending commitments carried over into 2018 but the Government would not be able to use all the available space anyway if the  tax base emerged below forecast in 2017.

 

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.

 

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.