Budget policy should be deployed to cool down the booming Irish economy, according to recent suggestions. While the focus of debate has been on deferring tax cuts, a full discussion should also involve public spending, for a number of reasons.
Firstly, a slower rate of expansion in Government employment and the amount it spends on goods and services directly reduces pressures on labour and output markets. Secondly, it allows the running of larger budget surpluses, providing a cushion for any future downturn. Finally, at the cost of less debt reduction, it permits tax cuts at a lower risk of overheating.
In this context, it is useful to examine recent trends in government spending. In the accompanying table, there are data on the inflation-adjusted growth in various expenditure components and, for comparison purposes, GDP over three periods: 1986-90; 1990-93; 1993-1997.
The broad message from the table is that the austerity of the 1980s has been replaced by a sharp fiscal expansion during the 1990s, with an acceleration since 1993.
The largest turnaround has been in government investment, which declined precipitously in the 1980s, but has recovered more recently.
Non-wage government consumption and transfers have also grown at a rapid pace during the 1990s. Public sector pay has also expanded. Non-interest government spending has grown by a staggering 51.8 per cent since 1990, only marginally behind the 53.5 per cent expansion in GDP.
This expansion in public spending has been made possible by the resources released by the decline in debt interest payments, which have fallen by almost 20 per cent during the 1990s, and the spectacular pace of economic growth.
As a result, government spending has decreased as a proportion of GDP since 1993, allowing tax cuts without raising the budget deficit. However, the reduction in government debt and/or the tax burden could have been significantly larger, if the expansion in non-interest public expenditure had been more restrained.
Prudence dictates that government spending (excluding investment) should be increased only in a restrained manner during a boom period. An aggressive expansion both exacerbates the boom, with the public sector contributing to shortages by competing for scarce resources (including labour), and stores up trouble for the future, in the sense that spending commitments incurred now may prove a source of inflexibility in any future downturn.
Moreover, inside EMU, the correction of such mistakes in the future cannot be facilitated by exchange rate devaluation, providing an even greater motivation to be fiscally cautious in the current situation. Unfortunately, governments have recurrently pursued pro-cyclical fiscal policies expanding when times are good and cutting back when they are bad.
Applying the brakes to public spending does not imply cuts. All that is required is a slower rate of expansion. In a growing economy, there is no reason for all sectors to expand at the same rate indeed, in the presence of labour shortages, some sectors must grow relatively slowly, or even contract, in order to release workers for the industries leading the expansion.
At a time of buoyant tax revenues, a fiscal balance that is only marginally in surplus represents a loose fiscal position. Rather, a current budget surplus of several percentage points of GDP would be more appropriate under present conditions.
Stronger controls on public spending would allow a combination of debt reduction and tax cuts that would do more both to prolong the current boom and provide us with a cushion to deal with any future downturn. Moreover, restraint on non-investment public spending is all the more necessary if we are at the same time to tackle infrastructural bottlenecks in the economy.
Of course, such fiscal discipline requires the political will to rein in expansionist spending plans. This represents a challenge to our consensus-based approach to economic policy formation, since it is difficult to obtain agreement on which programmes should receive relatively less funding.
The lesson of the 1980s is that it took a severe crisis before consensus was reached on fiscal adjustment in 1987. A preferable alternative is to take some mild preventive action during the current good times, in order to avoid the need for any harsher medicine in the future.
Martina Lawless assisted in the preparation of this article. See Philip R. Lane, On the Cyclicality of Irish Fiscal Policy, Economic and Social Review, February 1998.
