The European Commission has warned that the Government faces several economic challenges and a "noticeable deterioration" in its budgetary position in coming years.

Slowing domestic demand, lower levels of activity in the housing market, rising unemployment and a slowdown in important export markets such as the US and Britain are all factors underlining a transition to a period of lower growth. These factors could prove challenging for public finances as tax revenues are foreseen to weaken, says the EU executive's annual report on the economy under the Stability and Growth Pact.

"Ireland is facing several macroeconomic challenges in its transition to a period of lower economic growth, mainly linked to a return to more sustainable activity in the housing sector. Slowing domestic demand has been accompanied by losses in recent years in export market shares, pointing to price competitiveness challenges.

"The fiscal position is expected to register a noticeable deterioration in 2007-2008," says the report, which is an assessment of the Government's policy programme submitted to the EU last December.

In light of the more difficult economic climate, the commission recommends that the Government maintain firm control over expenditures and implement further pension reform to improve the long-term sustain-ability of public finances.

Ireland is at "medium risk" with regard to the sustainability of public finances and the long-term budgetary impact of ageing is well above the EU average. This is primarily due to high projected increase in pension expenditure over the coming decades, argues the commission.

The report is one of the most negative assessments of the Irish economy published by the commission since it began preparing annual evaluations in 1999. But on a more positive note it says that, after a decade of buoyant economic growth, Irish per capita income is among the highest in the EU. Ireland's public debt is also well below the 60 per cent of gross domestic product (GDP) reference level set in the EU treaties and the Government met its medium-term objective of balancing its budget in 2007, according to the report.

However, the commission warns that the Government's fiscal position is expected to register a "noticeable deterioration" in 2007/08, from a sound surplus in 2006. Ireland will register a budget deficit in 2008, which will increase somewhat thereafter, says the report, which will be discussed by EU finance ministers at a future council of ministers meeting.

The commission's economists say the Government's projections for real economic growth falling from to an annual average of 3.5 per cent up until 2010 from 4.8 per cent in 2007 are "plausible". But it describes its inflation projections as "somewhat on the low side" for 2008 given recent rises in energy and food prices, but plausible after that.

The report says risks to the Government's budgetary projections appear broadly balanced in 2008 but there is a lack of detail on what measures it will take to ensure spending growth will be contained below nominal GDP growth. Government commitments to reduce tax and social contribution rates are also risks to raising revenue, it says.