ECONOMICS:Irish fiscal adjustment runs the risk of failure because it avoided cuts in public spending, writes JIM O'LEARY

SO FAR, the adjustments made by the Government to correct the huge imbalance in the public finances have leaned too heavily in the direction of tax increases for the liking of many economists. This is especially true of the measures announced a fortnight ago of which tax hikes accounted for two-thirds on a full-year basis. Looking forward, what detail has been published for the next two years suggests that taxation will continue to shoulder a much larger share of the burden of adjustment than either current or capital spending.

In 2010, tax increases are projected to raise a further €2.5 billion, with current and capital spending cuts contributing €1.5 billion and €750 million respectively. In 2011, the corresponding figures are €2.1 billion, €1.5 billion and €1 billion.

It is only fair to point out that the Government has indicated that the tax increases envisaged for 2010 and 2011 are the maximum and the spending cuts the minimum that will be sought.

The scale of the tax increases imposed this year is enormous. The measures announced in October, together with those announced on April 7th, will increase taxes on income alone by more than €4 billion in a full year, the equivalent of 2.5 per cent of GDP or not far short of 4 per cent of personal income. Tax hikes of this magnitude in a single year are without precedent in Ireland.

The budgetary adjustments under way mark an abrupt end to Ireland’s much vaunted low-tax regime, a regime to which all the major political parties were fervently pledging their allegiance as recently as the 2007 general election.

The regime shift is cast in especially sharp relief by the behaviour of marginal tax rates, which declined steadily and very substantially on a cumulative basis over the preceding two decades, but have now rebounded sharply, by as much as 7-8 percentage points for substantial swathes of taxpayers. In some cases – for example, single PAYE taxpayers earning in the vicinity of twice the average industrial wage – the marginal tax rate is now back at a level last seen in the early 1990s.

When it comes to fiscal adjustment, most mainstream economists would prefer that public spending take the strain rather than taxation.

There is both a theoretical and empirical basis for this preference. Arguably the most compelling of the theoretical reasons, and the one that resonates most strongly with Ireland’s historical experience, has to do with competitiveness.

Tax increases damage an economy’s international competitiveness because of their effect on labour costs, while cuts in current spending, especially spending on payroll and transfer payments, tend to have positive competitiveness effects.

The empirical basis for the preference is provided by a large body of research into the question of what makes for successful fiscal adjustments, the most influential contribution to which was a 1996 paper by Alesina and Perotti*.

They concluded that fiscal adjustments that relied on reductions in current spending tended to be successful and had relatively benign effects on the wider economy; adjustments that leaned heavily on tax increases and cuts in capital spending tended to be self-defeating and to have more contractionary macroeconomic effects. So far, Ireland’s fiscal adjustment is much closer to the second type than the first, suggesting that it runs a high risk of failure. However, there are some reasons to hope that this is an unduly pessimistic assessment.

On the one hand, the current Irish adjustment is at an early stage and there is plenty of time for its character to change. That said, if its character is to change decisively in the direction of the kind of adjustment discovered by Alesina and Perotti to be successful, most of what remains to be done will have to be accomplished by spending cuts, implying that the parameters that the Government has set out for 2010 and 2011 will need to be radically altered.

On the other hand, and much more fundamentally, one must enter an important caveat about the existing empirical research, namely that applying the conclusions of that research assumes that the sort of economic behaviours that obtained on average across countries over the past 40 years or so will continue to obtain in the future.

Ordinarily, that might not be such a fragile assumption but, in the aftermath of events as tumultuous and epoch-making as those that are currently unfolding, it could prove to be a treacherous basis for policy design.

When the dust has settled on the current economic and financial crisis, we are unlikely to see a return to business as usual, to coin a phrase.

In particular, one of the features that may well distinguish the period ahead from the closing decades of the 20th century is the attachment by citizens of much greater value to the services provided by the State and its agencies and, on that account, a much greater willingness by workers to pay taxes without attempting to pass them on to their employers.

If this is the case, it offers the hope that the negative connection between tax increases and competitiveness, which operates through compensatory wage increases, can be weakened or broken entirely.

Of course, in this kind of world, the spotlight is even more firmly directed than hitherto on the quality, effectiveness and value for money of public services. Bringing the concept of the social wage to life may provide more head room for raising taxes, but it doesn’t in any way diminish the imperative of maximising public sector efficiency.

*A Alesina and R Perotti (1996): Fiscal Adjustment in OECD Countries – Composition and Macroeconomic Effects, NBER Working Paper 5730