Budget 2004 sees the Government trying to honour its many fiscal commitments in a climate of economic change, writes Philip Lane.
The Government is currently designing the 2004 Budget, to be announced by the Minister for Finance on December 3rd. It is useful to view the upcoming Budget in the context of designing a new medium-term fiscal strategy. Although there is much to celebrate in the fiscal turnaround in Ireland since the mid-1980s, there is much to suggest that we are now at a turning point and a new direction must be set for budgetary policy.
In recent years, Ireland has enjoyed extraordinarily favourable fiscal dynamics. Rapid economic growth combined with low interest rates have resulted in a massive reduction in debt servicing payments. In turn, this has permitted the Government to sanction a spectacular increase in non-interest current and capital expenditure, with the ratio of non-interest spending to GNP rising by seven percentage points during 1996-2002.
The scale of the reduction in the debt burden has also allowed a considerable decline in taxation, despite this expenditure boom.
According to the National Economic and Social Council (NESC), the tax burden on a household receiving the average manufacturing wage has halved between 1993/94 and 2003, falling from 32.4 percent to 16.1 per cent.
Indeed, the Organisation for Economic Co-Operation and Development (OECD) calculates that the net tax burden (i.e. taxes less cash benefits) on a "typical" household (consisting of a couple with two children that is reliant on one earner bringing home the average wage) is now slightly negative in Ireland at minus 0.8 per cent of gross wages, whereas a similar household pays 18.6 per cent in Germany, 10.6 per cent in the UK and 11.3 per cent in the US.
Taken in combination, these trends cannot continue. The slowdown in the economy and a turning in the international interest rate cycle mean that the Government can no longer rely on declining debt servicing payments to mask unsustainable trends in expenditure and taxation.
A new fiscal strategy is required. This must be framed in a medium-term context, in order to avoid costly stop-go volatility in spending and taxation policies. Indeed, the Government has already made several medium-term fiscal commitments that must be incorporated into any coherent fiscal framework.
First, Ireland has a severe shortage of public infrastructure. A recent study ranked Ireland last among 22 industrial countries in terms of the ratio of public capital to GNP. This infrastructural deficit can only be addressed by maintaining a sustained level of public investment over a 10-15 year horizon, as opposed to a short-term burst of spending that delivers poor value for money through a combination of inadequate planning and project design plus its inflationary effects in the construction sector (EU data show that the construction price index rose by 92 per cent in Ireland over 1996-2002, as opposed to an EU average of 28 per cent).
Second, the Government showed remarkable prescience in launching the National Pensions Reserve Fund (NPRF) in 2001 and committing to a minimum contribution schedule, with at least 1 per cent of GNP to be paid into the fund each year. Although the level of pre-funding will only partly meet the rising bill for public pension liabilities, the fund is a welcome initiative and is now attracting imitators across Europe.
The recent ESRI Medium-Term Review proposed that payments into the fund be suspended until 2015, on the basis that the infrastructural deficit should be largely corrected by then, freeing up resources that could allow a tripling of the annual payment into the fund at that point.
This is a risky strategy in that there are many claims on Government revenues that are set to rise, with the fund unlikely to be at the front of the political queue. Rather, it is much more prudent to maintain the current level of payments into the fund, possibly with room for extra contributions after 2015.
The success of the fund also depends on the appropriateness of its investment strategy. In this regard, its plans to extend its scope to include participation in domestic PPP projects are extremely dangerous.
Greater involvement in the domestic economy risks politicising the investment process and harming the reputation of the fund, in that the interests of the fund may be pitted against the interests of consumers and taxpayers in a range of plausible scenarios.
Moreover, the fund taking on the role of 'private' partner in a PPP does not constitute a transfer of risk from the taxpayer to the private sector. Despite the construction of Chinese Walls, it also could give rise to perceptions of a conflict of interest between the various arms of the National Treasury Management Agency, in view of its central role in both the fund and the newly established National Development Finance Agency, which is charged with advising public sector entities on the financing of investment projects.
In addition to investment in public capital and NPRF financial assets, another medium-term target of Government policy has been the promotion of private savings, both through the SSIA scheme and the PRSA initiative. There are strong public policy reasons to provide incentives to save: however, the design of both schemes has been heavily criticised.
The PRSA programme is at an experimental stage but the low initial take-up suggests that its design will have to be soon revisited and will possibly involve some level of compulsory participation. From a budgetary perspective, the SSIA scheme suffers from the opposite problem, with its very generous conditions inducing a very high participation rate and now absorbing about €500 million annually in matching contributions from the Government.
However, the SSIA scheme has been quite successful in terms of policy objectives: household savings have sharply risen, even if it is partly attributable to greater economic uncertainty and other factors. The current SSIA scheme is set to conclude during 2006-2007. As part of its medium-term fiscal strategy, it is now time for the Government to design the terms of a successor programme.
The follow on "SSIA-2" scheme should encourage the transfer of funds from existing SSIA accounts to PRSA accounts. Moreover, the level of matching contributions in SSIA-2 should be markedly lower than the current 25 per cent rate.
Indeed, a lower matching rate would be perfectly consistent with the spirit of the existing programme: while a high subsidy rate may have been useful in establishing a pro-savings culture, a more modest subsidy should be sufficient to maintain an already-established savings habit.
Taken together with the adverse shift in the underlying fiscal dynamics, these various commitments suggest that Government should take three important steps.
First, as was recently recommended by the OECD, a "reinventing government" programme is required to ensure greater efficiency in public expenditures. In this regard, the modest productivity commitments under the benchmarking agreement should only be viewed as a first stage of a broader set of reforms.
Second, Ireland should take advantage of its EU Presidency to promote reform of the Growth and Stability Pact: countries with low debt and high net public investment should face a looser constraint on borrowing.
Third, even with more efficient public spending and higher borrowing, the Government will soon have to accept that the current tax regime is not compatible with its expenditure commitments and should prepare the electorate for some clawing-back of the income tax reductions that it introduced in recent years.
Philip Lane is director of the Institute for International Integration Studies (IIIS) at Trinity College Dublin. He is one of the speakers at today's Pre-Budget Seminar, jointly organised by the Economic and Social Research Institute and the Foundation for Fiscal Studies