BUDGET 2009 OPINION:A multi-year plan is needed to restore stability to the Government's finances, writes Philip Lane
BRIAN LENIHAN must design his first budget against a backdrop of an extraordinary economic decline, with an even more extreme deterioration in the fiscal position. In 2007, GDP grew at a very respectable 6 per cent rate. According to last Friday's Central Bank forecast, GDP will fall by 0.8 per cent in 2008, with a further contraction projected for 2009.
Moreover, the decline in real incomes is even more extreme, once the output growth rate is corrected for profit outflows and the increase in the relative price of imports, with the ESRI forecasting a decline in real income in excess of 2 per cent in 2008. This shift in economic performance is truly remarkable, with very few instances to match this decline in the recent history of OECD economies.
Given the scale of this economic downturn, it is not surprising that a Government budget deficit has emerged. During a downturn, it is natural that tax revenues fall in line with the decline in activity and that spending on unemployment assistance increases. However, the 11 per cent decline in tax revenues in 2008 cannot be solely attributed to normal cyclical factors. Rather, the scale of the decline reflects the collapse in property-related revenues.
Since 1997, the composition of core tax revenues underwent a striking shift, with the share of income taxes falling from 37.3 per cent to 28.7 per cent between 1997 and 2007, while the share of asset-related tax revenues increased from 4.7 per cent in 1997 to 14.1 per cent in 2007. Since the housing boom will not be repeated, asset-related revenues will not recover to the levels seen in recent years and the Government faces the difficult task of finding replacement sources of tax revenues.
The overall fiscal problem has been compounded by a rate of expansion in current spending in recent years that has exceeded the trend path for GDP. In effect, the windfall in tax revenues that was generated by the housing boom allowed the Government to increase many lines of current spending while still running a sizeable current budget surplus. Even when the economy recovers, current spending must adjust to a more moderate rate of growth, in which spending cannot grow more quickly than GDP growth, unless the Government commits to a substantial increase in traditional sources of tax revenue.
The combination of plunging tax revenues and still-fast current spending has contributed to an extraordinary decline in the general Government balance from a surplus of 0.5 per cent of GDP in 2007 to a projected deficit of 5.5 per cent of GDP in 2008. A deterioration of this speed and scale is unprecedented in the context of European Monetary Union.
The current Irish predicament easily meets the set of criteria under which countries can exceed the normal Stability and Growth Pact deficit ceiling of 3 per cent: the scale of the decline in growth is very substantial, the level of Government debt is low and the rate of public investment is high. However, further growth in the deficit combined with low or negative growth would see the debt to GDP ratio grow at an uncomfortable rate.
Moreover, it is plausible that the appropriate level of public debt for Ireland has been reduced by the rapid accumulation of private debt in recent years, with substantial private borrowing incurred to finance housing-related tax payments.
Accordingly, it is important for the Government to lay out a multi-year plan that will return the budget to inside the 3 per cent limit within a reasonable time frame. While there is clearly some scope for re-calibrating public expenditure, it is not credible that the adjustment can fully land on spending, in view of the considerable demand for improved public services and the added burden of increased spending on unemployment-related welfare payments.
Beginning in budget 2009, the fiscal correction requires a curb in many lines of current spending, the prioritisation of high-quality capital projects and a gradual increase in tax revenues. In view of the current low level of net direct taxes paid by typical middle and low income households (once account is taken of child benefit and mortgage interest relief), it is inevitable that the burden of higher taxation must fall on these groups, in addition to any extra revenues that are obtained from the highest income cohorts.
In this regard, a key priority is to design the nature of tax increases to ensure that incentives to participate in the labour market remain high for workers of all skill levels.
Since an excessive fiscal tightening runs the risk of deepening the recession, the fiscal adjustment should be conducted on a phased basis.
In terms of the overall budget balance, the general government deficit should be gradually reduced from the projected 2008 out-turn of 5.5 per cent of GDP, with a target of returning to below the normal 3 per cent ceiling by Budget 2011. Accordingly, a 2009 deficit in the 4-5 per cent range would signal a move in the right direction in terms of fiscal sustainability, while still constituting an accommodative counter-cyclical fiscal stance that takes into account the downturn in the economy.
It would be foolhardy to attempt to return to inside the 3 per cent limit too quickly, in view of the negative impact on the economy of excessively large increases in taxation or cuts in spending. This is especially the case in the context of EMU membership, since a loose monetary policy cannot be relied upon to fight the recession and other countries such as Portugal have counted the cost of tightening too quickly during a downturn.
The Government should also commit to establishing a new fiscal framework that minimises the risk of future pro-cyclical episodes in fiscal policy.
By reforming the fiscal process in this way, a period of temporarily high deficits can be reconciled with long-term fiscal sustainability. Moreover, as part of its commitment to fiscal sustainability, the Government should resist the temptation to deviate from its legal commitment to make an annual payment of one per cent of GNP into the National Pensions Reserve Fund: a suspension of payments merely represents deferred taxation, in view of the predictability of the increase in ageing-related public expenditures in the coming years.
Finally, the tight fiscal situation reinforces the urgency of pursuing reform across the public sector. Moreover, the loss of competitiveness in the private sector in recent years also requires the Government to intensify its efforts to promote lower costs and prices across the economy through its anti-monopoly policies.
Accordingly, even leaving to one side the Governments newly-expanded role in the banking system, the current debate about economic policy should be much broader than the forthcoming budget announcement.
• Philip Lane is professor of international macroeconomics and a research associate of the Institute for International Integration Studies at Trinity College Dublin. This article is based on his contribution to a pre-budget conference being hosted today in Dublin by the Economic and Social Research Institute