ANALYSIS:Having dodged the issue during the boom, a sustainable balance between spending and tax must now be struck, writes DAN O'BRIEN
THE CENTRAL political choice in modern, peaceful democracies is how big the state should be and what it should do. In essence, this involves a decision on how much tax to raise and from whom, and how raised revenues are spent and who benefits.
During the boom, public spending in Ireland grew more rapidly than any other euro zone country. Simultaneously, most tax rates were cut and many low and middle-income earners ceased paying any income taxes. Halcyon days.
All the main political parties bought into this have-it-both-ways bonanza. They vied with each other to demonstrate how they could be all things to all men.
Having the best of both worlds is wonderful, if it can be sustained.
In Ireland’s case it has proven to be spectacularly unsustainable. The public finances have exploded so disastrously that this State and its people face years of austerity and have already suffered the ignominy of becoming a ward of the international community.
Having lost a great deal of economic sovereignty as a consequence, the elected government will not have a say in the size of budget adjustments over the next three years. This choice will now be made abroad. That is what a loss of sovereignty of the kind that has been suffered means.
But within the parameters of a three-year bailout package, some choices remain about how the headline budgetary targets are met. Under the terms of the rescue, there is scope to alter the measures it contains, provided targets are met and subject to a veto wielded by each of the overseeing institutions – the European Commission, the ECB and the IMF. That scope includes the balance between taxation increases and spending cuts as a means of balancing the books by mid-decade.
The rescuing institutions have shown themselves, thus far at least, to be quite agnostic in setting this balance. European economics commissioner Olli Rehn has come closest to expressing a preference, twice stating in recent weeks that Ireland would become a “normal” tax country.
Paranoia in Ireland about corporation tax led these remarks to be wrongly interpreted as a desire by the commission to impose a higher rate on Ireland. In fact, Rehn was merely pointing to the fact that Irish Government revenues, which are mostly accounted for by taxation, have shrunk even more than has the economy.
As a result, what the Government takes in now is lower than during the boom years as a percentage of the most commonly used measure of an economy’s size – gross domestic product (GDP).
Even anticipating the big tax increases just announced in the Budget and the further (if considerably smaller) hikes the outgoing Government has slated for 2012, the European Commission’s forecasters believe that Ireland will remain the second lowest taxing state among the 16 members of the euro zone in the near term.
Their forecasts, which are illustrated in the graphic below, suggest that tax in Ireland as a percentage of GDP in 2012 will be just over one-third. Only Slovakia, which endured four decades of an overbearing state in communist times, is expected to have smaller government.
This size of the State in Ireland is expected to remain relatively small despite a nominal increase in the revenues, according to the Government’s estimates, which are based on somewhat more optimistic growth forecasts than the commission’s, of approximately €4.5 billion over the next two years.
The evidence of past crises of the kind Ireland is suffering points to spending cuts as the most effective means of restoring budgetary stability as economies get back on their feet. In the near term, therefore, effectiveness considerations would suggest that spending cuts, rather than additional taxing, be the focus of stabilisation efforts.
This approach is broadly shared by the Government and Fine Gael. The Labour Party advocates a 50:50 split between cuts and new taxes next year, while Sinn Féin proposes that approximately 80 per cent of the adjustment should come from tax increases.
By 2013, if the recovery is taking hold (a big if), a real political choice will emerge between raising more tax to pay for publicly provided services or a lower tax model with fewer services. This choice will not be guided by evidence, but by longer-term societal preferences.
Once a fiscally challenged economy recovers, past experiences do not point to cuts being a more effective way of balancing the books. Separately, the argument that lower taxes lead to higher economic growth is not supported by evidence from across the developed world over decades.
Having enjoyed such a long period during which hard choices were avoided and serious debate about the balance between tax and spending did not take place, followed by a period of traumatic crisis, there will be real choices to be made when something approaching normality returns.
Dan O’Brien is Economics Editor