Timid but sensibly executed

By Eoin Fahy, Tuesday, 6th December 2011 | 0 comments

The Irish government no longer has control over the “big” budgetary numbers, as the troika essentially dictate the overall shape of the budget.  The government’s remaining decision powers relate only to whether to go further than the minimum troika-agreed cuts, and exactly how to implement them.  The fact that the austerity measures were at the lowest end of what was required is disappointing, but perhaps understandable.  And on a positive note, the details of the austerity measures were reasonably well-judged, with a focus on spending cuts and increases in spending (not income) taxes. 

It’s been known since the publication of the Medium-Term Fiscal Statement a month ago that this year’s austerity measures would total €3.8bn.  That’s essentially the minimum that the troika would accept, given the “hard target” in the bailout deal for the government deficit to be no larger than 8.6% of GDP next year. 

The Fiscal Advisory Council (the new independent body set up by the government to advise on fiscal policy) was among those pressing for a much larger austerity package, i.e. to reduce the deficit by even more next year, but this advice was rejected.

Deficit reduced by only 15%

The decision to go for the minimum cuts necessary was no doubt partly due to political necessity, and partly due to a genuine belief that larger cuts would be counterproductive as they would have a negative impact on growth. 

Still, the projected deficit of 8.6% of GDP next year is very high indeed by historical standards.  This year's deficit will be around 10.1% of GDP, so today's austerity measures - tough though they are - only reduce the deficit by about 15%. 

That leaves Ireland a long way and several more tough budgets from the balanced budget that is the ultimate aim of fiscal policy and that is clearly being insisted upon by our European neighbours (or should that be paymasters?).  It means that Ireland still has to borrow €19bn from the EU and IMF next year to fund the deficit, funding which we can only get if we continue to meet our targets during each quarter next year.

Overall policy mix was sensible

But while a bigger step along to the road to sustainable public finances might have been wise, the way in which this Budget implemented the €3.8bn of austerity measures was, in general, sensible from an economic point of view.  When income tax, PRSI and the USC are combined, the top marginal rate of tax is already above 50%.  At that high level, further increases would probably have raised little revenue due to the increase in avoidance and indeed evasion that arises as marginal rates rise too high, as well as the negative impact on economic activity that high marginal tax rates produce.  All told, a tax rate increase would probably have had a significant negative impact on economic activity yet might well have raised very little extra revenue, if any.

Instead, the government focussed on “indirect” taxes, i.e. taxes on spending, and of course particularly on VAT, which is set to rise by 2%.  As with any tax change, it has negative consequences.  In particular, it may impact lower income households more than an income tax increase, in percentage terms (although truly basic items such as food are not affected by the rise in the standard rate).  But it has the advantage of being efficient (hiring a clever accountant is far less likely to reduce a VAT bill than an income tax bill), and of leaving at least a small element of choice with consumers (they can, to a degree, decide whether or not to spend on standard-rated VAT items, but they have no choice at all if the money is deducted from their wages via the income tax system).

Apart from the income tax vs. spending tax question, the government also seems to have taken fairly sensible decisions in terms of the split between cuts in government spending and increases in taxation.  About 60% of the austerity package came from spending cuts, across all departments, and only 40% came from higher taxes (and less than 30% if the carry-over impact of last year’s tax increases is taken into account). Notwithstanding several tough budgets since 2008, government spending is still very high, which in the main is a carryover from the huge spending increases that were seen during the Celtic Tiger years and which are so very difficult to reverse.  In addition, the Croke Park agreement severely restricts the ability of the government to reduce public sector pay (it will fall by only about 1% next year).  So it was encouraging to see the government take tough decisions on the spending side.

EU issues remain key

In some ways of course, this is all a sideshow.  If the EU does not come with an final solution to the eurozone debt crisis, and quickly, the consequences for economic growth and indeed the banking system across Europe will be so large that decisions taken in this budget hardly matter. This was brought into sharp focus yesterday when S&P put the credit rating of every country in the eurozone on watch for a potential downgrade. 

But the Irish government has little influence or control over those issues; instead it must focus on managing the Irish economy and the Irish government budget.  It has made a reasonably good effort at doing so in this Budget.

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