Tough, But Another Step Towards Stability.

By Eoin Fahy , Tuesday, 7th December 2010 | 0 comments
This Budget will reduce the deficit by about €6bn , yet Ireland will still have a deficit of about €18bn next year.  In those circumstances Budget 2011 needed to have credibility, to be capable of implementation even after a change of government, to avoid the use of accounting tricks or once-off measures, and to minimise the risk of depressing growth so far that the onset of an economic recovery recedes further.  On the whole, it seems to have met those objectives, although the banking system and the political system remain the great unknowns.
The main measures in the Budget are described in a separate note.
So the most-feared Budget in a generation has finally been announced.  And there was very little in it that came as a surprise, given that the key features were first announced in the National Recovery Plan two weeks ago, and then reaffirmed when the draft agreement with the IMF/EU was published by the government last week.  Social welfare rates have been cut, income taxes have been raised, capital spending has been decimated, and day-to-day government spending is being trimmed.
In macro terms, the deficit will fall to 9.4% of GDP, or €18bn, from this year's astronomically high level of 32% of GDP, although this year's figure is of course inflated by the cost of the bank rescue.  The overall package is about two-thirds expenditure cuts, and one-third tax increases, and is about twice the size of the package in the last Budget.
After these measures, government spending next year will be about €57bn, while total revenue will be €39bn, leaving a budget deficit of €18bn.  In 2011, the state will spend about 1.5 euros for every one euro it collects. The (gross) government debt to GDP ratio will be 99% at the end of the year.
The first test of the Budget is whether it is credible.  Are the economic assumptions behind it realistic?  Are there significant accounting tricks built into it that massage the deficit downwards?  Does it assume an unrealistically low interest rate on the national debt?
The Budget does pass this test, though probably with a "pass" rather than "honours" grade.  It assumes 2011 economic growth of 1.7%.  This is a bit more optimistic than most private sector forecasters, although the difference is not huge.  Economic growth is generally quite strong in the first year or two after the trough has been passed, and at the moment it seems quite likely that the worst point of the economic cycle was in the first half of this year.  In addition, there don't seem to be any particular accounting tricks or 'dubious' once-off measures that flatter next year's figures.  So on the whole, the budget looks credible, although the economic growth forecast may raise some eyebrows.
Given the political reality that a general election is imminent, and that a change of parties in government is extremely likely, another test for this budget is whether it can be approved by the Dail in votes to be taken in the very short-term, and also whether an incoming government would be able and willing to keep most of the budget in place.
At this - early - stage it appears likely that the Government will have enough votes to pass the budget.  In itself that shows just how serious the current crisis is - only in such a dire situation would it be possible for a minority government to be able to get such an extremely tough budget through.  But if the budget does indeed pass, it is an important signal to the financial markets, the IMF and the EU, and perhaps most importantly to depositors with Irish banks, that Ireland has taken one more small but important step towards stability.  
And what of the incoming government?  It's hard to be sure about this as of course we don't even know what parties will be in government, never mind what policy position they might or might not reach next spring.  One of the likely new government partners, the Labour Party, has stated that it thinks the size of the total package should be €4.5bn in 2011, not the €6bn in this budget. Both it and Fine Gael have said they oppose the cut in the minimum wage.  So the question is whether by the time they might take office next spring, we will be too far into the year, and too far along in the EU/IMF rescue package process, for a new government to reverse this budget.  My guess is that it will be very hard for them to change economically significant parts of the budget, although it would certainly be possible to unpick some of the more politically controversial, but non-costly, issues.
The next test for this budget is whether it has been designed in such a way to minimise the risk to growth that inevitably arises when a huge sum like €6bn is taken out of the economy.  This is not an easy task, of course, but most (not all) economic literature would indicate that tax increases are more damaging to growth than spending cuts (in this context, leaving aside issues of equity or fairness but focussing only on what works in terms of generating economic growth).  This budget does follow that principle, with two-thirds of the package being in the form of spending cuts, not tax increases.
Secondly, the nature of the tax increases matter.  Increases in tax rates have tended to produce far less revenue than expected, and indeed often lead to declines in revenues for a variety of reasons, including consequent growth in the black economy.  So, in general, it is better to tax a broader base of revenue, at a lower rate, than an narrower base at a higher rate.  In this budget, the tax base has indeed been broadened.  A large number of tax breaks (which economists call tax expenditures) have been scrapped or curtailed, which is efficient and equitable, and is certainly preferable to raising tax rates.
So while of course there is a risk that such a large package of cuts will damage the economy, the budget has made at least some efforts to mitigate the downside.
Taking the Budget as a whole, it appears to be credible in terms of the assumptions and forecasts underlying it, it seems likely to be passed by the Dail, and not likely to require wholesale changes from a new government, and it seems to be well designed in terms of the mix of tax increases vs spending cuts, and the focus on broadening the tax base.  It's tough and will certainly adversely affect just about every person in the state, including many who can ill afford any reduction in income, but it's necessary.
However, while it is certainly a necessary step towards financial stability in Ireland, and an important one, the liquidity position of the banks remains a bigger short-term concern than the fiscal situation of the government.  And of course we don't yet know that the budget and all of the legislation that translate the budget into law will be passed by the Dail.  So while this is, as I said above, a necessary step towards stability, we are certainly not there yet.

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