Monday 26 September 2016

Economy is on track - but minimalist Budget would still be the wiser choice

The Government would do well to remember that it's best to keep some powder dry in the good times

Published 28/08/2016 | 02:30

Head of the Federal Reserve Janet Yellen hinted that the next increase in US interest rates could be coming soon. Photo: Mark Lennihan
Head of the Federal Reserve Janet Yellen hinted that the next increase in US interest rates could be coming soon. Photo: Mark Lennihan

The 2017 Budget will be introduced on October 11, which is just six weeks away. Documents released recently by the Department of Finance suggest that the Government will be able to further reduce the budget deficit while providing for spending increases and tax reliefs. There is some fiscal space, in other words. Lobby groups and political parties are returning from the holidays and the available fiscal space will be spent many times over before Budget day.

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The Government's five-year framework sees the presumed fiscal space absorbed mainly by extra current spending, with some going to tax reductions and to capital projects. This fiscal space is no more than a forecast, not some treasure chest located in the vaults below Merrion Street.

If the economy continues to do well over the next few years, it might prove possible to finally eliminate the deficit and to begin reducing the debt overhang, meanwhile accommodating a further relaxation of budget policy.

If the forecasts turn out to be too rosy, the exuberance of the politicians and lobby groups will have an early date with economic and financial reality.

The Irish economy contracted sharply over the period from late 2007 into 2010, bottomed out, and has been expanding at a rapid rate for the last three years. The percentage of the workforce unemployed has fallen from 15pc to a little over 8pc, and consumer spending has recovered. These developments have improved government finances, which have also benefitted from a sharp fall in debt service costs, courtesy of the European Central Bank's easy monetary policy.

Two other favourable factors were important. Ireland is heavily reliant on energy imports, and the collapse in prices was a major bonus. So too was the weakness of the euro against sterling and the dollar, more important trading currencies for Ireland than for the typical eurozone member. These three factors - falling borrowing costs, falling energy prices, and a softer exchange rate - explain a lot of the outperformance these last few years.

As a result, the economic recovery in Ireland has been faster than elsewhere in the eurozone, following a faster decline when the credit bubble burst. But the three favourable factors will not be repeated. Official interest rates are at an all-time low and the next big move, however long delayed, can only be upwards.

Last Friday, Janet Yellen, who heads the Federal Reserve, the US central bank, hinted that the next increase in US interest rates could be coming soon. Energy costs have stopped falling, and the Brexit decision has seen a depreciation of sterling and hence a reversal of the competitiveness gain for many Irish businesses.

The brisk pace of the Irish recovery has already seen some evidence of strain on productive capacity, with wage pressures beginning to emerge, and an acute shortage of affordable housing, especially in the Dublin area. Even if the Government had complete freedom of action, unencumbered by the huge overhang of public debt, it is not clear that fiscal stimulus would be timely.

The historic volatility of economic activity here, and the extreme vulnerability to external developments, should always be a caution against expansionary budget policy when things are going well anyway. It is always best to keep some powder dry in the good times, even more so when a high debt burden will constrain the Government's options should fortunes change. A policy of running the largest deficit allowable under EU rules is risky unless cheap borrowing is guaranteed indefinitely.

Recent forecasts, on which the estimates of 'fiscal space' are based, assume that economic expansion at some decent rate, like 4pc per annum, is likely to continue more or less indefinitely. After a really good three-year run, there is simply no guarantee of such a benign outcome, and the UK's imminent departure from the EU clouds the picture further. No definitive data is yet available, but Brexit uncertainty may trigger a slowdown in private sector investment here, and it will be well into 2017 before the impact is evident. The Budget in October does not need to give an extra boost to an economy already expanding as well as could be expected, and it would be wise to leave some 'fiscal space' unspent, given the uncertainties.

It is clear from the commitments in the Programme for Government that this will be an activist budget with numerous changes in both taxation and revenue, at a time when a minimalist budget might be the better course. There are commitments to commence the reduction in the Universal Social Charge (USC) and to assorted increases in current and capital spending. The USC raises €4bn per annum, a very substantial sum, and any material changes will be costly. The Tax Strategy Group, an internal civil service think-tank, has drawn attention to the very large increases in alternative taxes that would be needed to replace the revenue from USC, admittedly an unpopular imposition (so are the alternatives) but a progressive tax based on ability to pay.

The group's document on energy taxes proposes a major change to levies on motoring. Specifically, the group questions why tax on road diesel should be lower than the tax on petrol, noting that emissions from diesel are actually more environmentally damaging than those from petrol, and that the differential encourages fuel tourism from the North, where there is no diesel discount. The forecourt price of diesel is about 15 cents a litre below the petrol price, mainly due to the more lenient tax treatment. As a result, sales of diesel cars have rocketed.

It would make sense anyway to shift motoring taxes away from purchase taxes and fixed annual charges, towards charges for road use, including tolls, parking fees and fuel taxes. The purchase tax, called vehicle registration tax (VRT), is steep in Ireland, and is also very cyclical. When the economy weakens, VRT tends to shrink rapidly, and conversely has grown quickly through the current recovery. A cut in VRT to offset a rise in the diesel tax would impart greater stability to overall revenue.

Politicians will be tempted to resurrect capital spending plans cancelled when the bubble burst. Some deferred projects should certainly be reconsidered - circumstances change - and the case has been made for more spending in areas like water supply and social housing.

The biggest single project on the political wish-list is a second tunnel in north Dublin, this time to house Metro North connecting to the airport and suburbs further out, at the enormous cost of €2.3bn.

If it goes ahead it will cost, for a single route, an amount equivalent to the entire bill for all of the Dublin Luas lines and the Port Tunnel. There is already a road tunnel delivering frequent and popular bus access on this route, built and paid for. Metro North looks like a solution in search of a problem.

Sunday Independent

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