Tuesday 21 October 2014

Colm McCarthy: Great expectations of income tax cuts and wage rises are ill-founded

A real good news story will be when we have a balanced budget, not further borrowing, writes Colm McCarthy

Published 12/01/2014 | 02:30

WHEN THE BUBBLE BURST: Christmas shoppers in Grafton Street in 2008. The levels of public spending reached that year, the year of the bank guarantee, were financed to a substantial degree out of tax revenues that were artificial and temporary. Photo: Niall Carson

New taxes, sharp increases in existing taxes and deep expenditure cuts under numerous headings have been imposed since the extent of Ireland's budget crisis struck home back in the second half of 2008.

Despite all of this effort government spending out-paced government revenue by almost €1bn per month during 2013. In the coming year the Government will add a further €8bn to the debt mountain according to last October's Budget.

The State debt already exceeds €100,000 per employed person. Not until 2018 is a balanced budget envisaged in the recent medium-term government plan, and the debt will keep increasing until balance is achieved.

If the economy expands, the capacity to service that debt will improve and, ultimately, the portion of national income that has to be taken in taxation for debt service will peak.

But, if economic recovery is weak or delayed, the burden of debt on taxpayers will continue to rise. In 2014 the budget deficit, which has to be financed through fresh borrowing, will be almost five per cent of national output.

It is true that the figures were considerably worse a few years back and that substantial progress has been made in getting the deficit under control, but it is far too early for celebrations of success.

During the week, the National Treasury Management Agency (NTMA), the State's vehicle for borrowing money and managing the national debt, managed to raise €3.5bn in the international bond market at interest rates lower than have been available for some time.

The country is now exclusively reliant on market financing, since the €67.5bn borrowing programme from the EU, IMF and government-to-government loans has come to an end.

While it is reasonable to acknowledge that the deficit-reduction targets in the Troika programme have been met and that market funding is again available at better interest rates, the sale of yet more government debt is a funny kind of good news story.

It should make people nervous when a debt-raising exercise, in a country already seriously over-borrowed, is greeted as some kind of economic policy triumph. It will be genuine good news when the Government is able to announce that its revenue exceeds spending and that the NTMA is retiring government debt, rather than seeking holders for yet more new issues.

If the debt burden is to be contained, the gap between government revenue and spending needs to be eliminated as quickly as possible. That means more spending cuts and tax increases, even if the economy begins to improve.

It is stretching things to pretend that sufficient economic growth is in prospect to render this reality avoidable. But with the departing Troika barely checked out of Dublin the Government parties have already slipped the leash into pre-election mode, with public ruminations from ministers these last few weeks about cuts in income and payroll taxes.

It is hardly coincidental that there will be European and local elections in May and that the next general election is likely before the end of 2016.

If the Government sweet-talk gathers momentum, the opposition parties can be expected to weigh in with their own tax-cutting wheezes. The post-Troika celebrations are not confined to politicians: there is talk from trade union sources of 'restoring' public service pay levels and various expenditure budgets to their pre-crisis levels.

The levels of public spending reached in 2008 were financed to a substantial degree out of tax revenues which were artificial and temporary, a product of the credit bubble.

Even if that bubble could have been deflated without the huge Exchequer costs of the bank bailout, the budget would have gone into heavy deficit in 2008. Even the soft landing so widely presumed would have resulted in spending cuts and tax increases.

Since the landing was anything but soft, there can be no restoration of 2008 spending levels. The same applies to taxes unfortunately. Given the political commitment to a strong social safety net, tax revenues were simply too low when the bubble burst.

The State must now fund itself exclusively from the markets and must raise each year, at affordable interest rates, whatever deficits have to be financed as well as whatever maturing debt has to be rolled over.

Whether this can be done depends on the market believing that Irish State debt is sustainable. There are many different ways of measuring the sustainability of a country's debt. The most familiar is gross government indebtedness expressed as a percentage of national output.

This so-called debt/GDP ratio is likely to exceed 120 per cent at the end of 2014 and will decline quite slowly in the coming years, even if the economy recovers at a decent pace. Should recovery prove to be temporary or sluggish, it might not decline at all. While there are no hard and fast rules, a debt ratio above 100 per cent is a precarious position to be in.

Any country with such a high debt ratio is permanently exposed to the risk of an unfavourable turn in bond market sentiment. Even if things go well the Irish public finances will likely be in this precarious position for many years to come.

In addition to the overstretched public finances Irish households and non-financial firms remain heavily indebted too. This overhang of debt throughout the public and private sectors will continue to constrain domestic demand for many years to come, since all sectors need to restrain expenditure in order to pay down debt.

If aggregate demand needs to grow, and it certainly does, this growth needs to come from exports, not from a premature recovery in any of the domestic components of demand.

In particular, a consumer-led recovery is not advisable: there is too much leakage into imports anyway, and households need to save rather than spend if excess debts are to be curtailed.

Some trade union people have been urging wage increases in the private sector of the economy as a source of economic stimulus and job creation. This makes no sense at all: the economy had become seriously uncompetitive at the end of the bubble and regaining cost competitiveness, which means wage restraint among other things, is the key to export-led employment growth.

The unions appear to be saying 'Now that competitiveness is being restored, let's throw it away again', to which the answering chorus from some of the politicians is 'Now that the deficit is coming down, let's cut taxes and push it back up again'.

The source of this emerging loss of grip appears to be the exit from the Troika programme. In a speech last Friday, the Central Bank Governor Patrick Honohan judged the programme to have succeeded in its principal objective, which was to keep the Irish State in funds temporarily while market access was restored.

That is all that official lending programmes ever do and he made it clear that he sees the programme exit as a staging post on the way to resolving the larger Irish economic crisis, a process that has many years left to run.

He stressed the importance of measures to promote continued employment growth and noted "the crisis will have a lasting unfavourable legacy. The accumulation of debt, public and private, will continue to weigh on growth prospects in a variety of ways. And many households are being affected by long-term unemployment. But the damage can be ameliorated by a variety of means, including work on labour market activation and continued improvement of fiscal policy and measures".

Speaking at the same conference the IMF's Craig Beaumont (they haven't gone away you know) cautioned specifically against premature wage increases, precisely because it would put recent improvement in competitiveness at risk.

The speed of the budget collapse in 2008 and the growing realisation through 2009 that the banking system was also bust prepared the public for unpleasant policy measures.

A programme of painful adjustment was already in train before the EU/IMF bailout became necessary late in 2010. As a result there has been less public disquiet in Ireland, and less hostility towards the Troika, than has been evident in other distressed eurozone countries.

The public understood that the adjustment programme was not being imposed by outsiders but had already, in all key essentials, been adopted by the Irish authorities. It is vital that the progress made is not endangered through the mismanagement of expectations.

Irish Independent

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