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Colm McCarthy: Government spending is just too high for us to escape this rut any time soon

Ireland's efforts to get the budget deficit under control are into their fifth year, having started with mid-year expenditure cuts way back in July 2008. There have been tax increases in every Budget since, as well as cuts in both current and capital spending. But the deficit remains stubbornly high.

The underlying deficit (stripping out once-off costs of bank rescue) peaked at 11.5 per cent of GDP in 2009. In the current year it will be about 8.5 per cent, a small reduction and a meagre return for the enormous fiscal effort of recent years.

The reason why extensive cuts and tax increases have failed to cut the deficit more rapidly is straightforward: the pace of economic contraction in Ireland has been unprecedented. Over 300,000 jobs have been lost and gross national income has fallen about 20 per cent in money terms since the peak year of 2007. Even with increased tax rates under many headings, government current revenue last year had fallen by the enormous sum of €12bn from the peak 2007 level. The bubble-era tax bonanza through stamp duty, VAT on house sales and capital gains tax evaporated and routine revenues from PRSI, income tax and the 'old reliables' weakened as employment and consumer spending collapsed.

Despite the cuts, government spending remains at very high levels. Social transfers, including unemployment pay, have increased rapidly and so has the interest burden of servicing government debt, which has trebled since the crisis broke. Gross current spending of government in 2012 will come in at about 47 per cent of national income, up from just 32 per cent (of a higher income) back in 2007. When capital spending is added, total state spending will absorb about 52 per cent of GNP in 2012.

When the economy goes into such a nosedive, the deficit rises very quickly if nothing is done. Once the borrowing option has been exhausted, spending needs to be cut and revenue raised in order merely to prevent the deficit getting worse. These actions are, of course, deflationary in their direct impact, and hurt domestic demand.

A government with borrowing power has the option to use it in a normal cyclical downturn. But in Ireland, the borrowing option disappeared in the autumn of 2010 when the country had to be rescued by the EU and IMF. The incessant discussion of the pros and cons of 'stimulus' versus 'austerity' proceeds on the basis that Ireland possesses a freedom of action, which was lost more than two years ago.

If nothing had been done in the Budgets of recent years, the deficit was heading for 20 per cent of GDP, according to the Fiscal Council, and there would have been no lenders to the Government at all, not even the EU and IMF. The Government lost the ability to finance itself in October 2010, largely because of the additional strain coming from the bank bailout costs.

Governments with modest outstanding debt should willingly run deficits in a deep recession and it is a pity that some better-placed European countries have not done so. One of the factors in Barack Obama's re-election was the superior performance, at least in relative terms, of the US economy since the crisis struck in 2008. Unemployment has held below eight per cent and the economy is expanding again, if only at the modest annual rate of about two per cent.

This is a far better performance than is evident in most European countries, where there has been no coherent macroeconomic policy in place. Both the US Treasury and the Federal Reserve, America's central bank, have understood that some temporary stimulus to aggregate demand was needed. In Europe, the financially distressed countries, a growing number, do not have any stimulus options, while the European Central Bank has focussed on keeping inflation at bay and does not see itself as having a role in managing aggregate demand.

The result is that economic growth in the eurozone as a whole is essentially zero. This is now being compounded by the complete absence of any Europe-level macroeconomic strategy.

Ireland is now effectively excluded from the markets and

reliant on official lenders, the EU and IMF, who expect to see the debt figures stabilise. That requires the deficit to decline by quite a bit more, and soon. Government really has little choice in the matter at this stage – what cannot be borrowed cannot be spent, and the deficit must be reduced to zero, or close to it, within a short number of years.

The excessive bank rescue costs account for one-third of the national debt. They may be reduced if the Government succeeds in getting some sort of deal with the EU and European Central Bank. But relief from some portion of the bank-related debts makes no difference to the ongoing excess of expenditure over revenue. One way or the other, spending needs to fall and revenue to rise, for several more years, against a background of poor economic prospects.

When Finance Minister Michael Noonan presents his second Budget on Wednesday week, his freedom of action will be constrained by pre-election commitments. Income tax is one of the main sources of government revenue, while public service payroll and social welfare account for over 70 per cent of all spending. Any government facing an unsustainable budget gap needs to raise revenue and cut spending, so it makes things pretty difficult if raising income tax rates, cutting pay and cutting social welfare rates have all been ruled out.

One of these Three Unwise Promises, delivered pre-election by Fine Gael and Labour, looks to be on the verge of abandonment. Tuesday's announcement that the Government is to re-open talks with the trade unions over pay means, if it means anything, that the Croke Park agreement cannot be sustained and that both sides now acknowledge this. But the Government seems to be stuck with the other two unwise promises. They will preserve all social welfare rates as well as refusing to increase the rates of income tax. They will, however, raise taxes on income. Confused?

People cannot be faulted if they have lost track of the various deductions from their payslips. The main one is income tax but there is also PRSI and the new Universal Social Charge. Whether the hole in your payslip gets bigger due to an increase in income tax or in the other two taxes on income hardly matters at the end of the day. Beats me why the coalition parties regard increases in income tax rates as somehow unthinkable, while jacking up the other two taxes on income is just fine.

The Department of Finance released economic forecasts for the next three years the week before last. They are once again rather optimistic and come wrapped in the now-compulsory cheerleading about export growth.

Since the onset of the crisis, official forecasts have tended to be too upbeat. Ireland's much-vaunted export performance has faltered, according to the most recent data. In any event, it has been concentrated in sectors, including services, which do not appear to be hiring additional Irish workers. A far broader export recovery in labour-intensive sectors is needed in order to reverse the slide in employment.

It is always possible that the economy could begin to recover quickly. But there is no sign whatsoever of any such development and there are plenty of reasons to expect zero growth over the next few years.

Our European trading partners are stuck in a double-dip, which will make exporting tough, while the over-indebtedness of both public and private sectors in Ireland will inhibit recovery in domestic demand. It would be safer to prepare budget estimates on a zero-growth basis, and deal with pleasant surprises only after they have happened.

It would be nice if the Government had some painless taxation options with pleasant side-effects. Here's a candidate. There is an opportunity to raise useful revenue and put some criminal gangs out of business, through ending the diesel-washing racket. Farmers and others who use diesel off-road should pay the full price at the pump and claim rebates later, as is done in several other countries. It would require the UK authorities to agree a similar change in Northern Ireland but they would have every incentive to do so.

The revenue loss because of this criminal racket is now over €100m per annum. The Government has been head-scratching on this one for over a year. Time to go for it!

Sunday Independent