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What is a prudent fiscal space?

Posted on November 29, 2015 by Tom Healy

Tom Healy, Director NERI
Tom Healy, Director NERI

One of the impacts of the recent economic crisis is that new expressions have been added to the English language, as spoken here. One such example is ‘fiscal space’. When the economy is growing there is, at one and the same time, more demand for public services (more school pupils and more demand for health services for examlpe) as well as less demand for other public services (when there are fewer persons unemployed). Rising or ageing population also impact on demand for public services and pensions.  Alongside changes in spending that are ‘cyclical’ revenue trends so that there is a natural jump in revenue as people spend more and receive higher incomes – boosting state coffers.  Separating out the temporary ‘cyclical’ effects and the ‘structural’ effects is not at all easy for economists and statisticians.

For one thing, the goal posts keep shifting as what is ‘structural’ today may turn out to be ‘cyclical’ tomorrow. Is the surge in corporation tax revenue structural or cyclical or one-off? Time will tell!  ‘Fiscal space’ is a troublesome thing to estimate and depends on a range of technical assumptions. Normally, the approach taken is to define a ‘fiscal space’ of so many hundreds of million of Euro that the Government can use to spend more or tax less when planning for next year without undermining some agreed pathway to ‘correct’ the public finances or ‘prevent’ future shocks.  From the point of view of policy makers and public authorities defining a ‘fiscal space’ has the advantage of

  • concentrating minds
  • simplifying public debates
  • and strengthening negotiating power when various groups compete for scarce public finances.

A disadvantage is that it can impoverish public debate by focussing on marginal fiscal changes rather than the important and the long-term.   The question ‘How much fiscal space has the Government?’ is like asking ‘How far is it to Mizen Head?’ to which the answer may be given: ‘It all depends but you should not start measuring it from here!’.

This, year, the size of the ‘fiscal space’ in the budget of the Republic of Ireland has been a bit difficult to define and measure. On ‘Budget Day’ fiscal space for the coming year was indicated at €1.5 billion. However, another €1.5-2.3 billion emerged like manna from on high. If you find all of this confusing, it is. Such are public finances. IFAC make a telling observation (page 60):

It is essential, therefore, that the methodologies, definitions and processes underpinning the complex rules be made public prior to the national budget process.

Indeed.

Nobody knows for sure what the implications of demographic change, unforeseen shocks or shifts in patterns of corporate profitability could hold in store for Irish public finances in 12 month’s time let alone 12 year’s time.  Add to this the pressures (some might say temptations) of competing for votes and seats in a parliamentary democracy and the discussion becomes even more fraught.

Recently, the Irish Fiscal Advisory Council (IFAC) published its Fiscal Assessment Report (November 2015).  Reports of a lively discussion on the airwaves suggest that the Council was less than happy about some aspects of recent Government fiscal policy. Moreover, concerns have been expressed about the timing and notification of certain policy decisions at EU or national level with the Council. Whatever about matters of information-sharing and consultation it is clear that the Council seeks to exercise its remit in relation to the sustainability of public finances and the appropriate ‘fiscal stance’ of Government given EU and domestic fiscal rules as well as the likely stage at which we are in the business cycle. The Council is at pains to detach itself from decisions about the composition of any fiscal adjustment (whether on the negative or positive side). In other words, the Council does not express a view on how Government should apportion any overall adjustment between spending and tax. Given this detachment it appears odd that the Council took particular exception to the Government decision to add public spending without a matching revenue measure in such a way as to increase the estimated ‘structural deficit’ a little compared to estimates earlier this year.  This amount emerged almost as a last-minute addition like money at the back of the couch.  The view taken was that the money was there to spend given revenue buoyancy and, also, given the pressing needs in many areas of public service – not least health.  However, this money will not be counted as ‘fiscal space’ in 2016 since it has already become available in 2015 as a result of additional revenue which is believed to be ‘permanent. However, it does have the impact of pitching the ‘structural deficit’ somewhat higher than would otherwise be the case and, thus, requiring a slightly more protracted adjustment over the coming years.

2015 was the last chance to raise expenditure benchmarks before a new period of EU rules assessment began in 2016 (see page 13 of the IFAC report for an explanation of this). The Government made the right decision to use this opportunity to raise spending in areas of acute need including health, social protection, education and transport. Where the Government got it wrong was in reverting to the tried and failed policy of tax-cuts that characterised every economic upswing period since 1977. To this extent, only, IFAC has a valid point.

To use a football analogy IFAC scored an important goal but it was the wrong goal side on the pitch. They need to focus on revenue and spending in equal measure in expressing concerns about the direction of fiscal policy.

Their overriding concern is twofold: to pay back monies owed to lenders and reduce the overall level of Government debt while, at the same time, ensuring that future expenditures are sustainable in terms of the revenue base.  The Council is concerned about the possibility that future demographic change and cost pressure may have been underestimated (the history of Irish fiscal policy over the last 40 years would suggest that estimations of future spending showed a downward bias as demography, economic growth and other factors surprised everyone). The problem with IFAC analyses and conclusions is that while they focus on one thing only (as is their remit) they provide hostages to fortune where others are concerned. It might be concluded, by some, that the Council is telling or advising the Government what to do – otherwise the Government is acting imprudently or even recklessly. The history of Irish fiscal policy is littered with bad decisions – at least from the standpoint of wisdom after the event.  IFAC was right to question future spending plans and to raise doubts about the realism of plans to move Ireland ever closer to US patterns of public spending and taxation by contrast with general EU plans.  IFAC will point out they have no recommendation to make about which model to go – they are merely examining the fiscal prudence of lack of it in regards to the trajectory of public policy as it is announced or understood at this time.

But why is there a concern by IFAC, specifically, about public spending? Why, it may be asked, is the Council not focussing on the fact that the Government is continuing to cut rates of income tax when a deficit exists between spending and total revenue and when there is no evidence that Ireland over-spends on public services as a whole or over-taxes its population (admittedly the matter is complicated by issues to do with GDP and GNP as well as the age structure of the population compared to elsewhere)? In terms of the EU rules there is a built-in bias against public spending by means of the ‘expenditure benchmarks’ or ‘ceilings’ which limit public spending increases to increases in ‘potential output’ in the medium-term. There is no talk of ‘revenue floors’ whereby Governments might be taken to task for imprudent cutting of tax rates with implications for long-term funding (as we painfully discovered in 2008 after a decade of tax-cutting). The barn was empty when the storm struck and destroyed what remained of the winter feed. Worst still, there was an exceptional collapse in banking that led to socialisation of debt.

Might there be an ideological bias towards reining in spending while taxes are cut? To be fair to the Council they have signalled concerns about a policy cutting taxes. For example, on page 2 of the Report, it states:

Analysis in this Report shows that funding current levels of public services in future years and accommodating likely expenditure needs would absorb the majority of the estimated fiscal space available after 2016. Further tax cuts would make it very difficult to fund these expenditure pressures while complying with the rules.

The last sentence, above, is crucial and was missed in the public attention given to the IFAC report last week.  The focus was on that extra spending of €1.5 billion which was part of supplementary estimates. 

The reality is that cost pressures on all fronts are (or should be) enormous especially in areas such as social housing, community health, acute medical services, school running costs as well as the slow, gradual year-on-year rise in expenditure on pensions as the numbers of over-65’s increases.  It is only right that additional funding be put aside for these areas. However, it is vital that in providing additional funding for services that the money is differentiated by current and investment spending. Current spending should be funded from revenue that is robust and fairly allocated by income or means.  Investment spending may be funded by year-on-year revenue or, with agreement of the EU from long-term borrowing. The latter will require change to EU rules and political consensus which is probably many years away. Still, the right thing to do in 2016 is to invest for the future and to underpin efficiently delivered public services with an adequate and fair tax base.

IFAC make a very important  and valid observation (page 7):

Among the domestic risks is the highly concentrated nature of production in the Irish economy, whereby a small number of sectors and firms account for the bulk of manufacturing output and exports. This specialisation of Irish trade leaves the economy exposed to a potential loss of output in the event of a re-organisation of these firms’ global production chains.

IFAC is correct to raise concerns about the direction of fiscal policy as well as the realism of some of the technical working assumptions underlying future projections. However, they are wrong to target spending over revenue as a matter of concern.  If there is a concern about reducing public debt as quickly as possible to minimise the risk of adverse shocks in the future then the more prudent and wise thing to do is to match additional public spending with additional revenue on forms of income, consumption, capital gains or wealth that cause ‘no harm’ and promote equality, economic efficiency, environmental and fiscal sustainability. As for the stock of debt, a combination of ‘pro-growth’ policies, avoidance of large deficits (but we don’t need a permanent budgetary surplus as stated by the existing projections), prudent management of the existing portfolio of debt and a longer-term European—level strategy to achieve some agreed debt relief on the extreme odious portion of Irish sovereign debt (in other words those parts that were forced on the Irish taxpayer as a result of bailing out UK, German and French banks and other private lenders in 2008-2012). The latter would be a long-term strategy but is unavoidable at a European level given the accumulated debts in countries such as Greece. The issue will simply will not go away.

It is important to frame as well as inform public debate about fiscal choices and constraints. This is why the Nevin Economic Research Institute continues to adopt a cautious, evidence-based and values-informed approach as reflected, consistently in editions of the Quarterly Economic Observer since 2012. We have sought to show how, using empirical data and other research findings, Irish public finances can be put on a sound footing while moving Ireland gradually towards a dynamic enterprise economy with European levels of income protection, taxation and investment in services.  Pretending that there are easy choices or that we can pay for a rising and ageing population with lower rates of taxation is not helpful.

Posted in: Government SpendingInvestmentTaxation

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