Fiscal Rules, Fiscal Space and Growth Friendly Fiscal Policies

Posted on February 12, 2016 by Tom McDonnell


The reformed Stability and Growth Pact (SGP) and the creation of the Irish Fiscal Advisory Council (IFAC) have enhanced supervision of Irish fiscal policy and reduced the range of feasible fiscal stances an Irish government can promise or take. This new reality was brought into sharp focus with the recent debate about 'fiscal space'. The fiscal space represents the projected amount of additional resources available for public spending over a period of time.

We know that Ireland will have successfully exited the corrective arm of the SGP at the end of 2015. However, from 2016 onwards Irish budgetary policy will be subject to the requirements of the preventive arm of the SGP as well as being subject to national budgetary rules. The preventive arm of the SGP is assessed under two pillars.

The first pillar is the structural balance rule. Any country not at its Medium-Term Budgetary Objective (MTO) is required to achieve a minimum improvement in the structural balance of more than 0.5 percentage points per annum. The Fiscal Responsibility Act 2012 says that the lower limit of the MTO shall be an annual structural balance of the general government of minus 0.5% of GDP at market prices, except where the debt to GDP ratio is significantly below 60%, in which case the lower limit is reduced to minus 1%. A 2021 MTO of minus 0.5% of potential GDP is expected to be agreed later this year between the Department of Finance (DOF) and the European Commission.

A balanced budget in structural terms is a balanced budget after adjusting for the cyclical position of the economy and is calculated net of one-off factors such as asset sales and bank bailouts. The structural balance will remain constant if expenditure grows in line with potential GDP; will improve if expenditure grows below potential GDP, and will deteriorate if expenditure grows faster than potential GDP.

The second pillar is the expenditure benchmark rule. The expenditure benchmark places a cap on the net growth rate of public expenditure for a particular year. The rate is set equal to the economy's forecast medium-term potential GDP growth rate, and is known as the reference rate. From 2016 onwards the reference rate will be updated yearly based on a forward and backward looking ten year average for the forecast growth rate of nominal potential GDP.

Public expenditure may only grow faster than the reference rate if new discretionary revenue raising measures are taken which structurally increase government revenue, for example through an increase in one of the rates for USC, CAT or VAT. On the other hand measures that structurally cut government revenue, for example a cut in a tax rate, will reduce, on a one-for-one basis, the amount by which net public expenditure is allowed to grow each year.

Part of the expenditure benchmark rule entails the use of a convergence margin applied to every country in the preventive arm not already at its MTO. The convergence margin will ensure that Ireland's allowable growth in net expenditure is less than the reference rate for the period 2017-2019. This is because Ireland's MTO requires annual improvement of greater than 0.5 percentage points in the structural balance until the lower limit is reached. There is some debate about the true size of Ireland structural deficit and therefore how long the convergence margin needs to be applied to Ireland. Even so, it is the Commission's estimate that ultimately counts. A lower estimate for the structural deficit would imply additional fiscal space in 2019 and indeed beyond that.

The DOF have estimated (here and here), based on their forecasts of the reference rate for nominal GDP growth and the application of the convergence margin for 2017-2019, that the gross fiscal space to increase public spending over the period 2017-2021 is near to €10.9 billion and around €12.9 billion if income tax is not indexed.

Assuming non-indexation of the income tax system and accounting for certain demographic pressures and prior commitments in relation to the EU budget; the Lansdowne Road Agreement; the public capital plan, and other areas leads the DOF to estimate a net fiscal space of €8.6 billion by 2021. This amount will increase by €1.5 billion if Ireland is permitted to have a structural deficit of 0.5% instead of a balanced budget.

However, this estimate makes no provision for increases in public pay and pensions beyond the Lansdowne Road agreement or for increases in social benefits such as unemployment supports, illness and disability payments, the old age pension etc. Indexing public spending to account for inflation (likely to be somewhere between 1% and 2% per annum) is required just for these groups to stand-still in terms of living standards and in the worst cases prevent households falling in to poverty or deprivation. Needless to say, indexing public spending in this way will dramatically erode the fiscal space.

IFAC argues that indexation of public spending should be the baseline assumption as failure to index effectively means a cut in real terms. On the other hand the DOF argue that indexation to account for price changes is fundamentally a policy decision for the new government and that there is no obligation to index pay and benefits. Even so, the new government will certainly not have full discretion to ignore price inflation to the extent that it wishes to engage with the private sector for public procurement of goods and services. Non-interest public expenditure is forecast to be close to €67 billion in 2016. Assuming inflation of at least 1% suggests indexing public spending over the five years will cost at least €3 billion over the five years. €4 billion or even €5 billion may be more realistic.

In addition, the DOF's assumptions for demographic costs (around €400 million extra per year) may be optimistic. The available fiscal space is very sensitive to estimates for annual demographic cost increases. For example increasing the demographic cost assumption to €600 million a year erodes the five year fiscal space by a further €1 billion. In practice the demographic costs may well exceed this amount though it is difficult to be certain. IFAC's Dr Thomas Conefrey recently estimated expenditure pressures arising from demographic pressures at an NERI seminar. He estimates that expenditure pressures will exceed allowable expenditure growth in 2017, 2018 and 2019. Beyond 2019 Ireland is expected to have achieved its MTO and allowable expenditure growth will exceed expenditure pressures in 2020 and 2021.

A certain degree of craft is required to arrive at an appropriate estimate for the fiscal space but a reasonable range of estimates for the fiscal space after indexation of public spending and account of demographic costs may be around €2.5 billion to €4.5 billion with a central estimate of perhaps a little under €4 billion. In any event it is better to err on the side of caution in case the baseline forecast for potential GDP fails to materialise. IFAC's recent estimate of €3.2 billion may be a prudent baseline. Abandoning the USC would use up pretty much all of this space by itself leaving no new resources for housing, health and other areas. The fiscal pressure eases a little if, as is expected, the European Commission will allow an additional €1.5 billion of leeway over the five year period.

What does all of this mean for economic policy?

With such limited additional resources available over the next five years it is important to be strategic in terms of how we invest that money. What type of fiscal policies should Ireland pursue to cultivate long-run economic growth? Previous NERI research (here, here and here) has already considered this issue. The core point is that sustainable long-run growth in per capita output depends on innovation driving improvements in labour productivity. Ireland's growth potential in the medium-term depends on the economy's ability to generate employment and productivity gains year-on-year. Labour productivity increases along with learning and experience and human capital is crucial to economic develpoment.

Spending on education generates positive externalities for the wider economy to the extent that it represents genuine investment in human capital. Despite having a comparatively young population government spending on education was just 4.1% of GDP in 2013 compared to 5.0% for the EU and 5.5% for the UK. Innovation and R&D levels are also important determinants of productivity gains, competitiveness and growth. However, combined government and higher education spending was just 0.41% of GDP in 2014 compared to 0.72% of GDP in the EU. Priority should be given to increasing education spending and innovation spending to close to the EU averages. Efficient investment in infrastructure is strongly related to long-run increases in productive capacity, a point made clearly by the LSE Growth Commission and by the IMF. The World Economic Forum places Ireland just 36th in the world in terms of the overall quality of infrastructure. Public spending on gross fixed capital formation is close to 2% of GDP in 2015. This is well below the EU average of 2.9% and almost certainly lower than Ireland's medium-term growth potential. Such a low rate of public investment, if maintained, is likely to produce infrastructure bottlenecks and impede Ireland's growth potential

Overall, the best way to sustain long-run productivity growth is to increase investment in education and skills (particularly early years learning); increase investment in the production, diffusion and use of new ideas (R&D), and increase investment in productivity enhancing infrastructure. However, increasing potential output is not just about labour productivity. Output also depends on employment levels and average hours worked. One way we can increase total hours worked in the economy is to remove barriers to labour market entry. The very high cost of childcare is one such barrier. State subsidised childcare would facilitate the labour force participation of second earners and lone parents. This would increase the effective size and quality of the available workforce while retaining human capital within the workforce.

Raising Irish government spending to the EU average in each of these areas (either in GDP or GDP hybrid terms) would use up pretty much all of the fiscal space available over the next five years. Once we factor in additional commitments e.g. the cost of adapting to climate change and reaching Ireland's 0.7% of GNP target for overseas development aid it becomes clear that there is limited if any room for tax cuts over the next five years.

In this context it may be wise to re-evaluate plans to cut net government revenue in future budgets and instead take a more strategic approach to nurturing growth in the Irish economy. Education, infrastructure and innovation are the keys to unlocking productivity gains and productivity is the key to future growth.

Posted in: Government SpendingInvestmentMacroeconomicsTaxation

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