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What fiscal space?

Posted on June 10, 2016 by Tom Healy

Tom Healy, Director NERI
Tom Healy, Director NERI

In many respects the debate about ‘fiscal space’ is a major turn off for most people as it employs language, terms and concepts that are mechanical, contrived and highly dependent on questionable assumptions. Most policy makers tend to leave the technical details to specialist staff while they get on with the bigger picture on the economy and public finances.

The main role of ‘fiscal space’ is to moderate and ground expectations in the run up to a Budget such as the one planned for this October. On budget day and in the weeks following lots of things can change and it is not unknown for a billion to appear out of nowhere due to claimed ‘permanent structural changes’. Let’s say that structural changes are permanent until the next recession strikes (which is a contradiction in terms because a structural deficit is by definition the gap between spending and revenue when the effects of booms and recessions are removed).

The idea of ‘fiscal space’ is like the theory of phenomenology – powerful conceptually but mighty hard to pin down in practice. Nobody has ever observed fiscal space with a super telescope yet policy makers, economists and politicians dispute the size of the fiscal space available to the Minister of Finance as he prepares for Budget 2017.  The methods used in calculating the likelihood of a high pressure over Ireland next weekend are more exacting and reliable than those used by economists to estimate ‘the natural rate of unemployment’ and the ‘structural primary balance’.  Were one to build a time machine and go back, magically, to 2006 most commentators and economists would have signalled no major grounds for concern about the state of public finances. Indeed, they would have said – as they did at the time – that the ‘structural deficit’ or the gap between spending and revenue when an economy is neither over-heating or in recession was close to zero. 2008 changed all that.

Watching the electoral cycle is as important as watching the business cycle and politicians know how to manage technical assumptions that underpin ‘structural deficits’. True, there are constricting fiscal rules and their interpretation by the European Commission to place some order and discipline on public discussion. However, just as there is some scope and discretion over a number of years for member states to converge to what the EU calls ‘medium-term objectives’ in regards to debt and deficits there is political scope to manage annual target setting and review slippage. France and Italy are a case in point as were France and Germany in the last decade before the crash.

The truth is that nobody knows what the true extent of fiscal space is because we do not know the future and even our knowledge of the recent past is unstable given not so small statistical revisions to GDP, spending etc. Moreover, we do not know what the ‘normal’ rate of unemployment is because economies change dramatically over the decades and what seemed ‘natural’ or ‘normal’ in one decade no longer holds today. Depending on which assumptions one makes about the overall extent of slack or over-heating in an economy and depending on how one regards the impact of demographic change and various cost-drivers in public services one can estimate unused fiscal space as anything between zero and €2 billion. Most commentators settle for something just under €1 billion. The issue of windfall revenues such as that revealed on budget day last year is a separate matter and one that provides limited buffer room for spending ‘over-runs’ (which in many cases are not over-runs but under-estimates of spending need in the first place).  In theory, at least, the Government is not allowed to use such ‘windfalls’ unless they can prove to the European Commission that the windfall is ‘permanent’.

So, how much ‘fiscal space’ is likely in the run up to Budget 2017. NERI estimates, which are tentative suggests something in the region of €800 to €900 million next year. However, that very much depends on assumptions about the state of the economy as well as underlying cost drivers from demography (more children needing schooling and more elderly needing nursing care) to other cost drivers (the wage bill in the public sector, the interest payable on public debt and other costs). Were proper account to be taken of these factors it is quite possible that true fiscal space is closer to zero. In other words, the flexibility or room Government has to reduce taxes or raise spending is small. Revenue buoyancy – the darling of many a politician – does not count in calculating fiscal space unless it is ‘permanent’ in which case it would not be buoyancy anyway (but who is to know what is permanent in this uncertain world).

We should note that the very framing of public debate around fiscal space and, then, the appropriate split between tax cuts and spending increases is an ideologically driven one. To start with, ‘fiscal space’ is no more than 1-2% of total spending in any year – small change compared to the much bigger and more timely question of how well do we spend on health, education, housing and other areas. Second, why is it assumed that tax cuts is an option or desirable undertaking? The language of fiscal space and ratios of spending to tax changes dodges the more central question of whether our existing and future revenue take is adequate to the task of providing schools, health centres, roads, speech and language therapy, mental health clinics for teenagers and public libraries. The Republic of Ireland is a low tax and low-spend economy and much reliance is placed on a relatively narrow tax base as well as an incoherent array of indirect taxes (VAT and excise) to fund day-to-day spending.  Pay-related social insurance is very inadequate relative to the goal of providing sustainable pensions, sick pay, parental leave and lifelong learning and training. Almost everyone knows this but few are ready for a mature, evidence-based discussion on how we are to fund a reforming and reformed public service adequate for the challenge of the 21st century.

Later this month the Government will publish its ‘Summer Statement’ (it used to be called the ‘Spring Statement’) in which a revised estimate of ‘fiscal space’ will be published. It is unlikely that the estimate will be much different from what was already signalled by the Department of Finance earlier this year (Information Note on Fiscal Space 2017 – 2021). Just focussing on next year – 2017 – the Department of Finance estimated €1.3 billion in ‘gross fiscal space’. However, a number of adjustments are made by the Department to account for demography, pay agreements and discretionary revenue measures (the non-indexation of tax bands and credits as well as carry-over effects of tax cuts in previous budgets) and measures announced under the public capital programme. These adjustments reduce the gross figure of €1.3 billion to €500 million.  In more recent statements by the Minister of Finance the net fiscal space estimate which was €500 has been pitched higher at around €900 million (with a gross fiscal space estimate of around €1.7 billion). Part of the reason for this has been a recent upward revision of in the projection of the economy’s medium-term (10 year) potential growth rate. (in other words no depressions or significant recessions for the next ten years – fingers crossed).

The Irish Fiscal Advisory Council (IFAC) use a somewhat different approach which takes a greater account of inflation and demographic change leading to a smaller fiscal space estimate (see their recent Assessment Report here).

Taxes are not the answer to everything but they are an essential part of a joined up response especially when they are well designed, fair and consistent with sustainable development of economies and societies. Enterprise and the conditions for flourishing enterprise are a vital component.  The key to sustainable development, avoidance of exaggerated shocks and exposure to future global downturns lies in the strategic development of enterprises with a strong social safety net ensuring a seamless passage from education to work to training and retirement.

 

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