External shocks - change the detail but no need to rewrite the productivity playbook

Posted on November 04, 2016 by Tom McDonnell


The vulnerability of the Republic of Ireland economy to external shifts and shocks was brought home in 2016 in at least two ways. While the potential Brexit from the European Union (EU) has unclear political implications, it has almost certainly negative economic implications. At the same time, the opening shots of an international or at least EU clamp down on aggressive tax avoidance has exposed the fragility of Irish industrial policy to external policy shifts.

The NERI has argued repeatedly (see for example here, here, and here) that the best way to protect jobs and output in the long run is to focus on policies to sustainably boost the productive and innovative capacity of the economy. While Brexit might change the detail of what we might consider optimum policy it does not change the general direction. The clampdown on aggressive tax avoidance simply highlights the need for a revised enterprise strategy that looks beyond tax policy. In this context, the NERI will gradually release a number of working papers and other outputs on enterprise policy over the next two years focussing on different aspects of economic policy. These outputs will individually focus on one or both of the Irish economies.

We argued in our Autumn 2016 QEO that the best way to inculcate sustainable long-run economic growth in the Republic of Ireland was to prioritise use of the available fiscal space towards measures that enhance the economy’s ability to generate productivity gains year-on-year. We noted the Republic’s relatively low levels of spending by Western European standards on education, R&D and capital expenditure and pointed out that this implied there was scope to use fiscal policy to enhance future productivity by (A) increasing per capita investment in education and skills, (B) increasing investment in the production, diffusion and use of new knowledge and development of a strong innovation system and (C) increasing per capita investment in productive infrastructure.

Unfortunately the Republic’s low tax model constrains the state’s ability to make adequate levels of investment in each of these areas. In this context the tax cuts announced in Budget 2017 were short-sighted to say the least.

Another way to boost productive capacity is to use fiscal policy to structurally increase hours worked in the economy. This can be done by reducing barriers to labour market entry, by encouraging inward migration, and by increasing the attractiveness of labour force participation to second earners and low earners. State provision of subsidised childcare, the gradual tapering of family supports along with income and the introduction of refundable tax credits as a form of in-work benefit are all examples of policies that support higher labour force participation. The Republic has a comparatively low employment rate for females (57.9% in 2015 for females aged between 15 and 64 - compared to 74% in Sweden) and the very high cost of childcare in the Republic is likely to be an important factor underlying this poor performance. The progressive system of targeted subsidies based on net household income was therefore one of the most welcome measures announced in Budget 2017.

A third way to use fiscal policy to boost output and inclusive growth is to eliminate the distortions to economic efficiency arising from existing policies. In practice this would mean eliminating many existing government subsidies and tax expenditures. Ending such programmes and initiatives would create valuable fiscal space to pursue more growth friendly policies. Of course subsidies can sometimes be justified on non-economic grounds.

I could go on.

The main point is that the policies identified above are supportive of long-run economic growth regardless of the economic shock from Brexit and regardless of international developments in tax policy. We don’t need to rewrite the playbook we just need to start pursuing the right types of policy.

Posted in: Government SpendingInvestmentMacroeconomics

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