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Short-term outlook is good but stormclouds ahead - time to prepare the ship

Posted on August 03, 2018 by Tom McDonnell

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The NERI’s 26th Quarterly Economic Observer came out this Wednesday. You can find the release here and accompanying slides here.

Outlook

We examine the trends and short-run outlook for both Irish economies. The short-run outlook for the Republic of Ireland economy is very positive. We project real GDP will grow by 5.8% in 2018 reflecting our expectation that the cyclical upswing will continue for at least the rest of this year. Increasing employment and higher incomes will push domestic demand upwards. Hourly wages should rise by close to 3% this year and we project employment growth of around 100,000 over the course of 2018-2019. Our analysis is that the economy is not yet overheating and that there is some slack remaining in the economy. However, the outlook for next year is much more uncertain, and while our baseline forecast is for the above trend growth to continue, the projection comes with a major question mark given the uncertainty surrounding the outcome of the Brexit negotiations.

Brexit related uncertainty weighs even more heavily on the outlook for the Northern Ireland economy. Weakness in the manufacturing sector is holding back growth and their concerns about the quality of new employment being created.

Tax and spend – how the Republic compares

We also examine government revenue and public spending in the Republic of Ireland.

There has been a significant improvement in the fiscal position of the Irish state over the past few years. The government deficit, public interest payments and general government debt have all declined as a portion of output (however measured) and government revenues. Gross public debt is still relatively large however, and revenues are precariously dependent on volatile receipt flows from corporate tax.

Government revenue

Conventional comparisons of tax revenue across states tend to measure a country’s tax take as a portion of output, usually GDP. By this measurement, Irish government revenues are low by international standards. However, this particular metric is problematic in an Irish context, as GDP represents an inaccurate measure of fiscal capacity due to the unique distortionary effects of multinational activity on output. Alternative measures such as GNI* reduce the extent of the gap relative to comparator countries, but do not eliminate it. We can make a more meaningful analysis of Ireland’s comparative position by measuring tax revenues as a percentage of the potential tax base (Implicit Tax Rate, or ITR), or on a per capita basis.

In ITR terms, Irish tax revenues are low under the headings of taxation on Labour and Capital (data sources are given in the QEO). Revenue comparisons in per capita terms reveal a significant aggregate shortfall in revenues relative to other high-income EU states of almost 10 per cent. The shortfall is a function of the relative absence of taxes on Labour, itself mostly due to the relative shortfall in employer social security contributions. This is borne out in comparisons of tax paid for a single person on average earnings. The effective personal tax rate and total tax wedge in Ireland in 2016 of 19.2 and 27.1 per cent respectively, were the lowest observed in the EU-15 and even lower than rates observed in the United states. On the other hand, per capita tax receipts in the areas of Consumption Taxes and Capital Taxes are above the comparator average.

Public spending

Comparisons of public expenditure based on output are similarly problematic. Per capita measures likely present a less biased picture. Aggregate spending (excluding interest on a per capita basis) was lower than in all but one other high-income EU state in 2017. This is largely accounted for by underspends in Social protection and Defence. While this might be partly a function of demographics, other factors such as child demographics, population density and dispersion, and price levels likely bias spending in the opposite direction.

From a longer-term growth perspective, Ireland displays shortfalls in key expenditure areas. Public funding for R&D is only two thirds of the comparator average, and education per pupil shows significant relative deficits particularly at primary and tertiary level. OECD data also show low spending for early-childhood spending and care in Ireland, which can inhibit labour market access.

We conclude that fiscal policy should be reoriented to address these shortfalls. The growth literature indicate that taxes on property, wealth and passive income are pro-growth and pro-equity. A substantial revenue deficit occurs under this heading in per capita comparisons, implying some capacity to raise revenues in this area. However, the bulk of the revenue deficit is a function of the relatively low levels of taxes on labour, and specifically the low levels of social contributions.

 

The best way we can prepare for the Brexit stormclouds is to invest in the long-run productive potential of the economy.

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