Last week we discussed what is likely to be an expansionary Budget 2026. Given the strength and cyclical position of the economy an expansionary budget is the last thing we need. But this week I wanted to focus on what should be in the budget from a purely ‘sustainable economic growth’ perspective. Specifically, sustainable productivity based growth. The Government has been banging the drum on competitiveness. Competitiveness is of course a relative concept that is only meaningful relative to other countries or other firms and is a function of relative costs and relative productivity. In this blog I’ll focus on the productivity dimension in the context of Budget 2026.
Before considering what would enhance the medium-term productivity of the economy we should consider what types of policies are likely to be counterproductive. One clear example of a counterproductive policy is the use of tax reliefs that subsidise and preferentially promote low value-added business activities or failing business models.
These types of policy measures can be understood as forestalling the processes of dynamic churn and economic development. Such policies carry fiscal and other opportunity costs and are likely to be counterproductive by producing slower growth in the long-run. Examples of these policies include preferential reduced VAT rates for low-value added activities (e.g. the proposed VAT reduction for hospitality), and/or preferential inheritance tax breaks that entrench inequality of opportunity and often keep business management in less than capable hands.
In general, the use of tax expenditures as a tool of public policy should be minimised. This was a point repeatedly emphasised by the Commission on Taxation and Welfare in their 2022 report. Subsidies for business (including agriculture) can be deleterious to long-run growth to the extent that they skew incentives and distort resource allocation. Given the various downsides (e.g. perverse incentives, market distortions, deadweight, negative distributional effects, rent-seeking, complexity), tax expenditures are only justifiable where there is clear evidence of inherent structural market failure. It is clear that there is no market failure that would justify the introduction of a permanent VAT cut for the hospitality sector. The hundreds of millions per annum (exact figures depend on design) that such a measure costs to the exchequer would be better deployed on other things - whether they be policies that reduce poverty such a 2nd tier of child benefit or those that enhance productivity such as spending on productive infrastructure.
Extensive fiscal supports should generally be restricted to firms with significant developmental potential – which can include the development of new capabilities in a region; potential areas of import substitution such as renewable energy; and most clearly export-oriented sectors. Evaluation of particular enterprise policies should be based on the broader long-run ‘societal’ impacts, including the opportunity costs, and not just on the private firm impact.
For example, the characteristics of knowledge as a good and the potential for gains from knowledge spill-overs suggests that ‘new ideas’ will be produced by markets at a level below the socially optimal rate. This means there is a strong societal justification for government intervention to encourage R&D activities either through direct provision, through subsidies for business or indeed through tax reliefs for business notwithstanding other concerns about the use of tax expenditures. A similar positive case can be made for firms seeking to invest in green technologies.
The optimal approach to encouraging a dynamic economy and society is to focus on openness and opportunity and on the economic security that encourages risk-taking. Measures to support employment quality and economic and social security provide a strong foundation for such innovation and experimentation. More specifically, enterprise policy should focus on the wider picture of maximising the economy’s overall innovative capacity. Most obviously, governments should increase public funding for both basic and commercially driven research in order to increase the production, diffusion and use of new ideas. Ideally, this would be accompanied by the establishment of more attractive and secure career paths for researchers and by the establishment of deeper collaborative linkages between government, firms and universities.
In addition, governments should continuously examine the scope for reforms to education policy in order to ensure a balance between alignment with the developmental needs of the economy and society, an ongoing diversity of expertise and perspectives, and to ensure that it does not leave certain cohorts behind. Related to this is the need to meaningfully increase investment in education, and in personal development and skills, particularly for those disadvantaged cohorts that are most at risk of falling behind. Development policy should take a particular focus on early years learning and on measures to eliminate childhood poverty. Eliminating child poverty is not just a moral necessity but also an economic imperative.
Productivity interventions
I anticipate that most economists would regard the VAT cut as really bad value for money. But this should not be interpreted as hostility to enterprise. There are simply better more effective ways to strengthen the enterprise base than to give handouts to the least productive sector of the economy and one characterised by badly paid jobs.
In particular, there are at least three main areas where appropriate government intervention could potentially enhance the long-run productive capacity of the economy via supports for enterprise.
- Increasing the economy-wide rate of generation of high potential start-ups (HPSUs) and raising equity finance for HPSUs
Relevant supports that could be deployed in Budget 2026 or subsequent budgets to inculcate HPSUs include meaningful increases in public spending on R&D including funding for basic research, as well as meaningful increases in funding generally for science, technology and innovation courses and activities, for the career progression of STEM researchers, and for administrative and information related supports aimed at facilitating establishment of HPSUs.
In addition, governments could consider establishing independent state investment banks (SIBs) focused on investment in potential and existing HPSUs via a combination of equity stakes and low interest loans. The presence of the Strategic Banking Corporation of Ireland and the Ireland Strategic Investment Fund provide a strong basis for this activity. Nascent firms often have difficulty securing finance due to their lack of a track record. Investment banks of this nature could use their size and wider societal remit to focus on radical high risk and high reward activities that might otherwise struggle to receive private financing. The development of these advanced firms feeds off the broader raising of the productive base of the enterprise economy.
- Incentivising research, development and innovation
Enterprise policy should also seek to incentivise experimentation by firms in new ideas, in technology adoption, and in new business models and practices. Tax credits for R&D do make sense in this context. They should be accompanied by administrative supports to reduce the burden and the uncertainty around the use of these types of supports. Direct subsidies for innovation are likely to be of great significance for smaller firms and early stage companies and may carry less deadweight loss than tax expenditures. The appropriate nature and design of government supports targeted at increasing technology diffusion will depend on the precise reasons underlying the diffusion failure.
In addition, governments should seek to better develop their regional or national systems of innovation (NSIs) in order to cultivate and widen innovative capacity. This would entail deeper and more systemic collaboration between firms, academia, think-tanks and government including via access to researchers, secondments and demonstrations, and information campaigns. Small and new firms would particularly benefit from access to the human and technical capital embodied within university and government connections. Large scale advanced R&D programmes and institutions have focused on sectoral areas and research priority areas that are closest to the needs of the large multinationals located in Ireland. While these make sense for a certain range and type of firm, the research supports ecosystem needs to be more diverse in the types of research supported and the programmes that smaller companies, with still developing capacities, can participate in.
Finally, R&D carries significant upfront costs and has a high probability of failure. The small size of Ireland means it must inevitably specialise in a limited selection of technologies and activities. Policymakers should explore how best to establish collaborative linkages between the key actors in their NSI as well as the key NSI actors in other countries. Cost sharing, improved scale and cross-fertilisation of ideas between countries and regions opens up additional possibilities for frontier innovation and facilitates technology diffusion.
- Attracting and retaining human capital and diffusing technology more broadly
The ability of an SME to become aware of and exploit new ideas is called its ‘absorptive capacity’. Human capital is the most important element of absorptive capacity. An unintended consequence of the Republic of Ireland’s successful FDI strategy may have been a ‘golden cage effect’ whereby human capital is diverted away from the domestic economy and indigenous companies by the attractive opportunities and career prospects offered by foreign multinationals. Such a golden cage effect may be contributing to weaker technology diffusion outside of these multinationals by reducing absorptive capacity outside of these firms. NERI research by Smart and Taft (2024) found that Ireland has significant productivity deficits outside of the multinational sectors.
Impediments to labour supply and skills bottlenecks can also retard technology diffusion and absorptive capacity. Significant impediments to employment include the cost and/or lack of availability of childcare and adult care, as well as barriers to internal labour market mobility and inward migration such as housing costs and availability. Greater funding could also be made available to incentivise firms to invest in the human capital of their workforce and to incentivise engagement with academics and business networks.
VAT cuts
But what about those hospitality VAT cuts? Those on the fence should read Michael Taft’s excellent take-down on the Notes on the Front Blog. No country got rich spending hundreds of millions funnelling taxpayer money towards fast food restaurants.
Next week I’ll turn towards talk about those ‘once-off payments’ and what they should be replaced with.