In this week's blog by NERI Co-director Dr. Tom McDonnell, he discusses Budget 2022.
Next Tuesday’s budget will take place in a very different context to last year’s one.
Last year’s firefighting budget was all about preserving the economy’s productive capacity by as much as possible against the twin threats of Covid and Brexit. This was done via a menu of contingent wage subsidies and income and business supports that triggered and changed as the economy moved through its different stages of lockdown.
This year is different. With over 87% of the eligible population fully vaccinated the Irish economy has already entered the early stages of what’s likely to be a very strong cyclical recovery. Household incomes have largely held up and personal consumption should expand rapidly over the next 18 months. The household savings rate will normalise from its historically high level amid unprecedented pent-up demand for activities constrained by the lockdown, mainly services. There should also be increased private investment as economic uncertainty fades. The PMIs remain close to record high levels.
The Central Bank (5.5% and 7.1%) and Department of Finance (5.2% and 6.5%) are projecting robust growth in Modified Domestic demand this year and then again in 2022. Both bodies expect the unemployment rate to have fallen below 6% by the second half of 2023. The economy’s productive capacity has broadly been protected by the highly supportive monetary, fiscal, and labour market policies. There should be minimal labour market scarring from the Covid crisis provided the supportive policy stance isn’t reversed too early.
The Budget will also take place in the context of rising inflation. The annual change in the HICP was 3% in Ireland in August and 3.2% in the UK. Inflation in the US has been at least 5% since May, while the Euro area saw inflation accelerate to 3.4% in September. At issue is the extent to which these price rises are related to temporary issues such as post-pandemic supply chain bottlenecks or rising demand driving a once-off spike in energy costs. The Central Bank is projecting that the HICP will rise to an average 2.9% in 2022 before falling back to 1.9% in 2023.
Living standards will decline for many households if the Budget fails to account for these price developments. All social protection payments in Budget 2022 should exceed projected inflation, with additional increases for those most at risk of income inadequacy, in order to protect and increase real incomes and to ensure no one is left behind or falls further into poverty.
The government’s Summer Economic Statement points to a total budget package of €4.7 billion with similar sized packages in 2023-25. At the same time, temporary pandemic spending will decline from €14.8 billion in 2021 to €8.1 billion in 2022 and €1 billion in 2023. Annual growth in spending is set at 5% from 2023 onwards. This rate of growth in spending is linked to the assumed medium-run growth potential of the economy. The deficit as a percentage of GNI* is projected to fall from 9.4% this year to 6.2% in 2022 and 2.8% in 2025.
The fiscal impact on Ireland of the flagged changes to the international corporation tax system are uncertain. Ireland will certainly lose revenue under Pillar 1 of the OECD proposals which deals with location of taxing rights. However, the short-term fiscal impact of Pillar 2, which attempts to reduce harmful tax competition is as yet unclear. The global minimum tax of 15% might actually generate additional receipts for Ireland in the short-run. The OECD estimates that corporate tax avoidance costs countries anywhere from $100 to $240 billion annually.
The expenditure ceiling for public spending is €93.2 billion in 2025, or close to €18,500 per person. For context, the average for the EU’s high-income countries was over €20,000 per person prior to the crisis. Thus, the narrative of Ireland as a high public spending country does not stand up to scrutiny.
Two thirds of the budgetary package of €4.7 billion is already accounted for by maintaining existing levels of service (inflation), demographic pressures, National Development Plan commitments, and public pay. This leaves just €1.5 billion for new discretionary measures and €0.5 billion of this remainder is intended for a package of tax cuts.
Tax cuts make little sense at this point in the economic cycle. Savings rates are already at record levels and consumption is likely to expand rapidly as savings wind back. It’s unclear that there would be much additional demand arising from income tax cuts. The flagged increase in the marginal tax threshold would also be regressive and your median frontline worker in the retail sector will not see any benefit. Hopefully there won’t be any new market distorting and regressive tax reliefs along the lines of what we’ve seen in recent years.
There are a wide range of better alternatives. For example, a supply-side reform to make childcare services more affordable would boost participation rates and enhance the economy’s productive capacity, whereas a tax cut will just give a temporary sugar rush to the economy.
Budget 2022 should focus on improving our collective economic and social infrastructure, with emphasis on collective early years care, on education, on health, on R&D, on public transport, and on public housing services. Budget 2022 should also facilitate the digital and green transitions via greater funding for relevant public investment in green electricity, efficient buildings and public transport but also for re-skilling workers, apprenticeships and higher education.
Yet there is just €1 billion in each of the next four years for enhanced public services and social welfare increases. We will continue to be a very low spender on public childcare and early years. The country will also continue to be a low spender on per pupil education and on public R&D. Class sizes will remain amongst the highest in Europe. The cost of childcare will remain amongst the highest in Europe. The housing supply problem will persist.
Addressing our economic social challenges will ultimately require a comprehensive review of our tax and welfare systems in order to understand the different implications of increasing taxes in various areas and the potential interactions with our welfare system. The revenue base will need to be broadened but we need an informed debate about how we should fund necessary and desired public services.
Finally, we need to move away from single year budgets to a system of medium-to-long term budgeting. It’s time to start thinking strategically.