In this blog and its associated NERI Report Series No. 36, Dr. Tom McDonnell discusses the current economic situation and the upcoming Budget 2025.
The economy should remain strong
Ireland’s labour market and its economy have never been stronger despite the damaging impact of the pandemic and the recent cost of living pressures. GNI* has grown rapidly now for three consecutive years while employment growth has been stellar. The monthly employment index in May was up 15.2% since 2019 and was up 2.2% year-on-year. While the employment growth of recent years is not sustainable there is limited evidence of a downturn in the economy. Even so, cost of living pressure is significant for many lower income households after two years of declining real wages. 2024 and 2025 should see strong real wage growth given falling inflation, the tight labour market, and the lagged effect of inflation on nominal wage growth.
The short-run economic outlook is positive with moderate and broad-based growth likely to occur over the next year. There are a number of factors playing into this:
A) a gradual loosening of monetary policy from the European Central Bank;
B) mildly expansionary fiscal policy on Budget day;
C) an increase in real disposable income as wages outstrip inflation;
D) improving household and business confidence as price pressures recede, and
E) an outlook for modest but positive growth in Ireland’s main trading partners.
Price pressures will continue to ameliorate as inflation falls to close to 2% both this year and next, while the economy will remain close to full employment albeit with a slowing down in the rate of annual employment growth.
There are of course uncertainties. Major downside risks include but are not limited to weakness in trading partners, political turmoil in the US and radical shifts in trade policy, rising geopolitical tensions, and further shocks to the cost of energy imports.
The public finances also appear strong – but only in the short-run
The headline fiscal position remains strong. There was a general government surplus of €8.6 billion in 2022 and €8.3 billion in 2023 (2.9% of GNI*) notwithstanding ongoing ‘once-off’ cost of living measures. Ongoing surpluses and moderate growth will reduce the net debt ratio over the next few years.
The first and most significant caveat is the high concentration of corporation tax receipts and the potentially unsustainable or ‘windfall’ nature of the surge in corporation tax in recent years. Such concentration represents a dangerous fragility within the tax base. It makes Ireland’s fiscal outlook highly dependent on the commercial fortunes and tax decisions of a tiny number of companies making decisions outside of Ireland. Corporation tax receipts are also inherently volatile and pro-cyclical.
Secondly, Ireland’s strong headline fiscal position should be seen in the context of a very strong labour market and high employment rate. In other words, the structural position is less healthy than the headline position.
Thirdly, focusing only on the short-term position ignores the profound fiscal impacts of looming economic and social megatrends. The most fiscally significant of these shifts will be demographic change from longer life expectancies and falling birth rates. An ageing population means greater spending on pensions while the rapid growth in the over 75s will put increased pressure on social care and healthcare. Demographic change will also mean less tax receipts from employment as the population’s working age ratio declines. On a no-change basis ageing demographics imply an additional fiscal cost of 6% of GNI* by 2050. The Fiscal Council estimate even higher costs. Even if these are overestimates it is clear there are difficult tax and spending decisions ahead with immense significance for the future of the welfare state.
Climate transition costs will also be significant and range from green infrastructure and upgrades, to just transition supports, to the loss of green tax revenue as emissions decline. Supply side transition costs on the spending side have been estimated by the Fiscal Council at 0.6 to 1.1% of GNI* by 2030 with the transition away from fossil fuels costing 0.9% of GNI* in lost annual revenues by 2030 and 1.6% by 2040. On the other hand, failing to meet EU emissions targets will lead to substantial EU fines.
De-globalisation and disruptive technologies such as artificial intelligence may also have important fiscal impacts. De-globalisation and a shift in industrial policies towards subsidies and on-shoring may have implications for foreign direct investment and ultimately income tax and corporation tax revenues while technological disruption will require the state to invest more in digital skills and life-long learning.
We need a countercyclical budget
The economy appears to be operating at or above its potential. There have been rapid levels of employment growth, we have high employment rates and low levels of unemployment, and there has been strong output growth and high inflation. This suggests the economy does not need additional stimulus from an expansionary budget. Instead, a countercyclical budget appears prudent.
However, there are clear constraints on future economic growth. These include capacity constraints caused by a range of infrastructure deficiencies including in energy, water, housing, broadband, and public transport just to name a few areas. The future health of the economy will also require ongoing investment in education and skills and in public R&D at higher per capita levels than at present.
Finally, lower income households have seen an erosion of living standards in recent years due to the cost of living crisis while deprivation rates have increased. Welfare rates will need to increase by faster than inflation to begin to reverse this deterioration in living standards. In the medium-term, the welfare system needs to be reformed in order to adequately protect households on fixed incomes (benchmarking) while simultaneously eliminating distortions and perverse incentives within the system.
As such, the current context suggests the need for a relatively cautious budget (net basis) that simultaneously invests sufficiently in the long-run components of sustainable productivity-based growth and protects lower income households. This mix implies the need for taxes to increase in Budget 2025.
As it happens, the Government have stated their intention to increase spending by 6.9% in Budget 2025 along with tax cuts worth €1.4 billion. Once account is taken of pre-existing decisions there will be €1.8 billion in new spending measures and €1.4 billion in net tax cuts. The wisdom of such a large-scale package at this point in the economic cycle might be questioned and it will add modestly to inflation. Cutting taxes now means larger tax increases in the future and pushes the burden on to younger workers.