In this blog the NERI Co-director, Dr. Tom McDonnell argues for a countercyclical budget and cautions against using the potentially transitory corporation tax windfalls to fund tax cuts or day-to-day spending.
The Irish economy is in an unusual place. It’s been buffeted by Brexit, by the shock and disruption of the Covid crisis, and is still working its way through an energy price shock and cost of living crisis. There is a sense of winners and losers – net household wealth has reached record levels and corporate profits are healthy – yet deprivation rates amongst Irish households are on the rise.
The labour market has never been stronger despite an underlying sense of perma-crisis. Total employment, the employment rate, and hours worked are all at or near record highs while the unemployment rate is at a record low. We have clear capacity constraints across the economy particularly in construction.
And yet real wages declined over the last year. Inflation remains high, albeit falling, across most of the Euro area. Fear of core inflation becoming ‘sticky’, will lead policymakers at the European Central Bank to increase interest rates twice more this year, and they will only start to gradually reduce rates sometime in 2024. Tightening monetary policy will eventually start to weaken demand and growth across the Euro area including in Ireland. However, so far, the economy is holding up.
Economies move in cycles and each of these cycles has its own unique causes and characteristics. In general, we want to reduce the amplitude of the cycle and prevent boom-bust dynamics developing. Such dynamics can lead to permanent economic scarring and to a waste of human potential and physical capital. We only need to think back to the 2008 financial crash as a particularly extreme example of this.
Macroeconomists are, therefore, always trying to understand where in the cycle the economy is at any point in time. A correct understanding of whether the economy is ‘overheating’, ‘in recession’, or somewhere else along the cycle matters greatly for budgetary policy and for the appropriate fiscal stance taken by government.
If the economy is in a downswing then it makes sense for government to stimulate the economy in a Keynesian fashion through higher public spending or even, where appropriate, tax cuts or direct income supports. The opposite is true if the economy is overheating. In other words, fiscal policy should be counter-cyclical. My own view is that the economy is indeed overheating at the moment though there is some tentative evidence of weakening.
Irish governments have a long and unhappy history of pro-cyclical budgets and Budget 2024 seems likely to be the next chapter in this tradition. The Irish Fiscal Advisory Council has already attacked the government for breaking its own spending rules and for risking overheating, while the ESRI and the Central Bank have both cautioned against tax cuts. The Budget in its current form will modestly add to overheating and to inflation, while proposed income tax cuts will disproportionately benefit the better off.
It’s important that we widen the discussion beyond the fiscal stance and reflect properly on the composition of the budget.
For example, we need to protect low income households from cost of living pressures – not half-heartedly through once-off measures as was done last year - but through structural uplifts in working age and old age payments that adequately benchmark against wages and the cost of living. In addition, we need to deal with the chronic issues in housing supply and affordability and, of course, ensure that we allocate adequate capital resources over the medium-term to support climate action and a ‘just’ green transition.
There is a long-list of other public funding issues that also need addressing. From long waiting lists and chronic underfunding of mental health services, to large classroom sizes, high childcare costs and lack of public transport services.
But resources are not unlimited. The Department of Finance has identified that circa €12 billion in annual corporation tax receipts is potentially transitory in nature. It would be foolish to use these receipts to fund ongoing tax cuts or day-to-day spending commitments. However, using a portion of the windfall to establish a state housing finance company and a green infrastructure fund does make sense.
The state will need to increasingly invest in housing and to make significant capital investments over the next 20 years to support the green transition. Such investments need to be insulated from recession era cuts and from the vagaries of the political cycle. Experience shows that capital spending is vulnerable to cuts in downturns.
The Department of Finance is proposing to use the transitory receipts to set-up a state savings vehicle in order to part pay for future ageing costs. There is certainly merit in this strategy. But there is scope to do this and also to set up one or more infrastructure funds.
Crucially, the fiscal rules allow us to increase spending by as much as we want each year provided that there are offsetting measures that increase taxes. The Commission on Taxation and Welfare recommended just last year that we will have to meaningfully increase government revenue as a proportion of national income over the medium-term. Regardless of how we use the transitory funds we will still need significant structural PRSI increases over the medium-term in order to pay for future ageing costs.
The government seems set on ducking this issue for a little while longer at least.