The February exchequer returns combined with ongoing default risk perceptions mean the government has little choice but to bring forward its fiscal adjustment. I have doubts, however, about one argument for front-loading the adjustment that seems to be gaining currency – that it will be expansionary.
The classic argument for an expansionary fiscal contraction focuses on cuts to government spending. Permanent cuts in government spending lead to expectations of permanent cuts in taxes. The expenditure effect of the latter can outweigh the former (especially if starting from a large and distorting tax burden). In contrast, the current Irish debate is focused on adjustment through tax increases. With apologies for oversimplifying, the argument seems to be that households and businesses already expect higher taxes, but uncertainty about the precise nature of those taxes is causing increased precautionary savings and investment delays. Eliminating this uncertainty would lead to increased domestic demand.
Two comments: First, if the economy contains a significant share of myopic/liquidity-constrained individuals as well as forward-looking Ricardians, the reduced precautionary savings effect of the latter would have be very strong to offset the reduced spending of the former. Second, and less speculatively, the empirical work of Alberto Alesina, Roberto Perotti and co-authors finds that fiscal adjustments based on tax increases tend to be less durable and more likely to be contractionary.
I draw two tentative lessons. The first is that a cautious approach should be taken to front-loading until we understand better the role of discretionary fiscal contraction in the extremely sharp slowing of the economy. The second is that a narrow intertemporal macro perspective suggests a significant part of any adjustment burden should fall on expenditure. I would be very interested to hear views on the relevance of the expansionary fiscal contraction hypothesis to the current Irish situation.