A Grand Bargain?

If media reports are to be believed, the government looks intent on pursuing a large, tax-led fiscal adjustment on April 7.  While determination to take resolute action in the face of the recent exchequer returns is understandable, I am concerned that both the size and composition of the proposed adjustment will deepen the risks facing the economy. 

(1) Size.   My first concern is that the planned adjustment is too large.   As pointed out by Jim O’Leary in Friday’s Irish Times, the adjustment is equal to a massive 3.5 percent of GDP in an already reeling economy. 

The government faces an unenviable risk-management tradeoff.   On one side, it must reduce the risk of unstable public finances.  An out-of-control deficit – with the contingent liability of the bank guarantee looming in the background – increases the risks of higher interest rates, a sudden funding stop, or an even more dramatic forced adjustment later on.   On the other side, a fiscal adjustment of this size runs the risk of intensifying the vicious cycle of contracting economic activity and falling willingness/ability to spend. 

If we assume the 9.5 percent deficit target was appropriate before the news of weaker than anticipated exchequer returns, then continuing to aim at this target means the risk-balancing response is focused only on the public-finances element.

This strikes me as extreme.  The rationale appears to be that the government has tied its credibility to keeping the deficit in single digits.   I think this stance would be correct if there were solid signs that domestic demand is stabilising.  As it is, a too-firm commitment means the government is locked into a potentially increasingly contractionary fiscal stance as the economy spirals downwards. 

(2)  Composition.  Again based on media reports, it appears that tax increases and capital investment cancellations/deferrals will bear the brunt of the adjustment.  Alesina and Perotti (1997)* refer to this as a Type-2 adjustment.   In contrast, a Type-1 adjustment focuses on cuts to the government wage bill and transfer payments.  Although credibly establishing causality with available data is challenging, the international literature has quite strongly concluded that Type-2 adjustments are both less likely to be sustained and more likely to be contractionary. 

The evidence points to both demand-side and supply-side explanations for the relative superiority of Type-1 adjustments.  On the demand side, Type-1 adjustments have a more positive effect on expected future incomes and on interest rates.  On the supply side, these adjustments tend to be more effective in reducing unit labour costs and thus in improving competitiveness.  Added to these effects, I believe there is reason to worry that a shift towards higher marginal tax rates will undermine future growth potential and lead to large deadweight losses.  (Even the relatively innocuous-sounding removal of the employee PRSI income cap will raise the marginal tax rate of those earning more than 52,000 euro by four percentage points.)  And, assuming tax rate increases reach deep down into the income distribution, there is a danger of higher equilibrium unemployment as a result of rising income replacement rates.

Is there a better way?  With a large tax-led adjustment as the default, is it possible for a union-supported “grand bargain” that is better grounded in what we know about successful fiscal adjustments?  

I believe this would be a more modest Type-1 adjustment combined with a well-specified medium-term fiscal consolidation plan.   Interestingly, this is likely to have a good deal in common with Ireland’s successful 1987-89 adjustment. 

I have no illusions about how politically difficult this would be in the poisoned aftermath of the pension levy.   However, the impressive NESC report gives some reason for hope, especially its emphasis on the power of shared understanding:

“[W]hile a fair sharing of burdens is critical to overall success, the politics that can ensure a sense of fairness (such as taxation and holding financiers to account) will not, in general, be very effective in addressing the economic crisis of firm closures and unemployment.  In this sense, the paper seeks to draw on the Council’s particular contribution to Irish policy – the willingness and ability of diverse actors to engage in honest, joint deliberation and analysis of evidence and explanations . . . It is the shared analysis that warrants an integrated response, not the joint engagement that warrants an agreed response.” (p. 5)

I urge the key actors to examine the literature on successful fiscal consolidations in forming this shared understanding.  I believe it would considerably lessen support for a Type-2 adjustment. 

Possible elements of a Type-1 adjustment adapted to Irish circumstances:

• A 10 percent nominal wage cut and (at least) a freeze in transfer payments in real terms
• Cancellation of capital expenditure projects where they fail a cost-benefit analysis on current information.   Deferral of projects only when there is substantial doubt about net benefits given the uncertainty about Ireland’s future trend rate of growth.   Projects with a high certainty of positive long-run net benefits should be funded now.
• The announcement (with as much detail as possible) of phased plans to broaden the tax base (including a residential property tax and a carbon tax)
• Announcement of plans to raise income tax revenues while limiting increases in marginal tax rates to the greatest extent possible (e.g., phasing out tax credits and child benefit payments at higher incomes)
• Removal of tax shelters of unproven effectiveness that contribute to a sense of unfairness
• If necessary, introduction of a Obama-style higher third rate of income tax that raises marginal tax rates only in the thin part of the income distribution
• Announcement of plans for comprehensive pension reform to deal with what is now a major source of social insecurity

*Alesina, Alberto, and Roberto Perotti (1997), “Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects,” IMF Staff Papers, Vol 44, No. 2 (June), pp. 210-248.