Under the Addendum to the Irish Stability Programme Update (January 2009), the deficit target for 2009 is 9.5 percent of GDP. As a result of the February exchequer returns, it looks as if the actual deficit will be about 2.5 percent of GDP higher. The government must now decide how to respond.
One approach would be to adjust taxes and spending to hit the original 2009 target. As Jim O’Leary has pointed out, achieving a 2.5 percent reduction for 2009 based on changes that will be in effect for only a portion of the year would require an adjustment closer to 3.5 percent of GDP if in place over a full year (see here). Since making permanent changes to taxes and spending part way through a year to hit a single year deficit target would be nothing short of ludicrous, I take it that the gap in question is indeed the 2.5 percent of a full year’s GDP.
In a comment on a previous post of mine, Patrick Honohan made the sensible suggestion that the government should target the structural (or cyclically adjusted) deficit. It worthwhile to return to the Addendum and consider what level of adjustment would be consistent with the framework being applied in that document.
Table 8 of the Addendum contains projections for the deficit, the cyclically adjusted deficit, real GDP growth, and the output gap (i.e. the gap between actual output and potential output as a percentage of potential output). Assuming that the actual deficit as a percentage of GDP (Def) can be written as: Def = Cyclically Adjusted Def + k(Output Gap), we can back out the value of k – -0.4 – being used in the projections. The original deficit target for 2009 comprised of a cyclically adjusted deficit of 6.7 percent of GDP and a cyclical component equal to 2.8 percent of GDP (-0.4 times a negative potential output gap of 7.1 percent of potential GDP).
A key issue is the appropriate adjustment for the recent cyclical deterioration of the economy. In the Addendum, the projected growth rate for 2009 is -4.0 percent. Recent official projections for the contraction of the economy this year have ranged from 6.0 to 6.5 percent. Taking the lower bound, this requires an additional cyclical adjustment to the deficit target of 0.8 percent of GDP (approximately -0.4 times -2 percent of GDP). (I assume here that the potential growth rate of the economy is unchanged and that the deterioration in the cyclically adjusted deficit is due to a larger than anticipated response of taxes to the bursting of the property bubble.) This would lead to a modified target of 10.3 percent of GDP and require a full-year adjustment of 1.7 percent of GDP (i.e. 2.5 – 0.8).
While still very large (I’m inclined to think too large given the fragile state of demand), this is roughly half of the 3.5 percent of GDP adjustment apparently being contemplated.