Without attempting to be comprehensive, here are a few principles that are worth considering in designing the April 7th fiscal package:
1. The size of the multiplier. The current empirical literature on fiscal policy throws up a lot of estimates. Some considerations:
(a) Anticipated fiscal policy versus unanticipated fiscal policy. For a few months, Irish taxpayers have been living with a firm expectation that taxes are set to increase, albeit with considerable uncertainty about the allocation of the tax increases. The sharp fall in consumption that has occurred has many sources but expectations of future tax increases is one reason. Accordingly, the extra impact on aggregate demand of raising taxes on April 7th will be less than in the case of an ‘unanticipated’ fiscal shock (the bad news has already been digested to some degree).
(b) The composition of spending cuts and tax increases. The short-run and long-run impact on the economy varies across the different spending and tax components: the aggregate multiplier effect depends closely on the precise details of the package.
(c) A positive slope for expenditure taxes. While it is certainly important that extra taxes are collected in 2009, it is also important to be as specific as possible about the tax schedules that will be in place in 2010 (and beyond). In particular, 2009 expenditure tax rates that are credibly below 2010 expenditure tax rates will be supportive of aggregate demand in 2009 (forward shifting of expenditure plans to 2009).
2. The fiscal target.
(a) In line with the suggestion of Patrick Honohan, the key fiscal objective should be to reduce the structural deficit within a reasonable time period. While there is uncertainty about the precise size of the structural deficit, it is sensible to take the 9.4 percent of GDP estimate that is adopted by the European Commission. Pushing the structural deficit towards zero over a 3-4 year period should be the guiding principle.
(b) If the correction of the structural deficit is accepted as credible, then some passive fluctuation in the overall general government balance can be tolerated, in line with cyclical developments in the economy. Otherwise, if the government simply targets the overall balance, it faces the problem that further unexpected cyclical bad news will either force it to pursue more within-the-year adjustment or miss its announced target.
(c) In communicating its strategy to fellow European governments and the European Commission, this technocratic distinction between structural and cyclical components must be ‘front and centre.’ The good news is that the set up of the Stability and Growth Pact and the monitoring conducted by the European Commission takes such distinctions very seriously and the ‘framing’ of the analysis in this way would be a very natural communications strategy in this context.
3. Front Loading. In an ideal world, it is better to make structural reforms during good times. It would also be better if Ireland had entered the crisis with a sufficiently large budget surplus that a large budget swing could be happily tolerated, with fiscal correction deferred until the recovery takes. However, there are domesic and international factors that support making substantial inroads in the structural deficit in 2009:
(a) Funding Risk. While there are arguments that can be made that Irish bond spreads are an over-reaction to the fiscal/banking situation, we have to live with the judgement of the bond market. Moreover, the risk of ‘contagion’ from possible problems in Central and Eastern Europe should be acknowledged. While such risks are hard to quantify, the high costs of funding crises justify prudential action to mitigate these risks.
(b) Signalling. While the government has implemented some degree of fiscal tightening since Summer 2008, a central source of scepticism in the international markets is whether Ireland can make the switch from a long period of easy fiscal conditions to substantial fiscal retrenchment. The most credible way to demonstrate this capacity is to implement tough decisions.
(c) Domestic Political Economy. By now, the level of awareness of the fiscal problem is much higher among the electorate than was the case in Summer 2008. It is timely to make a significant step forward in the process of restoring fiscal stability.
4. Commitments about the Future.
(a) The tradition in Ireland has been to focus on an annual time frame for budgetary policy. It would greatly help if the April 7th package could include credible commitments about taxes and spending plans in 2010 and beyond. To be credible, the announced tax increases and spending cuts for 2010 and beyond should be as detailed as possible, in order to minimise ambiguity. Moreover, the more credible is the ‘2010 and beyond’ element in the adjustment programme, the smaller needs be the initial fiscal adjustment in 2009.
(b) It is here that the opposition parties have an important role to play, since the period of fiscal retrenchment will likely extend beyond the next general election (whenever that is called). It would greatly calm the markets if the opposition parties could be clear about which elements of the spending/tax package would not be overturned if the composition of the government changed. The historical example is the promise by ‘New Labour’ before the 1997 election to maintain the fiscal parameters of the outgoing Conservative government for it first few years in office.
(c) Credibility about future fiscal plans could be boosted by institutional reforms that would make it more difficult for the government to deviate from its fiscal commitments.