I apologise for yet another post on fiscal policy. But it is better to err on the side of too much with crunch-time less than two weeks away. I sense wide agreement on the two most pressing goals for the April 7 budget: minimise the contractionary impulse; and maximise the positive impact on creditworthiness. Unfortunately, these goals tend to pull apart in terms of their implications for the optimal size of the adjustment. I read much of the recent fiscal-related discussion on the blog as exploring ways to lessen this tradeoff. It seems worthwhile to gather a number of the ideas together.
(1) Emphasise Type-1 adjustment (wage bill and transfer reductions) over Type-2 adjustment (tax increases and deferrals of positive net-benefit capital projects. The international evidence (and arguably Ireland’s own experience) shows that Type-1 adjustments are better sustained and less contractionary. This would allow either a smaller overall adjustment for any given target for creditworthiness, or a greater boost to creditworthiness for any given size of adjustment.
(2) Front-load certain structural deficit reduction measures but combine them with a temporary stabilisation offset. Take immediate actions to lower the structural deficit to boost credibility. Such actions could include increases in income tax rates or decreases in public-sector wages. Combine these measures with explicitly temporary stimulus measures. Possible measures include temporary reductions in VAT rates (which should move some expenditure forward in time) or temporary reductions in employer PRSI rates.
(3) Pre-announce detailed plans for back-loaded structural deficit reduction measures. In a post some time back I advocated a degree of “constructive ambiguity” on the details of out-year plans to raise taxes and cut spending. I was rightly chastised for this economics heresy. A detailed plan is critical to the credibility of the programme. (I now put my hopes in liquidity constraints rather than myopia to lessen the contractionary effects of lower expected after-tax/benefit incomes.)
(4) Reform fiscal institutions to enhance the credibility of future deficit reduction. In general, credibility is improved by emphasising fiscal rules over annual discretion. (An example would be a requirement to keep the pension system in balance over a long-time horizon. Imbalances would require currently legislated actions such as indexing retirement age to longevity.) It would also help to move to a system of multi-annual budgets.
(5) Introduce a notional defined contribution (NDC) pension pillar. This provides a long-lasting revenue injection with relatively benign demand- and supply-side effects. Properly designed, it would not add to long-term fiscal imbalances. It also meets a pre-existing need to improve retirement income security. It should be a valuable component of an overall package from a union perspective.
(6) Formulate the plan in terms of a revised Stability Programme for the European Commission. The plan should focus on achieving a 3 percent target for the structural deficit by 2013. A focus on the structural deficit allows for a more politically robust programme and thereby enhances credibility. It would also help to signal that the government takes its obligations under the SGP very seriously.