Improving the fiscal tradeoff

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.

Trends and Cycles in the Irish Economy

The shift in the fiscal debate towards a focus on the structural deficit as the key target has thrown up some interesting issues about how to think about trends and cycles in the Irish economy, plus their implications for the fiscal position.  It is certainly true that the current downturn has a big cyclical component: Minister Lenihan this morning suggested a current forecast for 2009 of about negative 6.5 percent growth in GDP.

However, it is also important to appreciate that forecasts of potential output growth for Ireland have also deteriorated.  In Autumn 2008, the European Commission projected potential output growth for Ireland of 1.6 percent per year in each of 2009 and 2010.  In the March 2010 analysis of the Irish stability programme, the European Commission’s projections for Ireland’s potential output growth had declined to negative 0.4 percent in each of 2009 and 2010: a two percentage points swing in each year.

Accordingly, it is useful to bear in mind that the current downturn involves a substantial negative shock to supply capacity,  in addition to the level of aggregate demand.  One factor relates to unemployment: increases in unemployment are difficult to reverse.  For Ireland, another factor is out-migration. Through these channels, there is a feedback effect whereby sustained declines in activity negatively affect longer-term supply capacity.

There are several implications to consider.

1.   Since the cyclical sensitivity coefficient of the budget deficit in relation to the output gap is 0.4,  an output gap in 2009 of  6.1 percent (- 6.5 percent recession relative to potential of -0.4 percent) means that the cyclical component of the 2009 budget deficit is approximately 2.5 percent.  Everything about 2.5 percent is structural.  [By the way,  2008 output  is estimated as being just above potential output: the 2008 recession just returned Ireland from a level of GDP that was well above the estimated potential level of output.]

2.  Clearly, in a deep recession, it can make sense to run some level of structural deficit as a ‘discretionary’ fiscal impulse to counter the decline in other components of aggregate demand

3.  It is also true that initial conditions matter: since we entered the recession with a sizeable structural deficit, it does not make sense to eliminate it too quickly.

4.  The March 2009 European Commission document that records the 9.5 percent deficit target also projects the output gap for 2009 at 4.5 percent.  If we update the output gap forecast to 6.1 percent, then allowing the automatic stabilisers to work means that the same target for the structural deficit would mean a revised overall deficit target of 10.2 percent (approximately).

5.  The implicit target for the structural deficit behind the 9.5 percent overall deficit was 7.7 percent of GDP. This is the challenge for the government to bring that number down over the period to 2013.

6.   It is imperative that as much as possible can be done to improve potential output growth:

(a)  A key challenge is to get unemployment down.  The various ‘activist’ labour market policies to fight unemployment that are currently being debated are worth serious consideration.  As I have argued in several previous posts, fostering rapid wage adjustment is highly desirable.

(b)  In designing the new tax system,  the promotion of labour supply is a key consideration. This is relevant in terms of the integration of tax and welfare systems for low earners and in terms of the tax treatment of highly-mobile high-skill types (maybe not so mobile in 2009 but more outside options may arise in 2010-2013).


The Autumn 2008 European Commission data are here.

The methodology behind the estimation of potential output (plus the estimates of cyclical elasticities) is here.

Implications of QNA Release for 2009

As I noted before, the Irish media and forecasters tend to focus on the year-average over year-average figure for GDP growth (averaging the four quarters of 2009 and comparing that to the average of the four quarters of 2008).   This figure is important for thinking about things like income tax revenue, which is levied on a calendar-year basis, but it can be misleading as an indicator of the economic growth taking place in the economy during a particular year.  This is because if GDP has fallen a lot coming in to the year, then the average level may be lower than the previous year, even if GDP starts to recover.

This situation exactly applies to measuring the Irish economy right now.  In news that will hardly be surprising to anyone who reads a newspaper, today’s QNA release shows that Irish GDP fell off a cliff in 2008:Q4, with seasonally adjusted real GDP falling 7.1% in 2008:Q4 relative to 2008:Q3—not at an annual rate.   This “base effect” will make the average-over-average figure for 2009 a very poor measure of underlying economic growth.  Here’s some quick calculations.  If Irish GDP stays at its 2008:Q4 level throughout the year (i.e. if we hit bottom in 2008:Q4 and managed to stay there for the year), then average-over-average GDP growth for 2009 would be exactly -5%.

Of course, all the incoming statistics suggest that the economy continued to contract rapidly in the first quarter this year—At 10.4 percent in February, the umployment rate has already risen by 1.8 percentage points since the December level, compared with an increase of 1.4 percentage points between September and December.  If GDP posted another 7 percent decline in 2009:Q1, then even a flat level of GDP for the rest of the year would imply an average-over-average growth rate of -11.6%.

An optimistic scenario would hope that the unemployment figures in the first quarter represent more of a lagged effect and hope to limit declines in the first half of the year to two percent in each of the first and second quarters, followed by a return to growth at, let’s say, a 3 percent annual rate.  This would still imply an average-over-average growth rate of -7.8% for 2009.

I think it’s time for those that use the average-over-average figures to revise their forecasts down.

Q4 2008 Macro/BOP data from CSO

The CSO has released new data today in relation to Q4 2008 and preliminary annual data for 2008.  As per Karl Whelan’s preference,  I will briefly focus on the Q42008-Q42007 annual changes.  The year-on-year decline in GDP is 7.5 percent (GNP declined by 6.7 percent).    The current account has declined from a Q42007 deficit of 5.8 percent of GDP to a trivially-small deficit of 0.3 percent of GDP in Q4 2008.

The National Accounts data release is here.

The BOP data release is here.

Brian Lucey honoured

Brian made it into the global Top 200 Young* Economists according to IDEAS/RePEc

*Active for less than 10 years