With so much being said and written about the budget this week, forgive me for putting in my two cents worth. From a macro perspective, the key trade-off going into the budget was always going to be between gaining credit worthiness and losing economic growth. Oversimplifying a bit, the former called for a larger adjustment; the latter a smaller one. However, it would be possible to improve this trade-off with a judicious composition of tax and expenditure changes. How did Minister Lenihan do?
On size, I think the adjustment was at the upper end of the reasonable range. Karl Whelan – and indeed the Minister himself in slightly different terms – has noted the budget restores the original 9.5 percent of GDP target if in place for a full year. Another way to look at it is in terms of the much-maligned structural deficit. (As an aside, it is hard to recall the star of an economic concept fading so fast as the structural deficit, with George Lee even amusingly referring to it as “voodoo economics.”) But if you look at the macroeconomic framework document made available by the Department of Finance, it seems the structural deficit target played an essential role behind the scenes in determining the size of the adjustment. In the update to the Stability Programme, the actual deficit was projected at 9.5 percent of GDP and the structural deficit was projected at 8.1 percent of GDP. These projections then slipped on evidence from the most recent exchequer returns to 12.75 percent and 10.25 percent respectively. The framework document projects that the budget brings the structural deficit back down to 8.2 percent – effectively the original target. It is important to note that this is the projection for the structural deficit for 2009, and not what it would be if it were in place for a full year. For this reason, the Minister has got a start – something in the order of one percent of GDP – in lowering the structural deficit from 8.2 percent in 2010.
By the Department’s own estimate, the budget will knock a percentage point of GDP growth for 2009. This is quite a hit given the measures will only be in place for seven months and only reflect a very short-term multiplier effect. Even so, given the precarious state of national creditworthiness, and the credibility advantage of adhering to the stability programme’s target for the structural deficit, I see the size of the adjustment as appropriate.
I am less impressed by the composition of the adjustment. As has been pointed out by many commentators, the weight of empirical evidence shows that fiscal adjustments based on tax rises and capital expenditure cuts tend to be more contractionary and less durable than adjustments based on cuts to the government wage bill and transfer payments. There is particular reason to worry about the supply-side effects of this budget. The increase in marginal tax rates over a significant portion of the income distribution is large relative to the revenue raised. Workers earning 52,000 euro, for example, saw their marginal tax rate rise from 44 [41 higher rate + 1 income levy + 2 health levy + 0 PRSI] percent to 51 percent [41+2+4+4]. Given that the deadweight loss of the income tax rises with the square of the marginal tax rate – which means the added burden of a given rate increase is greater that higher the tax rate is to begin with – we must worry about the large welfare cost of this rate increase. Added to this, higher taxes are likely to impact wage setting and job search, with resulting adverse effects on competiveness and unemployment.
Another way the trade-off could have been improved was with well-specified multi-year plan. Without minimising the difficulty of projecting the revenues from new revenue sources such as carbon and property taxes, I think more should have been done to reduce the lingering uncertainty about how severe the ultimate adjustment is going to be.
Finally, the Minister missed the opportunity for innovative temporary stimulus measures that a more thoroughgoing focus on the structural deficit would have allowed. My candidates for such measures were a temporary reduction in VAT rates and a temporary reduction in employer PRSI. I believe each would have an offsetting stimulus effect without undermining the path to a 3 percent structural deficit by 2013.
Overall, a mixed bag.
8 replies on “Thoughts on the budget”
The Irish Economy » Blog Archive » Thoughts on the budget…
With so much being said and written about the budget this week, forgive me for putting in my two cents worth. From a macro perspective, the key trade-off going into the budget was always going to be between gaining credit worthiness and losing econom…
John,
Please look all of your readers right in the eye, put your hand on your heart, and say:
“I insist that my proposed reductions in VAT rates and employer PRSI must be temporary.”
(For extra marks, do so while maintaining a straight face and without adding a qualifier such as “like the temporary income levies!”)
When anyone talks of “temporary” tax adjustments all he does is leave hostages to fortune and sow future confusion. The previous two US Presidents have demonstrated that in grand style for today’s Congress: Am I against not wanting to cut taxes, or am I in favour of not letting the temporary suspension of the proposed increase to lapse?
Tactics change as circumstances change, but if you have an overarching strategy, then spell it out and try to stick to it. You don’t really want any sort of “temporary” VAT or PRSI relief, honestly, do you? And, if you don’t, who benefits when you pretend you do?
@ben
Ooooh! Talk about arch! Perfectly correct, but you will find, as I did, no one likes those who talk straight as you mess up too many hidden agenda! I think you knew already, hence the single name?
Well done.
In defence of the government, it was only a supplementary budget. They have only a few weapons handy and some may not be necessary, (they hope!) and there can always be another supplementary….
The next full Budget is where you can sharpen your steel. I expect a worsening, so you won’t go short of targets!
Incidentally, you don’t actually trust Departmental estimates, do you? From experience, the Department will only advise what it has been told to advise. So an estimate will include whatever data, revisions and assumptions that they have been told to include. Or else no promotee, see!
People have been calling for a multi-year plan for well, multi-years!
Fat chance as it would prevent last minute contributions from the government’s backers! And I mean that in the sense of monetary and other support!
Now you know what microeconomic means to government ministers! Fivers (500Euro) in the pocket.
The term “Budget” is, probably, a misnomer. This exercise was advertised, and presented, as setting the parameters for economic recovery over a 5 year timescale. This included (1) a process for restoring some fiscal stability, (2) a means of regaining some credibility with international capital markets, (3) a plan to clean up the banks in a manner that would allow them to perform their normal financial intermediation role, (4) a modest proposal to boost some economic activity in the construction sector and (5) finally, and most importantly – but like the love that dare not speak its name – to give Fianna Fail a sporting chance of continuing in its self-ordained role as “the natural party of government”.
As the oirginal post indicates the deficit gap-closing seems about right, but the balance between tax increases and expenditure cuts is skewed because it adds to Ireland’s cost base rather than reducing it, so international competitiveness is damaged. International capital markets may note that something is being done at last after months of drift, but it is unlikley to reduce the spreads on sovereign debts when NAMA is factored in.
Other threads on this site are examining NAMA very intently, but it appears to be a choice between creepinmg nationalisation and immediate nationalisation. The proposal to tap private sector funds to part-finance construction sector activity has potential for much wider application to finance a badly-needed infrastructure investment stimulus programme.
On the protection of Fianna Fail it scores highly. Tax increases are being applied progressively to all income earners, so no specific group can act as a catalyst for public anger. Expenditure cuts have been largely postponed and are likely to be applied eventually so that everyone is again hit in a progressive fashion. Bank nationalisation is being kept off the agenda and the Government can preent itself internationally as being pro-active and forward-looking.
The reality is that this approach will drive the economy into a deeper hole and it entrenches the cost barriers and infrastructure deficiencies that will prevent the economy taking advantage of any eventual global upturn. What is required is a full sell-off of the semi-states to partly compensate for the huge increase in debt on the Government’s balance sheet that NAMA will entail and privatisation, with regulatory reform, could be applied to reduce the excessive utility cost base. Private sector funds could be mobilised to finance a major investment stimulus. And public expenditure will have to be tackled seriously, but it must be accompanied by measures to empower citizens, both individually and collectively, to do more for themselves.
@John
Yours is the first post critical of Tueday’s supplementary budget from any contributor to this site. For such a target rich zone, I find this a bit puzzling. Anyway, a few comments on your observations.
1. The 2% of GDP adjustment was plumped up a bit by creative accounting. Almost €1bn of pension fund net assets (universities and certain other semi-state bodies) were transfered to the management of the NTMA and this, under Eurostat rules, allowed what would otherwise have been a 1.6% adjustment become 2%. Moreover, the DoF’s estimate significantly downplays the second-round impact of Tuesday’s package on tax receipts: tax hikes and spending cuts totalling €3.3bn are assumed to generate negative tax ‘buoyancy’ of just €580m. The factor used here (0.18) is a good deal lower than the equivalent factor used in previous budgets, typically of the order of 0.30.
2. Even allowing for this, I agree that the incremental adjustment represented by Tuedsay’s measures is about as much as could reasonable have been expected in the circumstances but, as has been argued on this site in recent weeks, there is a strong case for front-loading the remaining adjustment. So, why not aim to make lots of progress next year? This, Tuesday’s exercise signally failed to do. The projected deficit for next year, at 10.75%, is the same as this year’s projected outturn (which, incidentally, I believe will be decisively overshot). Moreover, the structural deficit for next year is projected to be just 0.7% of GDP below this year’s 8.2% forecast. This is remarkably unambitious.
3. Your point about marginal tax rates is well made. For some categories of earners, MTR’s are now back at levels not seen since the early 1990s. Single earners on around twice the industrial average, for example, now face an all-in MTR of 51%, its highest value for such earners since 1993. The position is not so dramatic for married couples but still MTRs for those earning more than twice the industrial average are now higher than they’ve been for more than a decade.
4. A related point, and one that is made in today’s Irish Times by Tim Callan et al, is that the 2009 budget package is highly redistributive. Taking Tuesday’s measures and the earlier ones together, the ESRI team estimate that the disposable income of the poorest quintile of the population will be boosted to the tune of almost 5% while the disposable income of the richest quintile will be reduced by over 7% (all relative to what they call a ‘wage-indexed’ budget.
http://www.irishtimes.com/newspaper/finance/2009/0410/1224244350714.html
@Jim The Callan et al. measurement of the progressivity of this budget is indeed striking. If the intention is to come back in December and engage the less progressive measures (tax credits, child benefit, indexing of social welfare rates, etc.), it will be politically very difficult to do. Now was the time to do it as part of an overall package that clearly hit hard on the better off — comprehensiveness was supposed to be the hallmark of this budget. Even if these measures were impossible to implement mid-year, firm announcements of changes for next year could have been made. This would have avoided having to make them in relative isolation in the December budget. This is not to say that it was wrong to pursue a progressive budget overall; but the degree of imbalance is surprising given the size of the hole to be filled and the shared interest in restoring a high growth/employment economy.