Month: April 2009

It seems that the structural balance is going to be the primary target of fiscal consolidation in next week’s supplementary budget, thanks in part to the efforts of some of the contributors to this site, notably Philip Lane and Patrick Honohan. However, despite its obvious intellectual appeal, it is problamatical from an operational point of view: it is very difficult to estimate reliably. As a result, there is a fair amount of variation in current estimates of it for 2009, ranging from the lower bound of the ESRI’s 6-8% of GDP range to John McHale’s 9.6% in his post of March 30th.

Accordingly, all estimates of the structural deficit need to be treated with some caution. I think this is especially true of those that imply that a very small fraction of the prospective overall deficit for 2009 is cyclical in nature.

As any fiscal anorak will know, but perhaps not many normal readers, there are two main planks in the estimation of the cyclical (and hence the structural) element of the deficit: (i) the output gap and (ii) a measure of the sensitivity of the budget to the output gap. A word on each.

The output gap. The European Commission estimates that Ireland’s potential growth rate will be negative to the tune of 0.4% this year. This is surely a much lower figure than it is reasonable to use to represent the economy’s potential growth over the medium run. The ESRI’s latest estimate of the latter is 3%. Which one to use in calculating the output gap? If the former, it will mean a relatively small output gap and a correspondingly small estimate of the cyclical element of the deficit. Philip Lane has opted for this approach (see his post of March 26th). However, it can be argued that since the elimination of the structural deficit is properly regarded as a medium-term objective, it is the medium-term potential growth rate that should be used to estimate the output gap. The result is a bigger estimate of the output gap and a bigger cyclical component in the deficit.

The sensitivity measure. It has become commonplace to use 0.4 as the cyclical sensitivity co-efficient, implying that every 1% point change in the output gap changes the budget deficit by 0.4% of GDP through the operation of ‘automatic stabilisers’. The 0.4 is an OECD figure estimated on the basis of data for the 1980-2003 period. It is built up from a set of tax and spending elasticities with the overall tax elasticity computed as a weighted average of the elasticities of four different categories of tax, where the weights reflect the share of each in total tax receipts over the 1995-2004 period. An obvious point about this is that the composition of the 2008/09 tax take is different from that of this historical period.

A more important question is whether the elasticities so estimated accurately reflect the relationship between revenue and GDP in current circumstances. A case can be made for the proposition that the cyclical sensitivity of at least some categories of tax is higher than usual in the current recession. A very interesting comment from Niall on Patrick Honohan’s ‘Credit card sales’ post of March 31st sepaks to this point. He warns of a triple whammy undermining this year’s CT receipts, comprising (i) 2008 preliminary tax refunds; (ii) losses set back to 2007, and (iii) no preliminary receipts for 2009. In the OECD model, CT receipts are estimated to have an elasticity of 1.3. Does this chime with what’s happening out there?

To illustrate the difference that the above two points can make, consider the following arithmetic example. Assume a zero output gap in 2008, a volume decline of 8% in GDP and an overall budget deficit of 12 % of GDP in 2009. Now decompose that deficit into its cyclical and structural components using (i) a -0.4% potential growth rate and a sensitivity co-efficient of 0.4 and (ii) a 3% potential growth rate and sensitivity co-efficient of 0.5 (this being close to the OECD estimate of the EU average, by the way). In the first case, the cyclical/structural split is 3%/9%; in the second it is 5.5%/6.5%.

The retail motor trade is lobbying hard to get the government to introduce a car scrappage scheme, which would encourage people to scrap cars that are older than ten years and purchase new ones: See these pieces in yesterday’s Irish Times and the Morning Ireland interview with Alan Nolan, director of the Society of the Irish Motor Industry.

Willem Buiter discusses the plans of this sort that have been introduced in Germany, France, Italy and Spain.  He doesn’t like them—“This artificial shortening of the economic life of a car seems nuts.  It’s worse than getting paid to dig holes and fill them again.”  The case for these measures in Ireland is even weaker.  Unlike the countries listed above, we do not have car manufacturing, so this measure is largely aimed at helping a thin-margin wholesale and retail motor trade sector.

To be fair, Alan Nolan did put the case for the scrappage scheme articulately, arguing that the scheme would pay for itself by inducing new purchases and VAT revenue.  Economists, however, are always wary of claims about tax cuts and subsidies being self-financing.  In particular, schemes like this suffer from very serious “deadweight loss” problems: The government ends up subsidising lots of people who would be making the purchases anyway.

Mr. Nolan argued that since the scheme is limited to cars over 10 years old, the owners of these cars were unlikely to be in the market without this measure.  I think this could go either way.  Some people are happy to drive old cars but there is also the fact that old cars are far more likely to irretrievably break down, so their owners have no choice but to buy a new one (or take the bus …)

Beyond this small issue, there is an important general point that the government needs to be very wary of allocating increasingly scarce fiscal resources on this kind of special interest group subsidy.