Author: John McHale

Stimulating Investment

A striking feature of the recent Quarterly National Accounts  was the dramatic fall in real investment: a 30.6 percent decline between 2007:Q4 and 2008:Q4.   The growth in real GDP over the same period was -7.5 percent.   Real investment contributed -7.3 percentage points (pp) to this change based on a standard decomposition with 2007:Q4 expenditure shares as weights.   [The contributions of the other components were: consumption (-2.0 pp); government spending (+0.1 pp); inventory investment (-1.8 pp); and net exports (+3.5 pp).]   It is worth noting that this dramatic fall in investment spending was not confined to building and construction.   In its recent Quarterly Bulletin, the Central Bank reports that overall real investment fell by 32.5 percent in 2008 (year-over-year), with building and construction investment down 35.3 percent, and machinery and equipment investment down 23.0 percent. 

Of course, investment is well known to be a volatile component of GDP.   Even so, the large decline raises concerns both because of its role in driving output below potential and also its influence on the medium-term growth path of that potential.  It is worthwhile to consider, then, what policies might be used to support private investment spending. 

One contributing factor to the decline is the contraction in the supply of credit.  Indeed, one of the central motivations for policy interventions to strengthen the balance sheets of the banks is to increase their willingness and capacity to lend.  The Central Bank’s recent Bulletin does report a modest tightening of reported credit standards between 2008:Q3 and 2008:Q4.  But the explanation for the tightening of standards is likely to lie at least as much in the problems with the balance sheets of the borrowers as with the banks.   Moreover, the deterioration in business net worth, profitability and cash flow are likely to have significantly curbed the demand for credit, explaining part of the decline in credit aggregates.

We thus need to look beyond banking policy to policy actions that might strengthen the financial condition of the non-financial business sector.   In considering possible policy actions, it is worth keeping in mind the well-supported finding from investment research that cash flow is strongly related to investment spending – particularly for smaller, less creditworthy businesses.   This is explained by various agency problems that make it hard to raise funds from financial intermediaries – problems that become more intense as the balance sheets of borrowers and the banks become weaker.    

These findings suggest the importance of examining policies that improve business cash flow.  Given the beating that business profitability has taken, cuts in corporate tax rates or investment-related tax breaks would be unlikely to have a strong stimulative effects.  However, one policy that would directly improve the cash flow (and after-tax profitability) of almost all businesses is a temporary cut in employer PRSI rates for all workers.   (Fine Gael has proposed a cut for new hires.  But this would have a very limited impact on the underlying cash flow position of businesses.)   It is hard to think of another single policy with more potential to ease the pressure on investment, production, and employment. 

Avoiding confusion on the structural deficit

It appears the government will formulate its fiscal adjustment plan around a target path for the structural deficit.  This is a good idea in principle.  But unless carefully managed it could be a recipe for confusion in practice, especially if assumptions differ from those in the Commission’s Stability Programme (March 2009). 

At present, there are differences in estimates of the structural deficit between the Department of Finance’s Addendum (January 2009), the Commission’s Stability Programme Opinion (March 2009) and the recent ESRI analysis.   Such discrepencies are not surprising given the difficulty of measuring potential output and the rapidly evolving revenue estimates.  Although the Commission’s estimates of potential output strike me as overly pessimistic, it would be wise to use Commission’s figures (suitably updated to incorporate revised tax projections) to anchor the fiscal plan.

The important point is that the government should try to achieve as much clarity as possible on its analysis of and projections for the structural deficit.  

Illustratrive contours of a possible plan:  The Commission projected a deficit of 9.5 percent of GDP for 2009.  They also estimated a structural-cyclical split of 8.1-1.4.  I assume the recent disappointing revenue numbers have added 2.5 percentage points to the ’09 projection.   In addition, the real GDP growth forecast for ’09 has been revised from -4 percent to -6.5 percent.  Using the standard methodology, the new structrual-cyclical split is 9.6-2.4. 

It is useful to distinguish between two elements in the fiscal plan.  First, the adjustment required to correct for the slippage in the structural deficit from the 8.1 percent target.  This is 1.5 percent of GDP.   Second, the plan for reducing the structural deficit from the 2009 target of 8.1 percent to 3 percent by 2013.

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.

A sane fiscal adjustment

Under the  Addendum to the Irish Stability Programme Update (January 2009), the deficit target for 2009 is 9.5 percent of GDP.    As a result of the February exchequer returns, it looks as if the actual deficit will be about 2.5 percent of GDP higher.   The government must now decide how to respond.

One approach would be to adjust taxes and spending to hit the original 2009 target.   As Jim O’Leary has pointed out, achieving a 2.5 percent reduction for 2009 based on changes that will be in effect for only a portion of the year would require an adjustment closer to 3.5 percent of GDP if in place over a full year (see here).   Since making permanent changes to taxes and spending part way through a year to hit a single year deficit target would be nothing short of ludicrous, I take it that the gap in question is indeed the 2.5 percent of a full year’s GDP.

In a comment on a previous post of mine, Patrick Honohan made the sensible suggestion that the government should target the structural (or cyclically adjusted) deficit.    It worthwhile to return to the Addendum and consider what level of adjustment would be consistent with the framework being applied in that document.  

Table 8 of the Addendum contains projections for the deficit, the cyclically adjusted deficit, real GDP growth, and the output gap (i.e. the gap between actual output and potential output as a percentage of potential output).    Assuming that the actual deficit as a percentage of GDP (Def) can be written as:  Def = Cyclically Adjusted Def + k(Output Gap), we can back out the value of k – -0.4 – being used in the projections.  The original deficit target for 2009 comprised of a cyclically adjusted deficit of 6.7 percent of GDP and a cyclical component equal to 2.8 percent of GDP (-0.4 times a negative potential output gap of 7.1 percent of potential GDP).  

A key issue is the appropriate adjustment for the recent cyclical deterioration of the economy.   In the Addendum, the projected growth rate for 2009 is -4.0 percent.    Recent official projections for the contraction of the economy this year have ranged from 6.0 to 6.5 percent.   Taking the lower bound, this requires an additional cyclical adjustment to the deficit target of 0.8 percent of GDP (approximately -0.4 times -2 percent of GDP).    (I assume here that the potential growth rate of the economy is unchanged and that the deterioration in the cyclically adjusted deficit is due to a larger than anticipated response of taxes to the bursting of the property bubble.)  This would lead to a modified target of 10.3 percent of GDP and require a full-year  adjustment of 1.7 percent of GDP (i.e.  2.5 – 0.8).   

While still very large (I’m inclined to think too large given the fragile state of demand), this is roughly half of the 3.5 percent of GDP adjustment apparently being contemplated. 

A Grand Bargain?

If media reports are to be believed, the government looks intent on pursuing a large, tax-led fiscal adjustment on April 7.  While determination to take resolute action in the face of the recent exchequer returns is understandable, I am concerned that both the size and composition of the proposed adjustment will deepen the risks facing the economy. 

(1) Size.   My first concern is that the planned adjustment is too large.   As pointed out by Jim O’Leary in Friday’s Irish Times, the adjustment is equal to a massive 3.5 percent of GDP in an already reeling economy. 

The government faces an unenviable risk-management tradeoff.   On one side, it must reduce the risk of unstable public finances.  An out-of-control deficit – with the contingent liability of the bank guarantee looming in the background – increases the risks of higher interest rates, a sudden funding stop, or an even more dramatic forced adjustment later on.   On the other side, a fiscal adjustment of this size runs the risk of intensifying the vicious cycle of contracting economic activity and falling willingness/ability to spend. 

If we assume the 9.5 percent deficit target was appropriate before the news of weaker than anticipated exchequer returns, then continuing to aim at this target means the risk-balancing response is focused only on the public-finances element.

This strikes me as extreme.  The rationale appears to be that the government has tied its credibility to keeping the deficit in single digits.   I think this stance would be correct if there were solid signs that domestic demand is stabilising.  As it is, a too-firm commitment means the government is locked into a potentially increasingly contractionary fiscal stance as the economy spirals downwards. 

(2)  Composition.  Again based on media reports, it appears that tax increases and capital investment cancellations/deferrals will bear the brunt of the adjustment.  Alesina and Perotti (1997)* refer to this as a Type-2 adjustment.   In contrast, a Type-1 adjustment focuses on cuts to the government wage bill and transfer payments.  Although credibly establishing causality with available data is challenging, the international literature has quite strongly concluded that Type-2 adjustments are both less likely to be sustained and more likely to be contractionary. 

The evidence points to both demand-side and supply-side explanations for the relative superiority of Type-1 adjustments.  On the demand side, Type-1 adjustments have a more positive effect on expected future incomes and on interest rates.  On the supply side, these adjustments tend to be more effective in reducing unit labour costs and thus in improving competitiveness.  Added to these effects, I believe there is reason to worry that a shift towards higher marginal tax rates will undermine future growth potential and lead to large deadweight losses.  (Even the relatively innocuous-sounding removal of the employee PRSI income cap will raise the marginal tax rate of those earning more than 52,000 euro by four percentage points.)  And, assuming tax rate increases reach deep down into the income distribution, there is a danger of higher equilibrium unemployment as a result of rising income replacement rates.

Is there a better way?  With a large tax-led adjustment as the default, is it possible for a union-supported “grand bargain” that is better grounded in what we know about successful fiscal adjustments?  

I believe this would be a more modest Type-1 adjustment combined with a well-specified medium-term fiscal consolidation plan.   Interestingly, this is likely to have a good deal in common with Ireland’s successful 1987-89 adjustment. 

I have no illusions about how politically difficult this would be in the poisoned aftermath of the pension levy.   However, the impressive NESC report gives some reason for hope, especially its emphasis on the power of shared understanding:

“[W]hile a fair sharing of burdens is critical to overall success, the politics that can ensure a sense of fairness (such as taxation and holding financiers to account) will not, in general, be very effective in addressing the economic crisis of firm closures and unemployment.  In this sense, the paper seeks to draw on the Council’s particular contribution to Irish policy – the willingness and ability of diverse actors to engage in honest, joint deliberation and analysis of evidence and explanations . . . It is the shared analysis that warrants an integrated response, not the joint engagement that warrants an agreed response.” (p. 5)

I urge the key actors to examine the literature on successful fiscal consolidations in forming this shared understanding.  I believe it would considerably lessen support for a Type-2 adjustment. 

Possible elements of a Type-1 adjustment adapted to Irish circumstances:

  • A 10 percent nominal wage cut and (at least) a freeze in transfer payments in real terms
  • Cancellation of capital expenditure projects where they fail a cost-benefit analysis on current information.   Deferral of projects only when there is substantial doubt about net benefits given the uncertainty about Ireland’s future trend rate of growth.   Projects with a high certainty of positive long-run net benefits should be funded now.
  • The announcement (with as much detail as possible) of phased plans to broaden the tax base (including a residential property tax and a carbon tax)
  • Announcement of plans to raise income tax revenues while limiting increases in marginal tax rates to the greatest extent possible (e.g., phasing out tax credits and child benefit payments at higher incomes)
  • Removal of tax shelters of unproven effectiveness that contribute to a sense of unfairness
  • If necessary, introduction of a Obama-style higher third rate of income tax that raises marginal tax rates only in the thin part of the income distribution
  • Announcement of plans for comprehensive pension reform to deal with what is now a major source of social insecurity

*Alesina, Alberto, and Roberto Perotti (1997), “Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects,” IMF Staff Papers, Vol 44, No. 2 (June), pp. 210-248.